In times of economic decline, many investors ask themselves, "What strategies does the Oracle of Omaha employ to keep Berkshire Hathaway on target?" The answer is that the esteemed Warren Buffett, the most successful known investor of all time, rarely changes his long-term value investment strategy and regards down markets as an opportunity to buy good companies at reasonable prices. In this article, we will cover the Buffett investment philosophy and stock-selection criteria with specific emphasis on their application in a down market and a slowing economy. (For more on Warren Buffett and his current holdings, sign up for our Coattail Investor newsletter.)

The Buffett Investment Philosophy
Buffett has a set of definitive assumptions about what constitutes a "good investment". These focus on the quality of the business rather than the short-term or near-future share price or market moves. He takes a long-term, large scale, business value-based investment approach that concentrates on good fundamentals and intrinsic business value, rather than the share price. (For further reading, see Warren Buffett: The Road To Riches and What Is Warren Buffett's Investing Style?)

Buffett looks for businesses with "a durable competitive advantage." What he means by this is that the company has a market position, market share, branding or other long-lasting edge over its competitors that either prevents easy access by competitors or controls a scarce raw-material source. (For more insight, see Competitive Advantage Counts, 3 Secrets Of Successful Companies and Economic Moats Keep Competitors At Bay.)

Buffett employs a selective contrarian investment strategy: using his investment criteria to identify and select good companies, he can then make large investments (millions of shares) when the market and the share price are depressed and when other investors may be selling.

In addition, he assumes the following points to be true:

  • The global economy is complex and unpredictable.
  • The economy and the stock market do not move in sync.
  • The market discount mechanism moves instantly to incorporate news into the share price.
  • The returns of long-term equities cannot be matched anywhere else.

Buffett Investment Activity
Berkshire Hathaway investment industries over the years have included:

  • Insurance
  • Soft drinks
  • Private jet aircraft
  • Chocolates
  • Shoes
  • Jewelry
  • Publishing
  • Furniture
  • Steel
  • Energy
  • Home building

The industries listed above vary widely, so what are the common criteria used to separate the good investments from the bad?

Buffett Investment Criteria
Berkshire Hathaway relies on an extensive research-and-analysis team that goes through reams of data to guide their investment decisions. While all the details of the specific techniques used are not made public, the following 10 requirements are all common among Berkshire Hathaway investments:

  1. The candidate company has to be in a good and growing economy or industry.
  2. It must enjoy a consumer monopoly or have a loyalty-commanding brand.
  3. It cannot be vulnerable to competition from anyone with abundant resources.
  4. Its earnings have to be on an upward trend with good and consistent profit margins.
  5. The company must enjoy a low debt/equity ratio or a high earnings/debt ratio.
  6. It must have high and consistent returns on invested capital.
  7. The company must have a history of retaining earnings for growth.
  8. It cannot have high maintenance costs of operations, high capital expenditure or investment cash flow.
  9. The company must demonstrate a history of reinvesting earnings in good business opportunities, and its management needs a good track record of profiting from these investments.
  10. The company must be free to adjust prices for inflation.

The Buffett Investment Strategy
Buffett makes concentrated purchases. In a downturn, he buys millions of shares of solid businesses at reasonable prices. Buffett does not buy tech shares because he doesn't understand their business or industry; during the dotcom boom, he avoided investing in tech companies because he felt they hadn't been around long enough to provide sufficient performance history for his purposes.

And even in a bear market, although Buffett had billions of dollars in cash to make investments, in his 2009 letter to Berkshire Hathaway shareholders, he declared that cash held beyond the bottom would be eroded by inflation in the recovery.

Buffett deals only with large companies because he needs to make massive investments to garner the returns required to post excellent results for the huge size to which his company, Berkshire Hathaway, has grown. (To learn about the disadvantage of being confined to blue chip stocks, read Why Warren Buffett Envies You.)

Buffett's selective contrarian style in a bear market includes making some large investments in blue chip stocks when their stock price is very low. And Buffett might get an even better deal than the average investor: His ability to supply billions of dollars in cash infusion investments earns him special conditions and opportunities not available to others. His investments often are in a class of secured stock with its dividends assured and future stock warrants available at below-market prices.

Conclusion
Buffett's strategy for coping with a down market is to approach it as an opportunity to buy good companies at reasonable prices. Buffett has developed an investment model that has worked for him and the Berkshire Hathaway shareholders over a long period of time. His investment strategy is long term and selective, incorporating a stringent set of requirements prior to an investment decision being made. Buffett also benefits from a huge cash "war chest" that can be used to buy millions of shares at a time, providing an ever-ready opportunity to earn huge returns.

For further reading, see Think Like Warren Buffett and Warren Buffett's Best Buys.

Related Articles
  1. Active Trading

    Warren Buffett: How He Does It

    We look at the Sage of Omaha's methodology for evaluating value stocks.
  2. Active Trading

    What Is Warren Buffett's Investing Style?

    Learn the main principles that Warren Buffet uses in assessing a company. His take on value investing may surprise you.
  3. Insurance

    Warren Buffett: The Road To Riches

    Find out how he went from selling soft drinks to buying up companies and making billions of dollars.
  4. Investing

    Build a Retirement Portfolio for a Different World

    When it comes to retirement rules of thumb, the financial industry is experiencing new guidelines and the new rules for navigating retirement.
  5. Investing

    Automating Your 401(k) is Easier Than You Think

    If you like automation, you should check out these features that many 401(k) plans offer.
  6. Mutual Funds & ETFs

    ETF Analysis: United States 12 Month Oil

    Find out more information about the United States 12 Month Oil ETF, and explore detailed analysis of the characteristics, suitability and recommendations of it.
  7. Investing

    Redefining the Stop-Loss

    Using Stop-losses for trading doesn’t mean ‘losing money’, but instead think about the money you'll start saving once you learn how they work.
  8. Fundamental Analysis

    10 Major Companies Tied to the Apple Supply Chain

    Apple has one of the best supply-chain models. Here are some of the top businesses involved, and the benefits and challenges for all.
  9. Mutual Funds & ETFs

    Top 5 Japan Mutual Funds

    Discover five of the most popular and best-performing mutual funds offering investors direct exposure to equities of Japanese companies.
  10. Term

    Understanding Total Returns

    Total return measures the rate of return earned from an investment over a period of time.
RELATED TERMS
  1. Implied Volatility - IV

    The estimated volatility of a security's price.
  2. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets ...
  3. Profit Margin

    A category of ratios measuring profitability calculated as net ...
  4. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis ...
  5. Debt Ratio

    A financial ratio that measures the extent of a company’s or ...
  6. Passive Income

    Earnings an individual derives from a rental property, limited ...
RELATED FAQS
  1. What is the formula for calculating compound annual growth rate (CAGR) in Excel?

    The compound annual growth rate, or CAGR for short, measures the return on an investment over a certain period of time. Below ... Read Full Answer >>
  2. When does the fixed charge coverage ratio suggest that a company should stop borrowing ...

    Since the fixed charge coverage ratio indicates the number of times a company is capable of making its fixed charge payments ... Read Full Answer >>
  3. What is the difference between the return on total assets and an interest rate?

    Return on total assets (ROTA) represents one of the profitability metrics. It is calculated by taking a company's earnings ... Read Full Answer >>
  4. What does a high turnover ratio signify for an investment fund?

    If an investment fund has a high turnover ratio, it indicates it replaces most or all of its holdings over a one-year period. ... Read Full Answer >>
  5. What is the difference between passive and active asset management?

    Asset management utilizes two main investment strategies that can be used to generate returns: active asset management and ... Read Full Answer >>
  6. How can EV/EBITDA be used in conjunction with the P/E ratio?

    Because they provide different perspectives of analysis, the EV/EBITDA multiple and the P/E ratio can be used together to ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!