How to Invest Like Warren Buffett

Last Updated: 1st January 2016

Overview

“I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years” – Warren Buffett

Welcome to this guide on how to invest like Warren Buffett, I will be writing about Warren Buffett’s investment strategy and teach you how to invest in the stock market successfully. This investment guide is a brief version of my upcoming How to Invest Like Warren Buffett book.

As of 2015 Warren Buffett is the third richest man in the world with an estimated fortune of about $72.7 billion according to Forbes. Warren Buffett is the CEO of Berkshire Hathaway and over 5 decades he has consistently generated an average annual return of approximately 20%.

 

Warren Buffett is considered as one of the world's most successful investors. He started investing in the stock market using a businesslike approach and this investment guide will show you how you can do the same.

Buffett researches stocks by looking at the financial statements, reading annual reports and estimating what he thinks each business is worth.

His investment approach is very businesslike as if he was buying the whole company with a focus on the long-term value. If after carrying out his research he believes that the business has good long-term prospects and the business is trading at a price below what he thinks the business is worth, then he invests in it.

The businesslike approach also means that he thinks like a business owner, as he views his investment as an ownership interest in the business, he is no longer worried about day-to-day fluctuations in the market value of the business – he is only concerned with the business performance numbers such as how much the business earns.

Also, Warren Buffett ignores market forecasts and makes no attempt to forecast what will happen in the future, including whether the markets rise or fall, what a stock’s price will do in the short-term, whether the fed will raise interest rates, etc.

Warren Buffett believes that by investing in solid businesses with decent long-term prospects, over the long-term the stock price will move upwards with the earnings.

What Warren Buffett looks for?

When Warren Buffett looks at stocks to invest in, there are 4 four things which he looks for, which are as follows:

  • Simple Businesses
  • Consistent Earnings Power
  • Durable Competitive Advantages
  • A Reasonable Price

That is a very simple yet powerful investment checklist, I am now going to go through each of the items in a more detailed manner. Whilst this investment checklist seems very simple, most stocks will not meet all of his criteria.

Simple Businesses

"Experience, however, indicates that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago" - Warren Buffett

Warren Buffett is interested in businesses that are simple and that are not subject to rapid change. This is why he does not invest in technology companies which is an industry which is subject to rapid change. Technology changes very quickly, and you cannot not know for sure if the technology will still exist in the years to come.

Warren Buffett takes a long-term view when investing in the stock market, if the product is consistently changing then it is much more difficult to know where the business will be or what it will look like in 10 years from now. Remember Nokia, at one point they had the best mobile phones, then came Blackberry and now Apple and Samsung, Maybe in the near future we might just use Google Glasses for all our communications.

So you will want to find stocks which you really understand and where the product or services will be little changed in the future such as chewing gum manufacturer or maybe a furniture store. Of course the main point here is that you really understand the business, if you understand the business then you might understand what the business will look like in 10 years’ time from now.

Only invest in businesses that you understand, if you understand the business then you will know what the business might look like in 10 years’ time from now. If you know what the business might look like in the future, then you can consider investing in the stock.

Consistent Earnings Power

Warren Buffett likes to invest in stocks that have long and successful track records, he stays away from companies with a short earnings history. You will not find any hot IPOs or penny stocks in Warren Buffett’s portfolio. If a stock has a history of strong and rising earnings, it is likely the company will continue to earn over the long-term. When investing in stocks, the capital growth will come as the company earns more money over time - assuming you didn't overpay for any of the stock's, but I will go more into this in the how to value a business section.

When investing in the stock market it is important to find stocks that have consistently earned money over long periods of time, which will usually be over a number of business cycles, meaning that you know whether the company can do well even during recessions or other events which might affect the overall economy in general. You want to invest in stocks that will continue to do well regardless of general business conditions. You can only tell this with reasonable accuracy by looking at the earnings history for the stock that you are considering investing in. At the very minimum you want to see how a business performs over 10 years, 5 years is not enough time to get a good understanding of the quality of a business and the performance of its management.

The stocks that you invest in should be earning more money, year after year. Occasionally you might find a great company which has suffered a short-term setback which causes investors to panic and sell the shares which in turn causes the stock price to plummet and the business to become undervalued. The setback could be potential litigation, decreased earnings or even a recent earnings loss. As long as the company is strong enough to come back, then you can consider the stock as a potential investment. Consistent earnings are important, but from time to time even great companies might suffer from a short-term setback. 

Look for stocks with at least a 10-year history of earnings, the company’s earnings should be consistently rising. If the company has recently announced a loss but you think that it is only a short-term setback and the company can recover from this, then it could be a potential investment opportunity.

Durable Competitive Advantages

“Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere.” – Warren Buffett

The best businesses to own are the businesses which have a high return-on-equity (ROE) and have little or no debt. Let's say you invested $100,000 in a business which makes $50,000 in profits each year - that is an excellent business which has a 50% ROE. With time competitors will hear about your success and start creating competing businesses - this is the nature of capitalism. As more competitors start competing with you, your business starts to earn less, until it is no longer an excellent business. This happens all the time in business and the stock market.

Warren Buffett likes to invest in stocks which have durable competitive advantages, he likes to describe these competitive advantages as moats, which protects the castle (i.e. the business). If a business has competitive advantages, it can hold off and protect its business and profits from competitors.

There are a number of competitive advantages which a business may have, here are some examples:

  • A low-cost producer or supplier e.g. Geico
  • A powerful world-wide brand e.g. Coca Cola
  • A patent or license e.g. Pfizer
  • High Barrier to entry e.g. Burlington Northern Santa Fe

Businesses which have competitive advantages and have had them over long periods of time are very profitable business and they usually do not need to borrow large amounts of money to make money.

It is important to note that if a company has borrowed a significant amount of money, the ROE numbers will still be high. Let's say you started a business with $100,000, borrowed $500,000 from the bank, and the business earns $50,000 each year. The ROE will still be 50%, as the calculation does not take into account debt. The reality is, this is not a good business because it needed $600,000 to make profits of $50,000. In the last section when I discuss how to find stocks to invest in, I will show you how to use return-on-invested-capital (ROIC) to weed out the businesses which generate high return-on-equity but have large amounts of debt.

Wonderful businesses which have durable competitive advantages typically generate high return-on-equity (ROE) with very little or no debt.

A Reasonable Price

“It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” – Warren Buffett

When Warren Buffett invests in businesses, he doesn’t like to overpay. In fact, he always likes to pay less than what the business is worth. A business is only worth so much, the business cannot be worth more than what you can take out during it’s lifetime, therefore it is important to understand this and always pay less than what a company is worth. I will teach you how to value a business later on in this investment guide.

A business is only worth what you can take out of it during its lifetime, never pay more than what the business is worth.

Stock prices over the long term follow the company's earnings, sometimes the stock might be overvalued and sometimes undervalued, but over the long term the stock price follows the earnings. For this reason, if you overpay for a stock, especially if you significantly overpay, even as the company earns more and more, the stock price might go sideways or even go down because the stock price was way overvalued. An example of this is the Microsoft stock, which has the ticker symbol MSFT. Microsoft's stock price between 2002 and 2012 went sideways, it stayed roughly $25 for almost a decade whilst its earning-per-share (EPS) almost tripled and went from $.94 to $2.72.

The safest way to invest is to only invest in stocks that are selling at reasonable prices, that means the stock is undervalued and can be bought at less than what the company is actually worth.

We have just gone through Warren Buffett’s investment checklist, and now it’s time for you to look at some of the stocks in Warren Buffett’s portfolio.

Warren Buffett’s Portfolio

To help give you an understanding in Warren Buffet’s investment strategy and the types of businesses that he buys, I am going to list some of the stocks which are in Warren Buffett’s portfolio. These are Warren Buffett's holdings as of June 30 2015 which has been obtained from the Berkshire Hathaway's 13-F filing.

Symbol Company
AXP American Express Company
AXTA Axalta Coating Systems Ltd
BK Bank of New York Mellon Corp
CBI Chicago Bridge & Iron Company N.V.
CHTR Charter Communications, Inc.
COST Costco Wholesale Corporation
DNOW NOW Inc
DTV DIRECTV
DVA DaVita HealthCare Partners Inc
DE Deere & Company
GE General Electric Company
GHC Graham Holdings Co
GM General Motors Company
GS Goldman Sachs Group Inc
IBM International Business Machines Corp.
JNJ Johnson & Johnson
KO The Coca-Cola Co
KHC Kraft Heinz Co
LBTYA Liberty Global plc - Class A Ordinary Shares
LBTYK Liberty Global plc - Class C Ordinary Shares
LEE Lee Enterprises, Incorporated
LMCA Liberty Media Corp
LMCK Liberty Media Corp
MA Mastercard Inc
MEG Media General Inc
MCO Moody's Corporation
MDLZ Mondelez International Inc
MTB M&T Bank Corporation
PCP Precision Castparts Corp.
PSX Phillips 66
PG Procter & Gamble Co
QSR Restaurant Brands International Inc
SNY Sanofi SA (ADR)
SU Suncor Energy Inc. (USA)
TMK Torchmark Corporation
FOXA Twenty-First Century Fox Inc
UPS United Parcel Service, Inc.
USB U.S. Bancorp
USG USG Corporation
V Visa Inc
VIAB Viacom, Inc.
VRSK Verisk Analytics, Inc.
VRSN Verisign, Inc.
VZ Verizon Communications Inc.
WBC WABCO Holdings Inc.
WFC Wells Fargo & Co
WMT Wal-Mart Stores, Inc.

Note: Do not just go out buy these stocks because they are in Warren Buffett’s portfolio as some of these companies, he bought years or even decades ago when the stock prices were undervalued. Many, if not, most of these stocks are probably not undervalued.

Let’s move on to the next section now so you know how to find out if a stock is undervalued.

How to Value a Business?

Intrinsic Value

“Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.” – Warren Buffett

In order to value a stock properly, you are going need to estimate what you think you might be able to take out of the business during its lifetime, and then you will need to discount those earnings back to the present value, which will give you the business’s intrinsic value.

What do I mean by this, well there is a concept in finance called the time value of money which states that a dollar today is worth more than a dollar tomorrow. This is because you can invest that dollar today and have more than a dollar tomorrow. Therefore, the money that you have today is worth more than having the same amount of money in the future.

Let’s say you know that you can earn 10% annually by investing. If you invest $100,000 today at a 10% annual rate, after 5 years your money would be worth $161,051. If you were given a choice to receive $100,000 today or in 5 years’ time, today the money would be worth more to you as you will have a chance to invest and grow the capital.

The intrinsic value of a business is different to the market value, the market value is what you can currently buy the business for, whilst the intrinsic value is what you estimate the business to be worth. The market value of a business on the stock market changes second to second, as investors and traders buy and sell the stock, the market makers adjust the price to supply and demand which is based upon investors perceptions. However, the intrinsic value does not change quickly at all, if you have higher or lower expectations of the future growth rate of a stock, then you will adjust your assumptions in your calculations then you will get a different value.

The intrinsic value is the value which you estimate the business to be worth.

Margin of Safety

“We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.” – Warren Buffett

Benjamin Graham, was Warren Buffett’s teacher, friend and mentor. Benjamin Graham said that investors should only buy a stock when there is a sufficient margin-of-safety. In order to know if a stock has a margin-of-safety you will need to know two things, what is the market value of the stock and what is the intrinsic value. These numbers can also be per-share figures, which you will find easier to work with.

Let’s say there is a stock current selling for $75 per share, and you have estimated the intrinsic value to be $100 per share, then there is a margin of safety of 25%.

The margin-of-safety is the difference the between the intrinsic value and the market value. If the intrinsic value of the business is higher than the market value, then there is a margin-of-safety.

Remember a business is only worth what you can take out of the business, its not worth anymore, therefore when buying a stock there must always be margin-of-safety present, which means you will be buying the stock for less than what it is worth. By also paying less than that what the stock is worth, it leaves you room for errors, so if something changes or you were slightly wrong in your estimate, you can still end up buying the stock for less that what is worth.

Warren Buffett has said that the margin-of-safety principle is the cornerstone of success in investing.

Owner Earnings

“We consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes - both for investors in buying stocks and for managers in buying entire businesses” – Warren Buffett

When valuing a business rather than using the Wall Street earnings number, Warren Buffett prefers to use what he calls Owner Earnings. Warren Buffett's owner earnings number tells him exactly what the business really earned. Owner earnings is calculated with the following formula:

Owner earnings = net income + depreciation, amortization and certain other non-cash charges – average capital expenditures needed to maintain current volume

All this information can easily be found in the financial statements that company’s report. You can find the financial statements by looking on either the company’s website, search the SEC Edgar database where all the filings are stored, or lookup this information using financial portals such as Yahoo Finance, Morningstar and MSN Money.

To make things even easier for you, I have created an intrinsic value calculator which can automatically calculate the owner earnings for a particular business. You simply enter the ticker symbol and it will pull the values for you. More on valuing a business in a moment.

If you wanted to pull the numbers yourself for a company, then simply look at the cash flow statement for the company. For example, let's look at the cash flow statement for Nike

Net Income : 3,273

Depreciation & amortization: 649

Average Capital Expenditures:  (-636 + -880 + -963 ) / 3 = -826.33

Owner Earnings = 3,273 + 649 - 826.33 = 3,095.67

The main point in this section is that you understand how much the business is really earning, by adding back depreciation and amortization charges (which are non-cash charges) then subtract the average capital expenditures.

Rather than using the standard Wall Street earnings numbers to value a business, use the owner earnings number instead.

Discount Cash Flow (DCF) Analysis

Earlier when I introduced you to the intrinsic value concept, I talked about estimating the future earnings of a business then discounting them to the present value. Don't worry, the intrinsic value calculator will do all these calculations for you, for now it is just important to understand how this works. This process of estimating the future earnings of the company and then discounting them back to the present value is called Discount Cash Flow (DCF) Analysis.

In order calculate the value of a business you will need to know how much the company is earning, how much cash the company has, and an estimate of the growth rate that you expect the company to achieve over the next 10 years. Also, as you will want to work with per share numbers which quite frankly are easier to work with, you will need to know how many outstanding shares the company has and its most recent stock price. Again all of this information is public and it is very easy to find. To use the intrinsic value calculator, simply enter the ticker symbol and it will pull all the details from our database. You can then make adjustments to the data, if needed.

Discount Cash Flow Analysis Example

Let's look at Nike, which has the ticker symbol NKE. Our intrinsic value calculator says that Nike owner earnings are $3,095.67 and currently has $5,924.00 in cash, and we will make the following assumptions:

  1. Nike will grow owner earnings at a 12% annual rate
  2. We can get a 10% return elsewhere - the discount rate
  3. We will sell the business in 10 years' time for 12x owners earnings

This is what our DCF analysis will look like:

  Owner Earnings Present Value
Cash   $5,924.00
2016 $3,467.15 $3,151.95
2017 $3,883.21 $3,209.26
2018 $4,349.20 $3,267.62
2019 $4,871.10 $3,327.03
2020 $5,455.63 $3,387.52
2021 $6,110.31 $3,449.11
2022 $6,843.55 $3,511.82
2023 $7,664.78 $3,575.68
2024 $8,584.55 $3,640.69
2025 $9,614.70 $3,706.88
Sale Price $115,376.40 $44,482.60
Total   $84,634.16

The results say that Nike has an intrinsic value of $84,634 million, or $84 billion. To convert this into a per-share figure we simply divide the intrinsic value of $84,634 million by 884 which is the number of shares outstanding, this gives us a per share intrinsic value of about $95 and since we know Nike is current trading at $131 per share we can immediately see that this business is overvalued as the stock price is greater than the intrinsic value.

Valuing a Business

Now I am going to walk you through using our intrinsic value calculator tool, using Nike again as the example.

First click on the tools menu, then click on the intrinsic value calculator link.

Enter the ticker symbol NKE in the stock lookup box and click on the lookup button.

This will fetch all the numbers needed for calculating the intrinsic value from our database.

I have adjusted the growth rate to 12%. Once you have made adjustments, if needed, then simply click on the calculate button. Then the results are displayed.

At the bottom of the page you will see the per share intrinsic value and the margin-of-safety.

Now you have learnt what Warren Buffett looks for in investments, i.e. Warren Buffett’s investment checklist, as well as how to value a business, and what the margin-of-safety concept is.

So the next question is how to find stocks to invest in?

How to Find Stocks to Invest in?

You know that you want to find businesses which are simple, have consistent earnings over a period of 10 years or more, with durable competitive advantages and that can be bought at reasonable prices.

The easiest way to find the stocks to invest in, is to use a stock screener tool, there are many of these on the internet. However, I have created a stock screener just for you, which is both fast and simple and allows you to find the type of stocks that we have talked about in this investment guide.

There are more than 4,500 companies listed on the US stock exchanges, and you are going to want this to narrow this down significantly.

You will do this by simply screening for stocks which have a high return-on-invested-capital (ROIC), since you want to find companies which are earning high return-on-equity (ROE) and have little or no debt.

Screen for stocks which have an ROIC of 15% or higher, the higher the ROIC the better the company, just remember there will be fewer companies to choose from.

3 Step Stock Screening

  1. Click on the tools menu, then click on stock screener
  2. Enter the minimum ROIC that you want to screen for
  3. Click on the go button

All you need to do now is go screen for stocks, then do some research on them such as looking at the financial statements, value the businesses and check off the investment checklist.

If it makes sense then before investing, follow up and read the annual report for the stock which you can find on the company website or other financial websites such as Yahoo Finance, MSN Money or Morningstar.

Learn as much as you can about each business before making an investment.

If you have found this investment guide useful then please share this page with your friends using the share buttons as this motivates me to add new content and keep the content updated.

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