A student and employee of Benjamin Graham, Buffett is the brain-child of the original value investor. So, what is that exactly is this “Value Investing”?
The simple answer is value investors look for shares or companies that are valued 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.
Value investors are looking for companies that are undervalued and under-appreciated by people, investors and the stock market.
So why is Buffett different…
One argument might be Buffett’s ability to paint the picture. The true reason for his 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. i.e. When you buy a company, you 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. He 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.”
When Buffett invests, he does it as if he is owning the business. He plays the long-game, longer than most. His focus is ownership of quality companies that will deliver earnings returns. Sitting, waiting, watching.
Let’s take a look at some of the key measures Buffett lines up before considering to invest in businesses.
1. 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.
2. 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 this 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.
3. 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.
4. Companies that have avoided deep, dark debts
Sounds pretty obvious but plenty of investors don’t have a problem with big debts as long as the company has them covered. Buffet’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.
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.
5. 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.
6. Chunky profit margins and tasty trends
Like most investors, Buffett is looking for profitable companies. More than anything, he wants to see companies that are growing their profit margins. This one is pretty simple:
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.
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.