How Warren Buffett Picks Stocks
Warren Buffett is acknowledged as one of the very best stock investors ever.
It should go without saying that every investor from beginner to seasoned
expert can benefit by closely reading and studying Warren Buffett's thoughts on how to
pick stocks.
As an investor can you really afford not to study how Warren Buffett picks stocks?
The great man unfortunately has not written an investment book. But he has
written extensively in annual letters to his shareholders and in a number of
published articles. And many books have been written about Warren Buffett. The best insight
to his methods comes from reading his own words. A number of the books written
about him quote his own words extensively.
Here is how Warren Buffett described in his February 29, 2008 letter to shareholders
what he looks for in a company to buy.
In Warren Buffett's own words:
Let’s take a look at what kind of businesses turn
us on. And while we’re at it, let’s also discuss what we wish to avoid.
Charlie and I look for companies that have a) a
business we understand; b) favorable long-term economics; c) able and
trustworthy management; and d) a sensible price tag.
We like to buy the whole business or, if
management is our partner, at least 80%. When control-type purchases of quality
aren’t available, though, we are also happy to simply buy small portions of
great businesses by way of stock market purchases. It’s better to have a part
interest in the Hope Diamond than to own all of a rhinestone.
A truly great business must have an enduring
“moat” that protects excellent returns on invested capital. The dynamics of
capitalism guarantee that competitors will repeatedly assault any business
“castle” that is earning high returns. Therefore a formidable barrier such as a
company’s being the low cost producer (GEICO, Costco) or possessing a powerful
world-wide brand (Coca-Cola, Gillette, American Express) is essential for
sustained success. Business history is filled with “Roman Candles,” companies
whose moats proved illusory and were soon crossed.
Our criterion of “enduring” causes us to rule out
companies in industries prone to rapid and continuous change. Though
capitalism’s “creative destruction” is highly beneficial for society, it
precludes investment certainty. A moat that must be continuously rebuilt will
eventually be no moat at all.
Additionally, this criterion eliminates the
business whose success depends on having a great manager. Of course, a
terrific CEO is a huge asset for any enterprise, and at Berkshire we have an
abundance of these managers. Their abilities have created billions of dollars of
value that would never have materialized if typical CEOs had been running their
businesses.
But if a business requires a superstar to
produce great results, the business itself cannot be deemed great. A medical
partnership led by your area’s premier brain surgeon may enjoy outsized and
growing earnings, but that tells little about its future. The partnership’s moat
will go when the surgeon goes. You can count, though, on the moat of the Mayo
Clinic to endure, even though you can’t name its CEO.
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. There’s no rule that you have to invest money where you’ve
earned it. Indeed, it’s often a mistake to do so: Truly great businesses,
earning huge returns on tangible assets, can’t for any extended period
reinvest a large portion of their earnings internally at high rates of return.
So there you have how Warren Buffett picks stocks in his own words.
Earlier he had described buying common stocks this way in his 1987 letter:
See http://www.berkshirehathaway.com/letters/1987.html
Whenever Charlie and I buy common stocks for Berkshire... we approach the
transaction as if we were buying into a private business. We look at the
economic prospects of the business, the people in charge of running it, and the
price we must pay. We do not have in mind any time or price for sale. Indeed, we
are willing to hold a stock indefinitely so long as we expect the business to
increase in intrinsic value at a satisfactory rate. When investing, we view
ourselves as business analysts - not as market analysts, not as macroeconomic
analysts, and not even as security analysts.
Our approach makes an active trading market useful, since it periodically
presents us with mouth-watering opportunities. But by no means is it essential:
a prolonged suspension of trading in the securities we hold would not bother us
any more than does the lack of daily quotations on [our subsidiary companies that
do not trade on the stock exchange]. Eventually, our economic fate will be
determined by the economic fate of the business we own, whether our ownership is
partial or total.....
In my opinion, investment success will not be produced by arcane formulae,
computer programs or signals flashed by the price behavior of stocks and
markets. Rather an investor will succeed by coupling good business judgment with
an ability to insulate his thoughts and behavior from the super-contagious
emotions that swirl about the marketplace.
Charlie and I let our marketable equities tell us by their operating results
- not by their daily, or even yearly, price quotations - whether our investments
are successful. The market may ignore business success for a while, but
eventually will confirm it. As Ben [Graham] said: "In the short run, the
market is a voting machine but in the long run it is a weighing machine."
The speed at which a business's success is recognized, furthermore, is not that
important as long as the company's intrinsic value is increasing at a
satisfactory rate. In fact, delayed recognition can be an advantage: It may give
us the chance to buy more of a good thing at a bargain price.
Sometimes, of course, the market may judge a business to be more valuable
than the underlying facts would indicate it is. In such a case, we will sell our
holdings. Sometimes, also, we will sell a security that is fairly valued or even
undervalued because we require funds for a still more undervalued investment or
one we believe we understand better.
We need to emphasize, however, that we do not sell holdings just because they
have appreciated or because we have held them for a long time. (Of Wall Street
maxims the most foolish may be "You can't go broke taking a profit.")
We are quite content to hold any security indefinitely, so long as the
prospective return on equity capital of the underlying business is satisfactory,
management is competent and honest, and the market does not overvalue the
business.
...
We really don't see many fundamental differences between the purchase of a
controlled business and the purchase of marketable holdings such as [GEICO, The
Washington Post & Capital Cities / ABC]. In each case we try to buy into
businesses with favorable long-term economics. Our goal is to find an
outstanding business at a sensible price, not a mediocre business at a bargain
price. Charlie and I have found that making silk purses out of silk is the best
that we can do; with sow's ears, we fail.
...
In making both control purchases and stock purchases, we try to buy not only
good businesses, but ones run by high-grade, talented and likeable managers.
Many commentators, however, have drawn an incorrect conclusion upon observing
recent events: They are fond of saying that the small investor has no chance in
a market now dominated by the erratic behavior of the big boys. This conclusion
is dead wrong: Such markets are ideal for any investor - small or large - so
long as he sticks to his investment knitting. Volatility caused by money
managers who speculate irrationally with huge sums will offer the true investor
more chances to make intelligent investment moves. He can be hurt by such
volatility only if he is forced, by either financial or psychological pressures,
to sell at untoward times.
You can read all of Warren Buffett's annual letters to shareholders back to 1977 at
www.berkshirehathaway.com
You can find his older letters to his partners at
http://www.ticonline.com/buffett.partner.letters.html
On this Site we provide a list of books about Warren
Buffett that we like and we provide links to amazon where you can buy
them.