Is Pepco a Buffett Stock?

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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 Pepco (NYS: POM) -- 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 his most 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:

  1. Consistent earnings power.
  2. Good returns on equity with limited or no debt.
  3. Management in place.
  4. Simple, non-techno-mumbo-jumbo businesses.

Does Pepco 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 Pepco's earnings and free cash flow history:

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Source: S&P Capital IQ.

With the exception of 2010, when Pepco took an accounting charge due to early extinguishment of some debt, it's generated fairly consistent earnings. The free cash flow shortfalls over the past few years have been due to heavy capital investments.

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-to-equity ratio, because that will skew your calculations and make the company look much more efficient than it is.

The electric utility industry is fairly capital-intensive and doesn't tend to generate particularly high returns on equity. Still, Pepco's -- 6% over the past year, 5% on average over the past five years -- lags a lot of its peers'. At 116%, the company's debt-to-equity ratio is slightly below many other electric utilities'.

3. Management
CEO Joe Rigby has been at the job since 2009, though he's held lots of other positions at Pepco and other utilities over the decades.

4. Business
For now, electricity generation isn't particularly susceptible to technological disruption. Buffett's company actually owns another utility, MidAmerican Energy.

The Foolish conclusion
So is Pepco a Buffett stock? Probably not. Although the company operates in a straightforward industry and generates fairly consistent earnings, it doesn't particularly exhibit some of the other quintessential characteristics of a Buffett investment: high returns on equity with limited debt and tenured management. However, if you're interested in a stock that our top analysts and chief investment officer picked to beat the market, you can check out The Motley Fool's Top Stock for 2012. I invite you to download this special report for a limited time by clicking here -- it's free.

At the time this article was published Ilan Moscovitzdoesn't own shares of any company mentioned.Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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