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Sequoia Fund: The 4 Qualities to Look for in a Stock

- By Rupert Hargreaves

In the late 1960s, after just over a decade of managing money for partners, Warren Buffett (Trades, Portfolio) decided to exit the money management business. According to his letters from the time, Buffett decided to return capital to investors primarily because it was becoming harder and harder to find attractive investments.

Rather than break his own rules and invest in weaker companies, or impact his track record, Buffett decided the better course of action was to return capital to shareholders. This included distributing the shares in a little-known textile business called Berkshire Hathaway (BRK-A)(BRK-B), which Buffett had started buying as a cigar butt in the early 1960s and taken control of in the middle of the decade after falling out with management, but that's another story.

Buffett and Bill Ruane

Buffett told his partners that if they wanted to keep their money invested, a close friend of his, and astute value investor, Bill Ruane would be setting up his own partnership to take over the management of the funds. Ruane set up the Sequoia Fund, which has since become one of the world's greatest value success stories.

Ruane's strategy was very similar to Buffett's from the beginning, and he set out the four investment rules the fund would follow in a note sent out to partners several years after the firm first started trading.

The first factor the firm looked for in an investment was the mark of it being a "good business."

The single most important indicator of a good business is, according to the note, its return on capital:

"We believe that in almost every case in which a company earns a superior return capital over a long period of time it is because it enjoys a unique, propriety position in its industry and has outstanding management. The ability to earn a high return on capital means that the earnings which are not paid out as dividends but rather retained in the business are likely to be reinvested at a high rate of return to provide for good future earnings and equity growth."

The second factor Ruane and team were looking for was " pricing flexibility." The team strongly believed inflation was one of the biggest risks investors faced at the time and, therefore, it was essential to own stocks that could increase prices in line with inflation:

"If our assumption is born out, the pricing flexibility of companies with dominant market positions (in some instances oligopolies or even monopolies such as television stations and newspapers) will provide an important hedge against inflation."

Ruane and his analysts also wanted to invest in companies that were net cash generators. They believed it was essential to distinguish between reported earnings and cash earnings, particularly during periods of rapid inflation where "many companies must use a substantial portion of earnings for forced reinvestment in the business merely to maintain plant and equipment and present earnings power."

Unlike reported earnings, "cash earnings are those earnings which are truly available for investment in additional earning assets, or for payment to stockholders."

The final factor Sequoia wanted to see in a potential investment was a "modest price." Specifically, on this point the investment philosophy note declares:

"While price risk cannot be eliminated altogether, we believe that it can be lessened materially by avoiding high multiple stocks whose price-earnings ratios are subject to enormous pressure if anticipated earnings growth does not materialize."

These four factors are not particularly complex or difficult to understand, but when put together, they provide a robust framework for finding high-quality businesses trading at attractive prices.

Disclosure: The author owns shares of Berkshire Hathaway.

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This article first appeared on GuruFocus.