What Does Warren Buffett’s Investment Strategy Look Like?
A student and employee of Benjamin Graham, Buffett is the brain-child of the original value investor. But what exactly is value investing?
The simple answer is value investors look for shares or companies that are value below their intrinsic value.
This is where things get slightly lost and people go their own way, including Buffett and Graham.
What is the intrinsic value of a company? Well, numerous investors have their own take on things. Understanding the intrinsic value of a business requires understanding what the bare bones of the business are made up of. This is why analysing companies intrinsic value require checking out the fundamentals of the business.
In a nutshell, value investors are looking for companies that are undervalued and under-appreciated by people, investors, and the stock market.
So, How Does Warren Buffett Choose His Stocks?
Analysing Company Performance
One primary way Buffett chooses his stocks is by analysing company performance. Buffett has said that the perfect company would have these three characteristics:
- High returns on current capital,
- Opportunities to reinvest capital and;
- High rates of return on capital.
Warren Buffett has also stated that he keeps an eye out for management teams that are competent and aligned.
Buffett believes that Return On Equity (ROE) indicates strong performance relative to competitors in the same industry. Basically, a higher ROE in the same industry most likely means that a company is doing something right that distinguishes it from its competitors, and is a good sign of a sustainable competitive advantage.
Typically, the most relevant ROE values are from the past 5 to 10 years of the companies performance. What you want to see is consistent growth and continually growing earnings.
Is The Company In Debt?
Sounds pretty obvious but plenty of investors don’t have a problem with big debts as long as the company has them covered. Buffett’s favourite ratio here is the debt/equity ratio. He has traditionally preferred businesses with low debts, so the company is demonstrating how the revenues it is delivering come from the equity shareholders have stumped up.
Read More: A Brief History Of The Oracle’s Success
Checking the debt-to-equity levels is calculated by:
Total Liabilities / Shareholders Equity
This demos the proportion of equity and debt the company is using to finance its asset. So the higher the ratio, the more debt. Where debts are high, the company is less able to pay back quickly and will end up paying larger interest payments on those debts. It’s a bit like that student loan that seems to be getting bigger even though you stopped studying 7 years ago.
However, debt is not always a pure negative in a company, it’s only when servicing that debt eats through a lot of earnings.
What Do the Profit Margins Look Like?
Like most investors, Buffett is looking for profitable companies. More than anything, he wants to see companies that are growing their profit margins.
Profit margins are calculated using the following:
Profit margin = net income / net sales
Buffett will be looking for a decent track record and some strong indication of it happening more in the future. Rising profit margins tend to mean a management team that has their business on lockdown.
Profitability does not just mean coming out positive after subtracting expenses from revenue. It means that a company’s profits show continual growth.
It is usually best to consider the rate of growth of the profit margin over a suitable amount of time, Buffett prefers at least 10 years.
High profits indicate that a company does their job very well, but a continually increasing profit margin indicates good leadership and a highly efficient organizational structure.
There is no doubt Buffett is driven by value but what sets him apart is his willingness to ignore the party and parade and just get to know the company he is investing in. While Value Investing is by no means full-proof and has its flaws – particularly in an increasingly tech-growth charged world – Buffett’s ability to deliver returns across decades tells you everything you need to know.
Companies with Competitive Advantages
Companies with pricing power, strategic assets, powerful brands, or other competitive advantages have the ability to outperform in good and challenging times. A long term investing strategy requires investing in companies that can weather both good and bad economic times.
Is There an Attractive Unique Selling Proposition (USP)?
Building a brand is a difficult process. If you are starting out in a saturated industry then finding a unique identity that will distinguish your company from other competitors can be hard but it is necessary to come out on top.
Buffett looks explicitly from companies that possess attributes, assets, and abilities that are very hard to imitate and replicate. This is part of Buffett’s understanding of competitive advantage.
Companies that have a good competitive advantage have a large “moat” and are more resistant to other companies taking shares of the market. This is because the company has a unique fingerprint that distinguishes it from others.
Invest in What You Understand
Buffet only invests in companies he understands and believes have stable or predictable products for the next 10 – 15 years. This is why he has typically avoided technology companies.
Is The Company A Consistent Performer?
Buffett wants to own a business that has returned money back to investors consistently and who can blame him. The measure most people use (and Buffett uses himself) is the Return on Equity (ROE).
How is ROE calculated?
ROE = Net Income / Shareholders Equity
But Buffett looks at the ROE over a 10-15 year period and one that is heading the right direction.
Compounding and Patience
Buffet believes in long term value investing because he understands the power of exponential growth. Companies with sustainable profits can pay and grow their dividends. Nothing more beautiful or powerful long-term investing strategies than dividend growth compounding…right? Right.
Are The Stocks Undervalued?
This is arguably the most important metric of Buffett’s investment methodology. Value investing is focused on investing in companies that have a low P/E ratio. This means that, even though the companies are financially strong, they are valued lower on the stock market than fundamental analysis would indicate they should be. The whole point of buying undervalued stocks is because there is greater room for profits growth.
Identifying undervalued stock is also arguably the most difficult part of Buffett’s process. The simple reason being that determining intrinsic value is hard and there is no one foolproof way to do it.
Buffett’s particular predilection for accurately gauging the intrinsic value of companies in part explains his massive success; the man has a profound intuition for business which explains his nickname the “Oracle of Omaha”.
Specifically, once Buffett has determined the intrinsic value of the investment candidates, he compares his judgment to the actual market value.
If his intrinsic value valuation is at least 25% higher than the market value, Buffett considers it a high-value company.
Warren Buffett And Intrinsic Value
Warren Buffett argues that the key insight of value investing is to buy stocks that are valued at less than their “intrinsic value.”.
So What Is Intrinsic Value, And How Is It Applied In Buffett’s Strategy?
Intrinsic value here refers to the fundamental value of a company that is distinct from its current market value. There is no one particular method for defining the “intrinsic value” of a company, but Buffett has described intrinsic value as:
The present value of the stream of cash that’s going to be generated by any financial asset between now and doomsday. And that’s easy to say and impossible to figure.
Warren Buffett
By his own admission, intrinsic value is a fairly loose concept, but it ties in with cash flow, employment, management health, growth potential, state of the industry, etc.
The point of value investing is to find stocks that have a very low price-to-earnings ratio. This means that their individual stock is valued low, but the company shows a very high potential for growth. Instead of making money off of fast growth, Buffett’s investing philosophy states that having ownership in a reliable company that is capable of good returns is more important.
So in other words, value investing is about investing in companies according to their total intrinsic value and how much potential they have for growth.
Sustainable Competitive Advantage: What Is It, And How Does Buffett Use It?
Buffett has stated previously that the single most important thing he looks for in a company is sustainable competitive advantage.
In a nutshell, sustainable competitive advantage refers to company attributes, abilities, or assets that give them a favourable long-term advantage over their competitors. These attributes could be things like:
- Skilled staff
- Good PR
- Knowledge
- Outstanding leadership
- Product differentiation
- Brand visibility
- Strategic assets
What Are Some Examples Of Sustainable Competitive Advantage?
Like the concept of intrinsic value, sustainable competitive advantage is best understood by pointing to specific examples of good company qualities rather than giving an abstract definition.
The development of the iPhone is one thing that has given Apple a sustainable competitive advantage over many of its competitors. The iPhone turned the cell phone into a pocket computer and Apple’s proprietary and user-friendly OSX software allowed Apple to keep a unique edge on its products as smartphones entered the mainstream market. Likewise, a company like Uber revolutionized the ride-sharing industry due to its low cost of operation.
The idea of sustainable competitive advantage is that it gives a company more control over a market. If a company is sufficiently unique and fills a particular niche in an industry, then it is less likely to be affected by the behaviour of its competitors since it already has such a large share of the market locked down.
How Does Buffett Use Sustainable Competitive Advantage?
Buffett looks for companies with a sustainable competitive advantage because he believes that ownership, not capital gains, is the best investment strategy. It is best to buy a strong company that is undervalued because those kinds of companies have the best potential for long term growth and long term returns on investments.
In general, finding companies with a sustainable competitive advantage increase the chances you found a real value stock. Consider this guiding philosophy in the context of Buffett’s investment behavior after his acquisition of Berkshire Hathaway.
Shortly after his acquisition of the then failing textile mill, Buffett began investing in growing companies. Instead of trying to make money on capital gains alone as a growth investment philosophy might dictate, Buffett sought out ownership in companies with good potential that could generate a lot of earnings.
In other words, Buffett is not concerned with how attractive a company is in the market. He is concerned with how well a company can do its business.
In some ways, Buffett’s investment philosophy echoes the fable of the tortoise and the hare. Whereas the hare was focused on getting the race done as quickly as possible and gaining as much ground as possible in the least amount of time, the tortoise instead focused on a slower steady rate that eventually eclipses the hare.
Value investing follows a similar philosophy: less aggressive investing and sustainable growth is the aim of the game.
So, To Conclude: What Makes Buffett So Special?
One argument might be Buffett’s ability to paint the picture. The true reason for Buffett’s success is his utter obedience to his method of Value Investing. Most value investors will seek deals and undervalued businesses, whilst also accepting the influence of the stock market and ability to inevitably become efficient in valuing businesses.
For instance, when you buy a company, you might cross your fingers it’ll come good but accept the efficiencies of the market to get it right at some stage.
Buffett isn’t having this one bit.
He has little interest in the stock market movements, the buyer, sellers or momentum behind the stock. Buffett is interested in what the individual company is doing, how it is performing and whether it is fulfilling expectations.
“In the short term, the market is a popularity contest; in the long term it is a weighing machine.”
Benjamin Graham
When Buffett invests, he does it as if he is owning the business. He plays the long-game, longer than most. Buffett’s focus is ownership of quality companies that will deliver earnings returns.
Sitting, waiting, watching...
