Warren Buffett Investing Style
Warren Buffett is definitely the first name that comes to mind when you think about the world’s most successful investor. Known for his impeccable track record in stock picking and a simple lifestyle the ‘Oracle of Omaha’ is the best person to provide advice on investing.
Warren Buffett investing style is simple. He tries to compound your capital at the fastest rate consistent with a margin of safety. That margin of safety might be a strong balance sheet, or it might be a product with high gross margins that faces little competition.
Warren Buffett is highly educated and had attended the University of Pennsylvania’s Wharton School of Business for two years and later transferred to University of Nebraska-Lincoln for a B.S in Economics and went on to earn an M.S. in Economic from Columbia University. He understood early on in life that the more educated you are the more money you may and the less likely you are to be unemployed.
This is just a small piece of learning out of the large ocean of knowledge that Mr.Buffett has provided us over the years. Some of Warren Buffett investing philosophies also have a strong correlation with his simple lifestyle as well.
Value Investment Philosophy
Value investing is a style of investing that looks at stocks that are priced low or undervalued by the market, but still have the potential for strong growth in future. How does one find if a stock is low priced or undervalued? This involves analyzing the characteristics and fundamentals of the company and its business as well as its positioning in the market.
Based on the analysis one can arrive at an Intrinsic Value or estimate of true value of a stock. If the market price of the stock is significantly lower than the Intrinsic Value then it is a good investment candidate.
This process explained above is similar to bargain hunting that we do in markets. Just as regular bargain shoppers do a lot of window shopping and haggle for lower prices, the same philosophy applies to stock picking or investing. But in case of stock picking there is a lot of research of the company, its business and its future potential, which is where it is different from our regular shopping bargains.
Warren Buffett investing style is concerned with how well a company can make money as a business and is not concerned with whether the market will eventual recognize its worth. In other words Warren Buffett invests in companies that are strong business models with good earning potential.
How to Find Low-Priced Stocks?
(With some inputs from Investopedia.com)
Now most of us may wonder how Buffett manages to find low-priced stocks. There are a few important questions or parameters to be looked in to for every stock that one evaluates. However, remember that these are not the only factors to look for.
1. Consistent Returns
This is measured by looking at the shareholder’s return on investment, which is also commonly known as Return on Equity (ROE). This tells us how much of income is generated for every rupee invested by a shareholder in the company. This can be expressed in percentage terms.
ROE = Net Income / Shareholders Equity (i.e. Net Income divided by Shareholder’s Equity
What is a good ROE? A 20% ROE could be good but this is highly subjective. One has to look at historical ROEs of the company for the past 5 years or so. Similarly to judge if it is high/low you need to compare it with ROEs of its peer companies or its industry average. Understanding the consistency of ROE is more important rather than relying on the recent ROE numbers.
2. Excess Leverage (or Debt)
Leverage is the use of debt to finance a company’s business. Although leverage can magnify returns if used wisely, Buffett likes companies with small amount of debt. He prefers companies that generate earnings growth from shareholder’s equity.
The Debt Equity Ratio indicates the level of leverage.
Debt-Equity Ratio = Total Liabilities / Shareholder’s Equity
What is a Good Debt Equity ratio?
- If debt equity ratio is lesser than or equal to one, it is generally considered normal, however, Mr.Buffet prefers minimal debt much lesser than this.
- If debt equity ratio is greater than one it means that more debt is used to fund the company’s business. A higher debt equity can be a big concern because if business does not do well the debt service or interest payments can eat in to the earnings and affect the shareholder’s returns.
- A good or bad debt equity ratio should also be decided based on comparison with industry averages or those of peers. Similarly looking at historical trends will reveal if leverage has been under control or allowed to increase indiscriminately.
This is also true in case of personal finances. Warren Buffet is known to lead a modest lifestyle and still lives in the same home in Omaha which was bought 50 years ago and drives his own car as well. His characteristic are just opposite of what we see in billionaires such as Donald Trump, Bill Gates or Richard Branson. Warren Buffet has also advised youngsters to stay away from credit cards and debt.
3. Profit Margins
The profitability of a company is linked to its ability to maintain good profit margins (i.e. the difference between revenues and costs). There are several types of margins such as gross margins, operating margins and net margins. All of these are important but lets look at what Net Margins indicate.
Net Margin = Net Profit / Net Sales
A high profit margins indicates that the company is able to maintain good prices and control its costs, thereby generating higher earnings and value for shareholders. This is applicable for any business right from a kirana store in your neighborhood to a large airline.
4. Company’s Market History
Many investors including me are sometimes keen on investing in IPOs either to make long term gains or short term listing gains. But companies that list for the first time are not on Mr.Buffett’s shortlist. The basic premise of value investing is to identify companies with a good track record that have been in the market for a long period across economic cycles.
When these companies are undervalued by the market it is a good time to buy cheap at attractive valuations. But remember the common disclaimer “Past performance does not guarantee future performance”. The investor needs to do more homework to see if the future potential is really good to justify an investment in the stock. If the potential is good, then it’s a good buy.
5. Company’s Products Linked to Commodities
There are many companies that produce products that are either commodities themselves or those products which rely on commodities. For example a company producing oil, gas or by products of oil or gas, etc. Mr.Buffett avoids companies if he feels that the products are indistinguishable from its competitors.
So generally he avoids commodity based companies, but not always. If the commodity-based company offers a differentiated product or offering then it may be worth looking at it as a value investor.
6. Stock Price at 25% discount to its Intrinsic Value
This is the Bargain Offer or test that Mr.Buffet applies to companies to shortlist the best stock picks. Although this sounds pretty simple, finding the intrinsic value is not simple. This involves effective application of Value Investing Principles that we discussed above.
According to the investment guru the intrinsic value of the stock should be atleast 25% higher than the stock’s market value to qualify as an investment pick. Intrinsic Value would include the value of the company’s tangible assets plus intangibles such as brand name, trade marks, licenses, etc, some of which may not appear on the financial statements.
However, the process of determining Intrinsic Value or Fair Value of a company can be highly subjective since different analysts will have a different set of assumptions. Buffett’s acumen in estimating the Intrinsic Value precisely is a mystery which not many people can know or get access to.
Moreover, he is also good at judging a company’s management track record, which are highly subjective and difficult to judge unless one is an expert with a long experience and wisdom to back facts and findings.
Conclusion – Warren Buffett Investing
Warren Buffett investing style is followed by many middle class people, however, his down-to-earth attitude and lifestyle is difficult to imbibe for many. A huge house, fancy cars, hi-fi gadgets, parties, etc are things that most people aspire for. It is important for us to take a leaf out of Mr.Buffett’s simple and practical lifestyle which will provide us with more resources to invest and build wealth.
In addition to learning from Warren Buffett investing style, one should also try to use his/her own judgment that one learns over a period of time and take decisions precisely. For example, we have all seen how late 2008’s market crash was a great opportunity to buy the best stocks at deep discounts or bargains. Although it is dangerous to time the market, deploying your savings at these times can provide a boost to your portfolio returns.
When someone asked Warren Buffet about the holding period of his investment, he stated “forever”. He does not worry about short term blips or price fluctuations. However, remember that not everyone can become a Warren Buffet, and we also don’t have the same level of knowledge, funds or resources that Buffet and his company Berkshire Hathaway boasts of.
You can definitely implement some of the points from Warren Buffett investing recommendations, but it takes a lot of time and effort to become a successful Value Investor like Mr. Buffett. Whether you are a layman or a seasoned investor or a legendary investor, remember that “Practice makes perfect”.
Keep tracking your investments and apply your ideas and keep learning continuously. The desire to learn more and more will take you forward towards making your successful in various facets of life.