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 (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.
Chesapeake has had pretty wild fluctuations in its earnings and free cash flow over the past few years. Of course, this is to be expected of natural gas producers during what was a global 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 has higher leverage than its peers, yet it doesn't appear to have generated above-average returns on equity to show for it.
Chesapeake's chairman and CEO, Aubrey McClendon, has been at the job since 1989, though the high-profile spat over his pay and benefits probably wouldn't endear him to Buffett.
Natural gas production isn't generally an industry considered particularly ripe for massive technological disruption.
The Foolish conclusion
So is Chesapeake a Buffett stock? Probably not. The company may operate in a straightforward industry, but it doesn't especially exhibit the other characteristics of a quintessential Buffett investment: consistent earnings and high returns on equity with limited debt. However, if you'd like 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 by clicking here.
At the time thisarticle was published Ilan Moscovitzdoesn't own shares of any company mentioned.You can follow him on Twitter@TMFDada.Motley Fool newsletter serviceshave recommended buying shares of Chesapeake Energy. 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.
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