I refer to the legendary investor Warren Buffett a good amount on this website. The reason is because 1) he is the Michael Jordan of investing and 2) I like to resemble his investing style in my own. See I could easily go look at his portfolio and just chose the same companies he does and do a type of coattail investing but this wouldn’t prove to be beneficial to me. I would rather be taught how to fish rather than given a fish. Being reliant on anyone except yourself can have even its downfalls. Just follow these principles and you can pick stocks like Warren Buffett.
If I copied Warren Buffett on each of his stock picks that would be good but what will happen when he is gone? I will have no one to copy, therefore, be left to fend for myself which brings me back to my point of being taught how to fish instead of being given fish. In this article, I am going to do exactly what the titles says. Show you the characteristics Warren Buffett uses to select his investments. There are 12 total tenets and they come straight from the book The Warren Buffett Way by Robert Hagstrom (Affiliate Link). I can not begin to tell you how great this book was. If you want to become the best investor possible I strongly suggest you pick up a copy for yourself. There are few books that I like to suggest to investors but this is definitely one of them.
Warren Buffett has 12 main tenets for selecting his companies for investment. They are broken down into 4 different sections Business, Management, Financial, and Market. All of these combined give you the exact investment guide the big man himself uses. Let’s get into it.
Buffett, like many other great investors, has a full comprehension of the fact that each investment has an underlying company. A living breathing company. He believes that if someone is more concerned about the business itself rather than the stock price they would become a better investor. Instead of worrying about the market, Buffett learns everything there is to know about the company itself. Just like his teacher taught him and also many of us “Investing is more intelligent when it is most businesslike.”- Benjamin Graham
There are three main characteristics Buffett looks for in a business:
- The business must be simple and understandable
- Must have a consistent operating history
- Must have favorable long-term prospects
Simple and Understandable
Buffett believes that the success of the investor is strongly correlated to well they understand the investment. This alone will separate you from many other “investors”. In today’s market, there is so much buying and selling on a constant basis that there is no way to be able to fully understand each and every business he or she trades. For decades Buffett has owned many businesses in many different areas but maintains the same investing principle in each of them. He has a deep understanding of how the business operates. He knows the revenues, expenses, cash flows, and everything else about the company.
The ability to remember all of these complicated numbers and the plethora of knowledge is much easier to retain when the business is simple to understand. He limits his selections to companies that only are in his circle of competence. Think about how smart that is, if the success of one’s investment strongly depends on his or her’s ability to deeply understand the company why would they choose a complex business. The simpler to understand the better.
“Invest in your circle of competence. It’s not how big the circle is that counts; it’s how well you define the parameters.” – Warren Buffett.
We can all take a lesson from this. The rules are to never invest in a company that you do not fully understand. The simpler the business the easier it is to understand. If you only stick to companies that you know very well, then you yourself will be able to prosper in investments.
Consistent Operating History
It is not only the complex that Buffett avoids but he also says no to companies that are either solving difficult business problems or are fundamentally changing because their previous plans did not work out. Through his experience, he has noticed that the best returns are produced by the companies that have been producing the same product or service for years. These companies can pretty much be run on autopilot. With major change comes major room for error. We do not want to be involved with a company that has some major room for error.
Many investors are attracted to the companies that are changing but unfortunately, major change and exception returns do not usually go together. Many are attracted to shiny things in fast-changing industries and huge corporate reorganization. Everyone seems to be so infatuated with the prospects of tomorrow that they forget to think about today’s business environment.
There is little care for the hot stocks of today from Buffett. Instead, he is more focused on the companies that have been successful and will continue to be successful for years to come. We know that predicting the future is near impossible, but a company with a strong track record of success is a reliable sign that the company will continue to be successful. When a company has demonstrated consistent earning power with the same products year after year, it is not unreasonable to assume that the trend will continue.
Buffett has also taught himself to stay away from big corporate turnarounds, the reason; they often do not work. It is much better to look at good businesses at reasonable prices than to buy a difficult business at cheaper prices.
In the economic business world, there are two types of businesses; a small group of great businesses and the others that are not great. The former, Buffett refers to as franchises and the latter are ones he does not deem acceptable of investment. He defines a franchise company as one that meets 3 specific characteristics. Their service or product 1) is needed or desired 2) has no close substitute 3) is not regulated. Having all of these is key to long-term sustainability and gives these companies that ability to slightly raise prices without losing a huge amount of market share. Pricing flexibility is a defining attribute in a great business.
As a whole, these great businesses create what Buffett refers to as a moat-something that gives companies a clear advantage over others and protects it from the competition. Obviously, the bigger the moat the more Buffett likes it.
“The key to investing is determining the competitive advantage of any given company and above all, the durability of the advantage” – Warren Buffett
Buffett goes on to tell us that a moat filled with crocodiles and piranhas is what he loves to see. He defines a great business as one that will be great for 25 to 30 years.
When looking at new investments, Buffett studies the management with a fine tooth comb. He has said that the companies that Berkshire either buys or owns partially must operate with honest managers whom he can trust. When it comes to determining if the management is admirable he looks for 3 things:
- Is management rational?
- Is management candid with shareholders
- Does management resist institutional imperative
The biggest things Buffett likes to see is when the management behaves like an owner of the company. At the end of the day, the number one objective for a company is to increase shareholder value. Rational management will make every decision with this goal in mind. He also largely respects managers that will openly go against the tide of the industry. Ones that can say “Okay, they are doing X but we are not going to do X because that is not who we are.” Rational management will not blindly follow the industry.
Management’s most important job is to allocate capital. This is largely important because, over time, the allocation of the company’s capital is what determines shareholder value. The decision of what to do with companies earnings is what shows us the rationality of management. With earnings, management can do two things; return it to shareholders or reinvest in the businesses. The results of this is an exercise of rationality and logic according to Buffett.
The question as to where to allocate capital is mainly determined by the life cycle of the business. During the beginning of this cycle, the company must retain all of the earnings to reinvest in the business. During the later stages of the business life cycle when there are enough earnings to support the business and also help grow then still some left over there rises the question: What do we do with the extra cash?
If the cash can be used internally to produce a higher return on equity than the cost of capital, a company should retain all of its earnings. That is the logical course. But if the company is unable to produce large returns on equity it should seek other paths of capital allocation. Sadly, many companies choose to reinvest their money at a below-average rate. This hurts the shareholder.
A company that produces average to below average returns but generates extra cash normally has three options: 1) Ignore the problem and continue to reinvest the capital at below average rates, 2) it can buy growth 3) it can return the money to shareholders. It is at this crossroads that Buffett focuses heavily on management decisions. These decisions will prove rationality or not.
The only reasonable course of action when management is faced with this decision is to return the capital to shareholders. There are two options for this: 1) share buybacks and 2) initiating or raising the dividend.
Usually, when shareholders love to see a company that pays a dividend or raises the dividend. It must be a sign that they are doing well right? Buffett believes the company should only raise or pay out the dividend if the shareholder can get more for their cash than the company could generate if they retained the earnings.
Dividends can sometimes be misunderstood, the second mechanism of returning capital to shareholders can be even more confusing. That is because this decision is less direct, less tangible, and the effects are not as immediate.
When management decides to repurchase stock, Buffett feels that the reward is two-fold. If the stock is selling less than intrinsic value then it makes sense for the company to purchase their own shares. For example, if the companies intrinsic value is $100 and the current price is $50 then for every $1 spent there is $2 of value acquired. This transaction can be very profitable for the shareholder.
Candor of Management
Management that presents their financial performance fully and genuinely, admitting failures when there are some, and is all over candid with shareholders is highly regarded in the mind of Buffett. He especially respects the managers that are willing to discuss performance without hiding behind the generally accepted accounting principles.
A person that can openly admit failure and move on is the sign of a good person. When management does this it gives us a sense of trust. Buffett admires highly upper management that is able to openly admit to failure. There are too many managers that report in excess optimism instead of honesty. Excess optimism is a short-term view value, honestly is a long-term value.
Most annual reports can be a sham. They are mostly written by the public relations department and are suppose to sound optimistic about the future. If we take a lesson from the Berkshire Annual Reports we can see that Warren himself will openly admit his mistakes and doesn’t care what might happen the share price. Openly admitting mistakes takes a lot of courage, these are the qualities we look for in management. There is value in studying one’s mistakes rather than concentrating on their successes.
The Institutional Imperative
No matter how bad a company might do or how bad of a year they had their annual report will still stay optimistic. Even though the allocation of capital can be broken down into such a simple process there is still going to be companies that disregard what might be simple and invest it at terrible rates. Why does this all happen? Buffett describes this as the institutional imperative. Corporate managers will have a lemming factor to them. No matter how silly a decision might be, corporate managers would sometime be wrong and with the crowd than be the outsider and be right.
You would tend to think that most corporate managers will behave in a rational manner consistently. Not allowing small minded people to influence their decision making. When the institutional imperative comes into play the rational decision can go out the window for some managers.
What is behind this? Human nature. Most managers will not look foolish with a quarterly loss when others in the industry are all sporting earnings that beat estimates. Of course, it is never easy to go against the grain of conventional wisdom. But if the manager has good enough communications skills should be able to persuade owners that a short-term loss or maybe a change of direction will be beneficial for the long term.
At the end of the day, management is a large portion of the decision making done by Mr. Buffett. It is not an end all be all but it most certainly a large portion of the decision making. At the end of the day though, he will not buy a company for the management alone.
“When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that stays intact.” –Buffett
If there is one thing you should know about how to pick stocks like Warren Buffett; it is that when he values a company he does not take annual results to0 seriously, given that these are short-term results. He instead will focus on 5-year averages. He has said before does not always coincide with the time it takes for us to circle the sun.
There are 4 main things that he pays the most attention to when looking at businesses:
- Look at return on equity, not earnings per share
- Calculate “Owners Earnings” to get a real reflection of value
- Look for companies with high-profit margins
- For every dollar retained make sure the company has added at least 1 dollar of market value.
Return on Equity
Commonly analysts will measure the annual performance of a company on a earnings per share (EPS) basis. Buffett considers EPS to be nothing but a huge smoke screen. Since most companies retain a portion of their own earnings from last year to increase their equity base he sees no reason to get excited.
Instead, an owner should focus on the return on equity of a certain company. This is the ratio of net income to shareholder’s equity. He would much rather see a steady ROE than a company beating earnings every quarter. He wants to know how well management accomplished the task of generating a return on operations of the business given the capital employed.
Adding to the equation, Buffett is a big believer that a great business will be able to give ample returns on equity while employing little to no debt. A company can always produce a higher ROE when they load up debt but this doesn’t impress Buffett. A good company can produce satisfactory returns while employing little to no leverage.
Also, highly leveraged companies can be vulnerable during a market downturn. Whether you are making money or not, there is always debt that needs to be paid down. For companies that have a lot of debt, it can be a struggle during a downturn.
We know by now that all earnings are not created equal. In fact, we also know that short-term quarterly earnings can be pretty much a smoke screen. Along with earnings cash flow can sometimes be a bit shady to trust. Cash flow is defined as net income after taxes plus depreciation, amortization, and depletion and any other non-cash items. The problem with this is it leaves out an important factor: capital expenditures. The business needs to put money into the land and equipment if they want to stay at competitive levels. Neglecting the business will only result in a decline. Capital expenditures should be taken as any other expense. If you want to use cash flow as a way of valuation you have to take into account capital expenditures.
Instead of cash flow Buffet uses what he calls “Owners earnings”. The formula to calculate this is this: Net income + Depreciation, depletion, and amortization – Capital expenditures and any other working capital needed. Although this is not the 100% perfect number many analyst desire when valuing a company. It is an accurate way to represent how much earnings the owners have access too.
Buffet likes to quote Keynes, “I would rather be vaguely right than precisely wrong.”
Great businesses can make lousy investments if they do not know how to turn revenue into profit. Let’s face it, there is no complexity in turning sales into profit. It all comes down to controlling your expenses. Buffett has said that during his experience, managers of high-cost operations tend to find ways to continually add to overhead, whereas managers of low-cost operations are always finding ways to cut expenses.
He has little patience with managers that allow costs to escalate. Commonly managers have to initiate a cost-cutting program to work in line with sales.
“The really good manager does not wake up in the morning and say, ‘This is the day I’m going to cut costs,’ any more than he wakes up and decides to practice breathing.” – Warren Buffett
Great managers will do whatever it takes to keep costs down on a regular basis instead of letting them grow larger then they have to correct the problem. Great managers, he says, “Abhor having a bigger head count than needed and attack costs vigorously when profits are at record levels as when they are under pressure.”
At the end of the day a business can be great but if it is unable to turn sales into profits it is not considered a good investment. You have to go out of your way to make sure the company is managing costs at all points during the life cycle.
The One-Dollar Premise
To speak broadly of the stock market and to determine what the value of a company is, he uses a simple premise. Buffett believes that if he has selected a company with favorable long-term economic benefits and is run by shareholder minded management, the proof will be reflected in the increase in market value over the course of a period of time. The same can be said about retained earnings. If over the course of a period of time, retained earnings have been used in a non-productive manner producing low returns on capital then the market will price the company lower. On the other hand, the opposite is should prove to be true. If a company has been able to use retained earnings in a productive manner over a period of time the success will be reflected in the stock price.
However, we know that while the stock market is relatively accurate in representing the value of a company over a long period of time, in any one year the price can move in all sorts of directions. Because of this Buffett has created a very simple test to see the economic attractiveness of the business and also how well the management has been able to create shareholder return: the one-dollar test. The increase in market value should at least reflect the amount of retained earnings dollar for dollar over a period of time. If the market value of the company goes up larger than retained earnings even better.
All of what I have laid out for you above has led to one certain point; do we buy or sell. Any investor at this point has to weight two main things: is this company a good value and is it time to buy it. Only if the price is favorable of course.
Price is established by the stock market and the value is determined by the analyst. Price and value are not an equal thing. We know that sometimes the market will price a company down to a point that is well below value. We also know that a company could be priced much higher than its actual value.
Rational investing comes back to two questions.
- What is the value of the business?
- Can the business be purchased at a discount?
Determining the Value
Throughout the years, financial analysts have used many formulas for determining value. They use shorthand methods like the price to earnings, price to book, and a high dividend yield. But the best system for determining value, according to Buffett, was determined more than 70 years ago by John Burr Willams. Willams stated that essentially to value a company you have to determine the cash flow of the company for many years into the future and discount it back to the present.
This exercise is much like calculating the present value of a bond. A bond is made up of 2 components, a coupon, and a maturity date. To determine the value you add up all the coupons and divide them by the appropriate discount rate (the bond’s yield) the price of the bond will be revealed. This can be pretty much copied and pasted to work for businesses as well. To determine the value of a company one must add up all of the estimated coupons (Owners earnings cash flow) that the business will generate for years into the future, then discount them back to present.
For Buffett, determining the companies value comes directly from two key variables; the stream of cash flow and the appropriate discount rate. In his mind, the predictability of a companies cash flow should be as easy as a coupon on a bond. If he can not determine the certainty of cash flow into the future, he will not determine the value of the company. This is what separates him from the pack.
After he has determined the future cash flow of the business, Buffett applies the discount rate. A lot of you will be surprised to learn that he uses the rate of the long-term U.S. Government Bond (30-year treasury). This may seem crazy to a few of you, it cannot be simple as that right? Well, there are a few things Buffett will keep in mind. If interest rates are at all-time lows, then he will add a few percentage points to reflect a more normal environment.
Some will argue that you need to add the risk-free rate with an equity risk premium to calculate the discount value. To comment on that Buffett says “I put a heavy weight on certainty, If you do that, the whole idea of a risk factor doesn’t make any sense to me. Risk comes from not knowing what you are doing.”
Buy at Attractive Prices
Focusing on good businesses- that is understandable, with long-term economic favor, and run by shareholder-oriented managers- by itself does not guarantee success Buffett says. For a successful investment to work one must buy at attractive prices and then the business must work out to expectations. Sometimes, it doesn’t always work like that. Buffett points out the three areas that we made a mistake in if something goes wrong with the investment (1) the price we paid (2) the management we joined (3) the future economics of the business. Buffett follows his mentor Benjamin Graham when it comes to purchasing a company well below the intrinsic value. This is the margin of safety.
Margin of safety assists an investor in 2 ways. It protects you from downside risk. Instead of pulling the trigger on every company that dips below intrinsic value Buffett waits patiently for the company to come well below the intrinsic value. He uses the 25% rule. That way if he is off in his calculation by 10% he will still yield an adequate return.
The next thing margin of safety provides opportunities for extraordinary stock returns. If Buffett is able to correctly identify the characteristics of a business, then the stock return over the long run should go upward. Plus by maintaining a large margin of safety you will earn a nice bonus when the market corrects itself and brings the price back to intrinsic value.
There you go! Those are all the things Warren Buffett looks for while investing. I was able to cover the topics lightly and if you are smart you will go pick up a copy of the Warren Buffett Way (Affiliate Link).Once you learn to pick stocks like Warren Buffett investing does not seem like some strenuous task. If you stick to identifying these principles in your investments, I have no doubt your investing will improve dramatically. Mine certainly did after reading this book. Go get a copy for yourself and it will only help you.
Peace and Love,