A Short-Cut For Finding Great Stocks That Can Make You Wealthy
If you’re interested in learning a short-cut for finding the same type of stocks that has made Warren Buffett one of the richest men in America, this cheat sheet is tailor made for you.
Before we begin, I need to answer one question that comes up frequently: “wouldn’t it be easier to just invest in Berkshire Hathaway Stock?”
My answer comes in two parts.
The first is simple – yes. Most investors will never have the inclination or desire to become actively involved in stock selection and therefore are best leaving the task to a successful investment professional.
The second answer is the caveat and also where the big money lays for those that are willing to do a little work.
Because Warren Buffett now manages such a large sum of money (over 100 billion dollars) he’s forced to invest in the largest companies which limits his performance going forward. In essence he’s no longer able to invest significantly in those small and mid-cap companies that have the potential to double or triple market returns. That’s been the strategy for one of our best newsletters, the award winning Worthington Stock Letter, which has proven to be very successful for beating the market.
While most investors aren’t able to garner the favorable investment terms or arbitrage situations that Warren Buffet now commands, they are able to invest in those smaller companies with economic advantages that Warren is too big to pay attention to anymore. Here’s what Warren had to say about investing in small and mid-cap value stocks.
“The highest rates of return I’ve ever achieved were in the 1950s, I killed the Dow. You ought to see the numbers. But I was investing peanuts then.”
“It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that. But you can’t compound $100 million or $1 billion at anything remotely like that rate.”
Yes, I would still say the same thing today…You have to turn over a lot of rocks to find those little anomalies. You have to find the companies that are off the map – way off the map. You may find local companies that have nothing wrong with them at all…
Having a lot of money to invest forced Berkshire to buy those that were less attractive. With less capital, I could have put all my money into the most attractive issues and really creamed it.
As you can tell, it pays to do a little homework to find those gems that the large hedge funds and Warren Buffett are unable to invest in due to their size.
Below you will find the teachings of Warren Buffett distilled down to the essentials, focusing on content that is of practical value and easy to implement. I’ve eliminated theoretical concepts and complicated financial models, opting for a more simplified process. A process that anyone can use to beat the market given the inclination and willingness to do so, along with a modicum of talent for the task at hand.
For those interested in additional information I highly recommend reading “The essential essays of Warren Buffett” and reading his Berkshire Hathaway Letters.
Section I: Investing Principles
Most stock investors simply want a list of stocks to invest in handed to them. That’s one of the biggest reasons they never become successful investors. The reason being, if you don’t first build a strong foundation and understand the philosophy or “why” of what you’re doing, your chances for success are very small, if not non-existent.
In this section I rely on a lot of quotes by Warren to illustrate his investing principles or the why of his stock selections. The reason that I took this approach is two-fold. The first is that I wanted to attribute the ideas to the person that came up with them. The second is that he puts the concepts and teachings together so succinctly. Remember one of the goals of this article is to give you exactly what you need, without all the fluff to make you a successful investor.
Investing Principle #1: Invest in Great Companies, Not Mediocre Businesses at Bargain Prices.
“Time is a friend of the wonderful business, the enemy of the mediocre.” Warren Buffett
A mistake that many value investors make and one that Warren Buffett made early in his career was to invest in mediocre companies offered at bargain basement prices. Warren warns about this approach;
“If you buy a stock at sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the “cigar butt” approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the “bargain purchase” will make that puff all profit.” “Unless you are a liquidator, that kind of approach to buying business is foolish.”
“Our goal is to find an outstanding business at a sensible price, not a mediocre business at a bargain price.”
“…but this investment approach-searching for the superstars-offers us our only chance for real success” “Charlie and I are simply not smart enough, considering the large sums we work with, to get great results by adroitly buying and selling portions of far-from-great businesses.”
How do you find these great companies to invest in? That will be covered in the second half of this article.
Investing Principle #2: Only Invest in the Very Best Opportunities the Stock Market Has to Offer.
This is slightly different from investing principle #1 one in that you’re now looking for the best of the great companies to invest in.
One of the reasons Warren Buffett has become so successful is that he does the opposite of what most investors do. To that point, he does not believe in diversification of investments. He believes diversification is aimed at protecting people from their own stupidity and argues that the only investors who need broad diversification are those that don’t know what they’re doing.
As of this writing Warren Buffett has about 67% of his $128 billion portfolio concentrated in only 5 stocks. The five stocks are Wells Fargo, The Kraft Heinz Co., Coca-Cola Co., IBM and American Express. All have strong brand recognition and stood the test of time.
His top five holdings have accounted for an average of 73% of his investments over the last 25 years. The number would be even greater if it weren’t for the large sums of money he now has to invest.
Warren feels that it’s too hard to make hundreds of smart investing decisions over a lifetime. Here are some of his thoughts on this investing principle:
“…able to understand business economics and to find five to ten sensibly priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices”
“…but this investment approach-searching for the superstars-offers us our only chance for real success”
“Inactivity strikes us as intelligent behavior”
Investing Principle #3: Not Every Stock You Select, Will Be a Winner.
The goal of investing is not to be right in every selection. Trying to be perfect is a fool’s game.
The main thing to focus on is not the percentage of winning stocks you pick, but how much your winners offset your losers.
“To date, our corporate over-achievers have more than offset the laggards.”-Warren Buffett
The goal therefore is to pick the best stocks you can find, that on aggregate will greatly outperform the stock market averages over time. That’s how you get rich investing in stocks.
Investing Principle #4: Buy More When the Market is Down
“Our goal is more modest: we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” – Warren Buffett
Behavioral science suggests that human brains are hard wired to do the opposite of what’s required to be a successful investor. They buy companies at high prices when news is good and sell at low prices when news is bad.
It should come as no surprise then, that Warren Buffett does the exact opposite. The eternal optimist that he is, Warren believes the best time to buy stocks is when no one else wants them.
His process is simple in that respect. He builds up cash reserves when stocks are expensive and buys them when they are cheap. His best buying opportunities come during bear markets, industry recessions or a one-time negative event that hits a company’s stock price.
Here are two quotes by Warren Buffett that illustrate this point best:
“Our advantage, rather, was attitude; we had learned from Ben Graham that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values”.
“The most common cause of low prices is pessimism-sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer.”
At this point many investors jump to the wrongful conclusion that contrarian investing is the best approach. However, if you go in the opposite direction of the market simply to be a contrarian you can quickly find yourself with large losses.
This is what Warren had to say; “None of this means, however, that a business or stock is an intelligent purchase simply because it’s unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy.”
Investing Principle #5: Long-Term Investing Doesn’t Mean Lifetime Investing.
While the idea of buying and holding a stock forever has great appeal, in actual practice it can severely limit your success and lead to significant losses.
Warren Buffets mentor Benjamin Graham, was nearly wiped out by the stock market crash of 1929. After that experience Benjamin Graham decided to transform his investing approach.
Warren Buffets right hand man Charlie Munger, faced a similar challenge during the 1973-1974 stock market correction which cost Munger’s partners a 53% loss. After recovering from this loss, Munger shut down his fund in 1976.
As an astute student of history, Warren Buffett learns from the mistakes of others so he doesn’t repeat them. Therefore, he has three situations where he will sell stock positions of the companies he owns.
Situation #1: The first situation occurs when the market values the company a lot higher than the underlying facts suggests it should be valued. Let’s look at a couple of those times.
In 1969 Warren Buffett judged that the market was overvalued. Stalwart companies were selling at 50-70 times earnings at that time so he closed his investment partnership, sold off his investment portfolio and “sat on his hands” for 3 years. Buffett said those were the longest 3 years of his life. Although he got out of the market a bit early, he was able to start buying again in 1973-1974 taking advantage of a 45% correction in the Dow Jones Industrial Average.
In late 1990 leading pundits accused Warren Buffett of losing his touch as the dot com bubble reached manic proportions. Again, company stalwarts were trading at or near all-time Price-to-Earnings ratios. Coca Cola and Walmart were trading at 40-50 times earnings. This signaled to Warren that the market was overvalued so he sold positions and raised cash. He was once again able to take advantage of the ensuing market meltdown and buy at bargain basement prices.
The most recent example came in 2007 when Warren again thought the market was overvalued based on valuations and was letting his cash pile up. After the financial collapse, he was able to leverage his cash holdings, buying companies for pennies on the dollar towards the end of 2008.
When price-to-earnings ratios and profit margins of non-cyclical companies are near record highs, it’s time to be cautious and consider selling portions of your investment holdings to raise cash. You want to have cash on hand for the times the market corrects and offers buying opportunities.
There are two other situations when Warren advises that your stock holding(s) should be sold.
Situation #2: The second situation to sell your stock is when there’s a fundamental change in the business or the industry that erodes the underlying competitive advantage the company has. This can be new technology, changes in government policy, a new executive team that’s not as competent or any other number of factors. These changes should be long-term in nature.
Situation #3: The third situation where it’s prudent to sell a holding is when another business opportunity presents itself that’s better than the current one you’re invested in. You always want to be invested in the best companies when their stock price offers the greatest opportunity for price appreciation.
Investing Principle # 6: Only Invest in Businesses Run by People That You Can Trust.
Buffett looks for a strong management team that is open and truthful in their reporting of events. He determines this by reading through past annual reports paying particular attention to statements made by executive leadership regarding future strategies and growth. By tracking how those strategies and growth estimates unfold, he is able to gain a perspective on how well the company is managed and how forthright the executive team is.
Do they fully disclose company performance, reporting both mistakes and successes? Do they report information beyond what is required by generally accepted accounting principles (GAAP)? How do their annual reports compare to others in the industry?
Warren Buffett looks for companies that provide him with enough information in their financial reports to determine the approximate value of the current and future business prospects for the company. He models his Berkshire Hathaway reports based on the type of information and disclosure he looks for in other companies.
In addition, he pays particular attention to how management is using cash flows to determine if they’re shareholder friendly. Good uses would include:
- Paying additional dividends
- Buying back stock to increase shareholder
- Funding acquisitions of related companies with a competitive advantage
- Reinvesting the extra cash back into the company.
Bad uses of cash flow include:
- Buying back stock to offset the simultaneous issuing of stock options.
- Making acquisitions in commodity type businesses simply for the sake of growth.
Investing Principle # 7: Beta Does Not Measure the Right Kind of Risk.
Beta measures how volatile an individual stock price is compared to the broader stock market index. If the stock price follows the market price up and down at about the same rate, it’s said to have a low beta or low risk profile.
Buffet points out how absurd this is;
“Value investors scorn the idea of beta because it implies that a stock that has fallen sharply in value is more risky than it was before it fell. A value investor would argue that a company represents a lower-risk investment after it falls in value.” – Warren Buffett
In the same vein, you shouldn’t measure risk by volatility. Volatility measures price movement to the upside and downside. Buffett contends that you shouldn’t be concerned about volatility to the upside, that’s why you invest. You should only measure risk by potential losses from where the company stock price is currently sitting.
Investing Principle # 8: Leverage – Buffett’s Hidden Advantage
in the paper ‘Buffett’s Alpha’ by Frazzini, Kabiller, and Pedersen, the authors found that Warren Buffett “applies about 1.4X to 1.6X leverage” in his investments. That essentially means that he invests $140-$160 for each $100 he has.
Typically, using financial leverage is a very risky proposition if not done right. Investors and businesses alike have lost vast fortunes from being too highly levered. Long Term Capital Management (LTCM) being one of the most infamous examples.
That said, instead of having to borrow money for leverage and worry about margin calls, Buffett gets his leverage from using the “float” of his insurance subsidiaries at extremely low and at times, even negative rates.
This is a big advantage that individual investors cannot recreate without incurring a good amount of additional risk.
I would strongly advise readers to use caution before attempting to use any leveraged financial investments as one mistake could wipe out your entire account.
Section II – Financial Concepts
Financial Concept #1: Stocks as Equity Bonds
What many investors don’t realize is that Warren Buffett is a bond investor disguised as an equity investor. Warren Buffett’s mentor Benjamin Graham, started as bond analyst looking for undervalued situations in bonds. This had a great influence on Warren Buffett who came to look at stocks with steady predictable earnings as an equity bond with a variable coupon.
Before we get any further, there’s an important distinction that needs to be made between stocks and bonds. I’m keeping this as simple as possible.
A bond is bought and sold at a fixed rate. While the value of a bond can change prior to maturity; at maturity it will sell at face value. If you buy a 10 year $1,000 bond, its value at maturity is $1,000. What you earn on the bond is the yield or interest rate you’re paid to hold on to that bond for the specified period of time, for example 5% for 10 years.
A stock on the other hand, is not bought or sold at a fixed rate. Its value can decrease or increase until you sell the stock. That’s a very important distinction as a company can grow its value by increasing earnings and book value over time. Its value is not fixed.
Bonds vs. Stocks
The safest investment is considered to be bonds backed by the U.S. Government. Investors use the yield on the 10 year U.S. Bond as the “risk free rate” for investing.
Therefore, you’d need any other investment to achieve a higher rate of return than the 10 year U.S. bond in relation to the additional (perceived) risk that you are taking in that investment.
To determine whether a 10-year bond or company stock is a better investment, Buffett compares the expected return of the company stock to bond yields using discounted cash flows. The discounted cash flow model asserts that the value of an asset is the net present value of its future expected cash flows (you can pick up a financial book or find a website for examples of how to do the calculation).
The discounted cash flow model works best with mature companies that have had consistent growth because the inputs of estimated growth and cash flows determine the output or net present value of a company. That’s one reason why Buffett is looking for companies with steady earnings over an extended period to time.
Here’s what Warren had to say about the calculation:
“..though the mathematical calculations required to evaluate equities are not difficult, an analyst-even one who is experienced and intelligent-can easily go wrong in estimating future “coupons”. At Berkshire, we attempt to deal with this problem in two ways. First, we try to stick to businesses that we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change, we’re not smart enough to predict future cash flows.”
“Second and equally important, we insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher that its price, we’re not interested in buying.”
There are many studies showing the futility of trying to accurately predict what’s going to happen next year, much less 10 years down the road. Therefore, financial analysis is as much of an art form as it is financial science.
“Back of the Napkin” Calculation
As a short-cut for comparing whether a stock or bond is a better buy, you can compare the company’s book value percentage change year over year to the bond yield.
While not perfect because historical growth rates aren’t fixed into the future and book value doesn’t account for economic goodwill (which will be covered later), it’s a quick calculation you can use to determine if a stock or bond would be a better investment.
As a safety net, Buffett would be looking for approximately a minimum 4-5% extra return on stocks compared to bonds to compensate for the additional risk of stocks. Based on the historical average bond yield of 5-6% he would need10-15% forward returns on his stock investment. In low interest rates environments, he would decrease the needed stock returns and vice versa.
You may surmise at this point, that it’s more advantageous over time to hold quality stocks rather than bonds, due to their ability to grow in economic value year over year and compound those returns over time. This is typically true, but not always. That’s why you have to do the work.
Financial Concept #2: Hidden Value – Intrinsic Value and Economic Goodwill
Intrinsic value – “the discounted value of the cash that can be taken out of a business during its remaining life” – Warren Buffett
The following quotes from Warren Buffett do best at explaining what he calls the intrinsic value of a company.
“Obviously, we can never precisely predict the timing of cash flows in and out of a business or their exact amount. We try, therefore, to keep our estimates conservative and to focus on industries where business surprises are unlikely to wreak havoc on owners. Even so, we make many mistakes.”
“Ultimately, business experience, direct and vicarious, produced my present strong preference for businesses that possess large amounts of enduring Goodwill and that utilize a minimum of tangible assets.” “Consumer franchises are a prime source of economic Goodwill.”
Economic Goodwill is the extra profit that a company makes, attributed to charging higher prices above comparable items due to brand names and reputation.
“… businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return. The capitalized value of this excess return is economic goodwill.” – Warren Buffett
Intrinsic value and economic goodwill allow companies to raise prices during inflationary times, maintain their net profit margins during recessionary times and protect market share. Companies that sell similar products/services that are considered interchangeable by buyers aren’t able to protect profit margins during such times.
Financial Concept #3: The Impact of Inflation
Warren Buffett illustrates the effects of inflation perfectly with the example of his purchase of See’s Candy. In 1972 See’s Candies was earning $2 million in revenue on $8 million in net tangible assets. He compared See’s Candy to a company earning the same $2 million that required $18 million in net tangible assets.
Both companies generate the same earnings and have similar cash flows which make investors look at them in the same way. But what happens over time when inflation doubles the price of goods?
See’s Candies will require an additional $8 million in net tangible assets to earn an additional $2 million in sales. The second company needs an additional $18 million in net tangible assets to generate the same additional $2 million in sales.
As inflation grows, so do the costs of doing business including servicing debt levels.
This helps to illustrate why using only earnings per share and cash flow can lead the investor astray over time. As inflation rises, the second company has to invest more than twice as much money for net tangible assets which means it will earn lower rates of return and have less money to return to shareholders.
Financial Concept #4: “It is Better to Be Approximately Right Than Precisely Wrong”
“In our view, though, investment students need only two well-taught courses – How to Value a Business, and How to Think About Market Prices.” – Warren Buffett
To deem whether a business is a good buy or not, you have to first put a value on the worth of the company. A couple of the more popular financial models to help determine that are the dividend discount model and enterprise value. If you want to delve into these financial modles I recommend starting out with ‘Security Analysis’ by Benjamin Graham, David Dodd, and Seth Klarman.
No matter which financial model you end up using, it will be fraught with imprecise calculations and dependent on guesswork for financial inputs and future growth estimates that can lead even the most advanced financial analyst astray. Different analysts can use the same financial model and come up with vastly different estimates.
That is but one reason why Warren Buffett is drawn to companies with a long successful track record of growing earnings in a stable manner. It makes financial analysis more predictable.
“..we favor businesses and industries unlikely to experience major change.” “A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek.” – Warren Buffett
To make matters more complicated, accounting itself is an art form. Earnings can be manipulated through financial engineering which can include, but is not limited to restructuring charges and one-time events to smooth out earnings. Financial Shenanigans by Jeremy Porter is a good read to understand more about financial engineering.
To get around complicated financial analysis you could use popular ratios such as price-to-sales, price-to-earnings, price-to-book etc. to help value a company but Warren had the following to say about using such an approach:
“Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business. Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years.”
Due to the inherent limitations of financial models Warren Buffett has the following advice when it comes to valuing a company’s worth:
“Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach.”
“It is better to be approximately right than precisely wrong.”
That said, it’s essential to have a solid understanding of financial statements and a framework to evaluate a company’s current and prospective worth.
At the very least, when reading through financial statements you have to be able to answer three basic questions: the approximate worth of a company, its ability to meet debt obligations and how well the company is run.
Financial Concept #5: Margin of Safety
I would be remiss if I didn’t cover one last point in this section, Margin of Safety.
Given the limitations of financial analysis and in predicting the future, Warren Buffett requires a margin of safety in the prices of the companies he buys. Essentially, margin of safety equates to only buying a company when the price is substantially lower than the range of possibilities you have assigned to the future value of the company.
The following two quotes provide a nice summary.
“You have to have the knowledge to enable you to make a very general estimate about the value of the underlying business. But you do not cut it close. That is what Ben Graham meant by having a margin of safety. You don’t try to buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principle works in investing.” – Warren Buffett
“A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world”. – Seth Klarman
Click on the following link for Section III of the The Essential Warren Buffett Cheat Sheet: Finding Great Companies To Invest In