As the world's third-richest person and most celebrated investor, Warren Buffett attracts a lot of attention. Thousands try to glean what they can from his thinking processes and track his investments.
We can't know for sure whether Buffett is about to buy Chesapeake Energy (NYS: CHK) -- he hasn't specifically mentioned anything about it to me -- but we can discover whether it's the sort of stock that might interest him. Answering that question could also reveal whether it's a stock that should interest us. In this series, we do just that.
Writing in a recent 10-K, Buffett lays out the qualities he looks for in an investment. In addition to adequate size, proven management, and a reasonable valuation, he demands:
- Consistent earnings power.
- Good returns on equity with limited or no debt.
- Management in place.
- Simple, non-techno-mumbo-jumbo businesses.
Does Chesapeake meet Buffett's standards?
1. Earnings power
Buffett is famous for betting on a sure thing. For that reason, he likes to see companies with demonstrated earnings stability.
Let's examine Chesapeake's earnings and free cash flow history:
Source: S&P Capital IQ.
Over at least the past five years, Chesapeake's earnings have been volatile because of rocky natural gas prices. Free cash flow fell over the past couple of years, mostly because of ramped-up capital expenditures that had been curtailed during the 2009 recession.
2. Return on equity and debt
Return on equity is a great metric for measuring both management's effectiveness and the strength of a company's competitive advantage or disadvantage -- a classic Buffett consideration. When considering return on equity, it's important to make sure a company doesn't have an enormous debt burden, because that will skew your calculations and make the company look much more efficient than it is.
Since competitive strength is a comparison between peers, and various industries have different levels of profitability and require different levels of debt, it helps to use an industry context.
Return on Equity
5-Year Average Return on Equity
Source: S&P Capital IQ.
Chesapeake generates a moderately low return on equity while carrying a moderate amount of debt.
CEO Aubrey McCelndon co-founded the company in 1989. Unfortunately, he's been at the center of numerous scandals, including having board of directors award him a special bonus that helped cover his margin losses during the financial crisis and buying his private maps collection, and more recently we learned of a special deal that gave him access to private-well ownership and revelations that he'd run a secret hedge fund out of Chesapeake offices.
Dry bulk carriers and drilling rigs aren't particularly susceptible to technological disruption, though the industry can be subject to a fair bit of cyclicality, as we've seen.
The Foolish conclusion
So is Chesapeake a Buffett stock? Probably not. Although the company operates in a technologically straightforward industry and has a tenured CEO, its shareholder unfriendliness would be a massive turnoff to Buffett. Nor does it particularly exhibit the other characteristics of a quintessential Buffett investment: consistent earnings and high returns on equity with limited debt. To stay up to speed on Chesapeake's progress, simply add it to your stock Watchlist. If you don't have one yet, you can create a Watchlist of your favorite stocks.
At the time this article was published Ilan Moscovitz doesn't own shares of any company mentioned. You can follow him on Twitter, where he goes by @TMFDada. Motley Fool newsletter services have recommended buying shares of Chesapeake Energy. The Motley Fool has a disclosure policy. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.
Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.