There are a lot of books about Warren Buffett and how he selects stocks. This is both good and bad because there are good books, and just as many bad books.
His annual Berkshire Hathaway Inc. (NYSE:BRK.B) letters provide qualitative information but never anything concrete. It’s left up to you to comb through his words and put bits and pieces together to come up with a firmer picture.
It really is a shame that Buffett does not write his own book.
Analyzing the Strategies of Gurus
I bring this up because I like to reverse engineer the strategies of the gurus and other well known value and investing master minds to see how it works.
Here are some gurus I’ve looked at previously:
How Peter Lynch averaged 29% annual returns
Quant Master – James O-Shaughnessy’s 5 Minute Investing Strategy
Guru Growth Investor Martin Zweig
I have also written extensively on Graham. Here are a couple:
Calculating Graham Net Net Stocks
Who Really Knows How Buffett Chooses Stocks?
For all the books and articles out there, there is no clear guideline on how Buffett and Berkshire select stocks. The key difference between Buffett and other gurus is that he has never clearly stated his process or checklist.
As strange as it might sound, Buffett is like my mother.
Growing up, when I asked her how much salt I needed to put into the stew, she would answer the way most mothers or good cooks do.
“Just enough” she would say with a knowing smile.
In the same way, Berkshire Hathaway Inc. (NYSE:BRK.B) and Buffett make a lot of decisions based on instinct and pattern recognition which is something he can’t truly quantify and something that you and I have trouble grasping.
He doesn’t run spreadsheets (unfortunate because I would beg him to endorse mine haha) or perform valuation calculations. And because of this, many value investors and authors have sought out to come up with their own ideas on how Buffett chooses stocks.
How Buffett Chooses Stocks to Invest In
This AAII article from 1998 goes into great detail of the types of companies that Buffett likes to invest in. It’s 4 pages of full text so if you don’t want to read it, I’ve grabbed the most important section from the paper. Aside from the obvious Buffett mantra of invest in businesses, it discusses in good detail, the selection criteria for Buffett stocks.
The Warren Buffett Stock Picking Approach
Buffett’s Philosophy and style
Investment in stocks based on their intrinsic value, where value is measured by the ability to generate earnings and dividends over the years. Berkshire Hathaway Inc. (NYSE:BRK.B)’s Buffett targets successful businesses—those with expanding intrinsic values, which he seeks to buy at a price that makes economic sense, defined as earning an annual rate of return of at least 15% for at least five or 10 years.
Universe of Stocks
No limitation on stock size, but analysis requires that the company have been in existence for a considerable period of time.
Criteria for Initial Consideration
Consumer monopolies, selling products in which there is no effective competitor, either due to a patent or brand name or similar intangible that makes the product unique. In addition, he prefers companies that are in businesses that are relatively easy to understand and analyze, and that have the ability to adjust their prices for inflation.
Other Factors
A strong upward trend in earnings
Conservative financing
A consistently high return on shareholder’s equity
A high level of retained earnings
Low level of spending needed to maintain current operations
Profitable use of retained earnings
Valuing a Stock
Buffett uses several approaches, including:
Determining the firm’s initial rate of return and its value relative to government bonds: Earnings per share for the year divided by the long-term government bond interest rate. The resulting figure is the relative value—the price that would result in an initial return equal to the return paid on government bonds.
Projecting an annual compounding rate of return based on historical earnings per share increases: Current earnings per share figure and the average growth in earnings per share over the past 10 years are used to determine the earnings per share in year 10; this figure is then multiplied by the average high and low price-earnings ratios for the stock over the past 10 years to provide an estimated price range in year 10. If dividends are paid, an estimate of the amount of dividends paid over the 10-year period should also be added to the year 10 prices.
How Buffett Analyzes Financial Statements
Combine the methods from above with how Warren Buffett analyzes and interprets financial statements and you have a powerful “Buffett toolset”.
A Buffett Screen?
If you are itching to take it one step further, how about applying this Buffett screen I found in a Seeking Alpha article.
ROE: 5-year Avg. >= 17%
Return on Invested Capital: 5-year Avg. >= 17%
Pre-tax profit Margin: 5-year Avg. >= 1.2* Industry Avg. Pretax Margin: 5-year Avg.
Price/cash flow ratio <= 0.8* Industry Average price/cash flow ratio
Price/cash flow ratio >=0.1
Debt to Equity Ratio <= 0.8*Industry Average Debt to Equity Ratio
Income per employee >= 1.1* Industry Average Income per employee
Alas, There is No True Buffett Stock Criteria
Sorry for the anti-climax but until the day comes when Buffett publishes his methods, we will never know for sure what his secret sauce is.
There is a lot of debate over how he chooses stocks. This is a good start, but it is still only a start that covers the building blocks and basics.
Ultimately, it all comes down to practice and integrating the concepts that Buffett teaches into your own investing methodology. It’s always better to transform a lesson and make it your own.
Become your own guru.
This is probably Warren Buffett’s ultimate strategy as he sits somewhere smiling knowingly.
This article was originally written by Jae Jun, and posted on OldSchoolValue.
