Investors have long praised Warren Buffett’s ability to pick which stocks to invest in. Lauded for consistently following value investing principles, Buffett has a net worth of $80.8 billion as of Oct. 2019, according to Forbes. He has resisted the temptations associated with investing in the “next big thing,” and has also used his immense wealth for good by contributing to charities. With his uncanny ability to uncover long-term profitable investments, it's understandable most investors would like to know exactly what Buffett looks for in a stock. We answer that question in this article.
Value Investing for Choosing Stocks
Understanding how Warren Buffett selects winning stocks starts with analyzing the investment philosophy of the company he is most closely associated with, Berkshire Hathaway. Berkshire has a long-held and public strategy when it comes to acquiring shares. The company should have consistent earning power, a good return on equity (ROE), capable management, and be sensibly-priced.
Buffett belongs to the value investing school, popularized by Benjamin Graham. Value investing looks at the intrinsic value of a share rather than focusing on technical indicators, such as moving averages, volume, or momentum indicators. Determining intrinsic value is an exercise in understanding a company’s financials, especially official documents such as earnings and income statements.
There are several things worth noting about Buffett's value investing strategy. To guide him in his decisions, Buffett uses several key considerations to evaluate the attractiveness of a possible investment.
How Has the Company Performed?
Companies that have been providing a positive and acceptable return on equity (ROE) for many years are more desirable than companies that have only had a short period of solid returns. The longer the number of years of good ROE, the better. In order to accurately gauge historical performance, an investor should review at least five to 10 years of a company's ROE.
*When looking at a company's historic return on equity (ROE), it's also essential to compare this with the ROE of the company's top competitors in the same industry.
How Much Debt Does the Company Have?
Having a large ratio of debt to equity should raise a red flag because more of a company’s earnings are going to go toward servicing debt, especially if growth is only coming from adding on more debt.
Instead, Buffett prefers earnings growth to come from shareholders' equity (SE). A company with positive shareholders' equity means the company generates enough cash flow to cover its liabilities and is not relying on debt to keep it afloat. For Buffett, low debt and strong shareholders' equity are two key components for successful stock picking.
How Are Profit Margins?
Buffett looks for companies that have a good profit margin, especially if profit margins are growing. As is the case with ROE, he examines the profit margin over several years to discount short-term trends. To stay on Buffett's radar, a company's management should be adept at growing their profit margins year-over-year, a sign that management is also good at controlling operating costs.
How Unique Are the Company's Products?
Buffett considers companies that produce products that can easily be substituted to be riskier than companies that provide more unique offerings. For example, an oil company’s product—oil—is not all that unique because clients can buy oil from any number of other competitors.
However, if the company has access to a more desirable grade of oil—one that can be refined easily—then that might be an investment worth looking at. In this case, the company's desirable grade of oil could be a competitive advantage that helps it earn profits through greater sales and margins.
How Much of a Discount Are Shares Trading At?
This is the crux of value investing: finding companies that have good fundamentals but are trading below where they should be—the greater the discount, the more room for profitability.
The goal for value investors like Buffett is to discover companies that are undervalued compared to their intrinsic value. An opportunity to buy at a discount exists when a company's current market value is cheaper than its intrinsic value. While there is no exact formula for calculating intrinsic value, investors will look at a variety of factors—such as corporate governance and future earnings potential—to estimate intrinsic value.
The Bottom Line
Beyond his value-oriented style, Buffett is also known as a buy-and-hold investor. He is not interested in selling stock in the near-term to realize capital gains; rather, he chooses stocks that he believes offer good prospects for long-term growth. This leads him to move focus away from what others are doing. Instead, he looks at whether a company is in a solid position to make money moving forward and if its stock is sensibly-priced.