Passing the Buffett Test

05/24/2010 11:18 am EST

Focus: STOCKS

John Reese

Founder and CEO, Validea.com And Validea Capital Management

John Reese, editor of Validea Hot List, says a London-based pharmaceutical company meets many of the criteria Warren Buffett would look at before buying a stock.

AstraZeneca PLC (NYSE: AZN) is a biopharmaceutical company. The company focuses on the discovery, development, and commercialization of prescription medicines for six areas of health care. Its six areas of health care include cardiovascular, gastrointestinal, infection, neuroscience, oncology, and respiratory and inflammation. [Its] products include Crestor, Nexium, Synagis, Seroquel, Arimidex and Symbicort. The Company owns and operates a range of research and development (R&D), production and marketing facilities worldwide.

Buffett likes companies to have solid, stable earnings that are continually expanding. This allows him to accurately predict future earnings. Buffett would consider AZN's earnings predictable, although earnings have declined [twice] in the past seven years, with the most recent decline three years ago. AZN's long-term historical [earnings per share] growth rate is 16.7%.

Buffett likes companies that are conservatively financed. Nonetheless, he has invested in companies with large financing divisions and in firms with rather high levels of debt. AZN has a debt of [$9 billion] and earnings of [$8 billion], which could be used to pay off the debt in less than two years, which is considered exceptional.

[He also] likes companies with above-average return on equity (ROE) of at least 15% or better, as this is an indicator that the company has a durable competitive advantage. US corporations have, on average, returned about 12% on equity over the last 30 years. The average ROE for AZN, over the last ten years, is 26.4%, which is high enough to pass.

For non-financial companies Buffett also requires that the average return on total capital (ROTC) be at least 12% and consistent. ROTC is defined as the net earnings of the business divided by the total capital in the business, both equity and debt. The average ROTC for AZN, over the last ten years, is 21.2% and the average ROTC over the past three years is 23.1%, which is high enough to pass.

Buffett likes to see if management has spent retained earnings in a way that benefits shareholders. To figure this out, he takes the total amount of retained earnings over the previous ten years of $13.27 and compares it to the gain in EPS over the same period of $4.68. AZN's management has proven it can earn shareholders a 35.3% return on the earnings they kept. This return is more than acceptable to Buffett. Essentially, management is doing a great job putting the retained earnings to work.

Based on two different methods [of calculating it], you could expect an annual compounding rate of return somewhere between 14.9% and 20.3%. To pinpoint the average return a little better, we have taken an average of the two different methods. Investors could expect an average return of 17.6% on AZN stock for the next ten years, based on the current fundamentals. Buffett would consider this a great return, thus passing the criterion.

(AstraZeneca closed above $41.50 Friday—Editor.)

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