Investors have long praised Warren Buffett’s ability to pick which companies to invest in. Lauded for consistently following value investing principles, Buffett has accumulated a fortune of over $80 billion dollars over the decades, 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.
Understanding Warren Buffett 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, good return on equity, 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 investing strategy. To guide him in his decisions, Buffett uses a number of 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.
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.
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.
How unique are the products sold by the company?
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.
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 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 thinks 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.