Anyone who has has dabbled in the markets knows picking stocks is difficult, but exactly how hard is it? Well, with over 6,500 individual stocks traded in the United States today, picking winners from losers is hard just because there are so many choices.
And once you’ve selected a stock, put your hard earned money on the table and bought some shares, how can you be sure that the choice is going to pay off five, ten or even twenty years from now? In other words, how can we pick stocks for long term investment?
Whenever tough questions like this arise it’s best to look to seasoned experts for answers. And to pick winning stocks for the long term, look no farther than legendary value investor Warren Buffett. Buffett has not only thought long and hard about selecting stocks, but – lucky for us – he’s talked about it enough that we can benefit from his success.
So how does someone like Warren Buffett do it? How does he select stocks for the long term? In this article we’ll identify eight key factors Warren Buffett considers.
For each factor we present a relevant Warren Buffett quote, discuss the concept in a little more detail, then summarize with a rule.
SELECTING STOCKS FOR THE LONG TERM
VALUE
“Price is what you pay. Value is what you get.”
First of all, Buffett likes to buy cheap companies. That doesn’t mean they are inferior enterprises, rather good value.
To do this he looks at the value of the underlying business, revenue, assets and earnings. He also looks at the company’s break up value; that is, if all the divisions were to be sold off individually, what would the sum total received be? Would the sum be more or less than the price of the business? It all the various divisions are worth more than the company, the stock is a good buy.
Rule: only purchase a stock when we get good value, in other words, when we pay less than what that business is really worth.
PROFITABILITY
“The investor of today does not profit from yesterday’s growth.”
Like us, Buffett buys shares because he wants them to increase in value. Companies don’t increase in value unless they are profitable (ignoring hostile takeovers and other, unusual events). And Buffett not only likes profits, he likes profits that are increasing, as increasing profits increase the value of a company.
So to determine if the company passes this test, Buffett looks at current and past profitability. He looks at the change in profitability; is this company’s profits increasing or are earnings static, perhaps shrinking? Finally, Buffett likes businesses that have above average industry profit margins, so he’ll compare a company to it’s competitors.
Rule: purchase a company that is profitable, a company that earns higher profits than it’s competition, and a company that is increasing profits.
DEBT
“I do not like debt and do not like to invest in companies that have too much debt, particularly long-term debt.”
Buffett doesn’t purchase companies with a large amount of debt, taking the view that debt payment represents both uncertainty and cost. Uncertainty as nobody knows if interest rates will increase or decrease. Cost as higher interest rates means more money is used to pay debt, shrinking profits.
Rule: purchase companies with little or no debt.
LONGEVITY
“Buy companies with strong histories of profitability and with a dominant business franchise.”
Buffett prefers companies that have been in business for ten years or longer. Not only have these enterprises stood the test of time, and are far more likely to be around for another ten or even twenty years, but ten years gives him a good idea of long term profitability and growth.
Rule: avoid start ups and companies that are unproven.
SIMPLICITY
“Never invest in a business you cannot understand.”
Buffett is a proponent of what he calls the “circle of competence”. Simply put – Buffett invests in businesses he understands. During the dot com bubble, Buffett frequently commented he didn’t understand their business and therefore avoided investing. Buffett like simple, slow changing industries as the companies he picks will be around for a long time.
By looking at some of Buffett’s key holdings, we see he likes food (McDonads), retailing (Tesco), insurance (GEICO) and some forms of media (Buffalo Evening News).
Rule: invest in what you know.
ADVANTAGE
“Your premium brand had better be delivering something special, or it’s not going to get the business.”
Successful businesses have what’s called a “competitive advantage”, something that keeps competitors at bay. Warren Buffet calls this “The Moat”, and will only invest in company’s that have some clear advantage over competitors. Key advantages will help not only during times of economic growth, but also during recession.
Examples of this could be brand, key patents, or geographical expertise. Again, looking at Buffett’s key holdings we see examples of this in McDonalds or Coca-Cola.
Rule: select companies with clear advantage over competitors.
TAKE YOUR TIME
“Lethargy, bordering on sloth should remain the cornerstone of an investment style.”
We invest to increase wealth, not decrease it. Spending money on a bad stock pick can cause us to lose some – or perhaps all – of our money. Buffett is famous – in fact sometimes criticized – for doing nothing with his money, sometimes for long periods of time. If Buffett sees a good opportunity he’ll move, otherwise he’s comfortable waiting.
Rule: it’s better to wait for a good investment than to be rushed into a bad investment.
LONG TERM
“Our favorite holding period is forever”
Buffett prefers to buy, not sell stocks, and we see this in some of his key holdings and when he acquired them – for example, The Washington Post (1973) or Coca-Cola (1988). He considers most of his holdings “permanent stocks”, and has said that he’ll never sell them regardless of how high their prices go.
And Buffett has held these securities even as prices have sometimes dipped below what he’s paid – a paper loss that was later recovered. Buffett has said several times that he thinks most people are too quick to buy and to quick to sell stocks.
Rule: buy stocks as if you were going to never sell them.
SUMMARY
Rather than recommending specific companies, this article has illustrated the thought process Warren Buffet goes through when selecting his investments.
Warren Buffett’s investment decision making process can be summarized in eight key phrases – Value, Profitability, Debt, Longevity, Simplicity, Advantage, Take Your Time, Long Term. For each we have provided a relevant quote and a single rule which captures the essence of Warren Buffet’s approach.
Selecting stocks for the long term is difficult, but that doesn’t mean impossible. By following these rules, by picking stocks the same way Warren Buffet does we can select stocks for the long term.