image borrowed from here.
Before we begin the principles section of this post, I should say two things about Warren Buffett stock picks and how he choses them.
One, I’m not telling you what stocks to pick—there are other sites who would love to take on that liability. I’m not that guy, so don’t come to me. These are just some of the principles I’ve picked up from people wiser and savvier than myself.
Two, this isn’t the end of the journey but the start of one. I’m only pulling one set of metrics from one book—The New Buffetology—as an example, which means this is an autodidact post—the main goal is to prompt you to teach yourself at your local library.
That said, in Warren’s words, if you’re doing math with Greek letters in it, you’ve got the wrong profession. This stuff is stupid simple if you do it right, so learn the math and do your research. Basically, the man is taking advantage of a short-sighted market by being greedy when they’re fearful and fearful when they’re greedy. He’s looking for companies with durable competitive advantages that function like monopolies in their markets. A competitive advantage is a significant edge over other companies in the same industry. A durable competitive advantage (DCA) is one that can withstand recessions. We could go into what that looks like, but the easiest way to find them is through the financial data.
Here’s the list of requirements for Warren Buffett stock picks:
- Does this company earn a regular high return on shareholder equity (above 12%)? Most strong and potentially DCAs reinvest equity in order to make it work for you—like renting out a second house you own instead of letting it sit. A company that can recover from internal blunders that the market overreacts to will have regular, high returns on everything they own. Here’s the formula for the numbers on that fundamental balance sheet:profit / equity = return profit = income – expenses
equity = assets – liabilities
- Does this company earn a regular high return on total capital (12% or better)? Every dollar—borrowed, earned, or merely owned—should be working overtime in a company with a DCA. Therefore Warren takes a peak at their total assets and sees if they have a regular return that’s over 12%. Here’s the formula:net earnings / total capital = return on total capital
total capital = assets
- Does this company’s earnings move in a dramatic upward trend? Companies with DCAs post per share earnings both strong and on the rise:per share earnings = net earnings / shares outstanding
- Is this company financed with a sense of modesty and contentment? Companies with DCAs generally carry long-term debt < 5 x net earnings
NOT debt-to-equity ratio for ascertaining the financial strength
LONG TERM debt-to-earnings. Take this year’s earnings, multiply it by five. That should be less than the total outstanding debt they have.
- Does this company own a brand-name product or service that gives it a competitive advantage in the marketplace? Though dissimilar to a DCA, it’s a great beginning. Use some quantitative/qualitative filters to find out if this company truly has a durable competitive advantage:Must stores carry this product to stay in business? Would businesses carrying this product lose sales if they chose to stop carrying this particular brand-name product overnight?
- Does this company rely on an organized labor force? Companies with organized labor forces seldom have DCAs. (This is the main reason we need alternative economic systems. Capitalism is broken if it doesn’t see the value in a union. My father may have died without one multiple times).
- Can the company increase prices along with inflation? A DCA business can increase the prices of its products right along with any increases in its costs of production, which means that the underlying value of the company and its stock price will at least keep pace with inflation… if not beat inflation:Wrigley’s was .20 to make, .40 to sell in 1980
Then .40 to make, .80 to sell in 2000
Moved from a 4 mil profit to 8 mil profit.
- How does this company allocate the earnings they retain? DCA businesses can better retain their earnings and can even better utilize them in a way increases net earnings, thus increasing their stock price and making their stockholders richer. Take the amount of earnings retained for a period and then measure the overall effect on the earning capacity of the company you choose:
1989 H&R Block earned $01.16 per share
between 89 and 99, total earnings $17.14 per share
between 89 and 99, total divids. – $09.34 per share
retained earnings? $7.801999 H&R Block earns $2.56 per shareless
1989 per share earnings – $1.16 per share
Thus $7.80 retained produced additional $1.40.
$1.40 / $7.80 = 17.9%
increased earnings / retained earnings = additional wealth
- Does this company repurchase their shares? Any company that enjoys a durable competitive advantage will keep a surplus of cash (just look at Apple’s pile), which can motivate them to start repurchasing shares. When they do, they increase shareholder ownership in the business with the company’s money, not the money of the shareholders.shares owned / (outstanding shares – repurchased shares) = increased holdingsI own 100 shares / (2,000 outstanding – 1,000 repurchased) = moves me (the shareholder) from 5% to 10% ownership of the company
- Do the company’s share price and book value keep going up? Both share prices and book values of DCA companies will, on average, increase over ten years. Price-competitive businesses (cars, airlines, etc.) typically do nothing over ten years, and their book values will, once in awhile, be utterly destroyed by the fight to stay competitive in the price-based market.
When Warren figures out that a company holds a durable competitive advantage, he will only invest if it makes “business sense” to him. Since you’re buying pieces of a company, he thinks you should see each share as representative of the whole—you should only buy a share if you’d buy the whole company, in other words, and you should never buy an overpriced company just like you should never buy an overpriced house.
Warren discovered his most historically epic buying opportunities are presented to him when the shortsighted market overreacted to bad news. Sometimes this is a recession or a depression (he was buying shares of Wells Fargo shortly after the banking crash of ’08), but most of the time it’s because something went wrong and the internal economics of the company remained intact. American Express’s salad dressing fiasco is a great example, but so is an industry recession such as the banking crisis of ’08, of which Wells Fargo played a smaller part than banks like Goldman Sachs, JP Morgan, and Bank of America. Anyways, the price will tank to a p/e ratio of low-teens or even single digits and Warren will go on a buying spree. Some believe that the current market is artificially propped up by the quantitative easing of the Federal Reserve. If true, this means the market will take a significant downturn sometime in the next two years as they taper off the easing. Regardless, we still have two more years of this secular bear market in which time any number of corrections could happen before it levels off and turns full-bore bullish again. All kinds of buying opportunities in there.
After he purchases the shares, Warren holds the stock and lets retained earnings increase the underlying value of the business. The market, seeing the underlying increase in the value of the business, then correspondingly drives up the market price of the stock. He then continues to hold until the business is significantly overvalued and then sells off—even shares of his own company.
This is the method that Warren has used to create his superwealth. The trick is to find the durable competitive advantage and buy when the stock market is pricing it cheap. He’s been known to say the difference between billionaire investors and mere millionaire investors is who buys the best companies at the lowest price, fastest.
Other recommended reading:
- The Essays of Warren Buffett
- Warren Buffett Speaks — an anthology of quotes from the Oracle of Omaha
- Berkshire Hathaway Annual Reports — These are the most legible annual reports on the market. An eight grader could understand them.
- The Intelligent Investor by Benjamin Graham — This book was written by the first guy who seriously braved the stock market after the Great Depression.
- Security Analysis by Benjamin Graham
And for the general theory of economy, three views: