In the first part of ‘The Essential Warren Buffett Cheat Sheet: A Short-Cut To Quickly Finding Great Stocks That Can Make You Wealthy’ we laid down the foundation covering investing principles and financial concepts. In this second part, we uncover how to discover those rare investing gems that can make you a very wealthy individual while minimizing your risk and draw-downs.
If you follow the guidelines, you’ll find the best value stocks to buy, the ones that even Warren Buffett himself would be proud to invest in. If you find yourself short on time, the Value Investors Association provides the best value investing newsletter – The Worthington Stock report to do the hard work for you.
While Warren Buffett has never laid out the details of his value investing approach in detail, many insights can be found in books written about him and the explanations for his holdings in his Berkshire Hathaway annual reports. If you want to approach the level of success that he has achieved, follow the outline that he had laid out for you.
The Best Value Stocks To Buy
Warren Buffett starts by searching for companies that he’d be interested in buying. He focuses on those industries where he has a good understanding of how the market operates and the financial metrics that are important in determining how much the company would be worth to an outside investor. Further, he limits himself to the best companies that the industry has to offer.
His favorite industries are ones that
- don’t change much,
- don’t require a lot of research and development to keep pace with new technologies,
- offer products or services that people and companies need to purchase in good times AND bad (non-cyclical)
- offer products or services that wear out fast or are used up quickly
- have a competitive advantage whereby they can raise prices in inflationary times.
“We want a business to be one (a) that we can understand; (b) with favorable long-term prospects; (c) operated by honest and competent people; and (d) available at a very attractive price.” – Warren Buffett
Warren Buffett’s favorite industries have included financial, consumer goods, data, industrial goods, healthcare, services, and basic materials. Below are some of the current industries and companies where he has made his most concentrated investments.
- Finance: American Express, Wells Fargo, U.S. Bancorp
- Oil: Phillips 66 (refineries aren’t as susceptible to changing oil prices)
- Consumables: Coca-Cola, The Kraft Heinz Company, Proctor and Gamble, Walmart
- Big Data (media): IBM, Moody’s
Finding Attractive Companies To Buy
Warren Buffett invests in companies that have a “monopoly” within their industry. Monopolies are defined as companies that sell products or services that are protected by a patent, a strong brand name or a business model that is hard to duplicate.
You’ll often hear this advantage termed as the companies protective moat referring to the moat around a castle that’s created to protect from invaders. The broader and deeper the moat, the harder it is for a competing company to penetrate their market advantage. The real benefit of a monopoly other than high-profit margins is that they can raise prices relative to inflation without risking a significant loss in sales and profits.
Financially monopolies are characterized by:
- Strong Cash Flows
- Little need for long-term debt (other than for purchasing other monopoly type businesses),
- A strong consistent upward trend in earnings and long-term price appreciation.
- Operating margins, net profit margins and return on equity are all above industry averages.
Criteria For Investing In A Company
Here are the guidelines to follow once you have found a company that has a successful track record as a leader in its industry due to a competitive edge;
- Look for a history of increasing earnings for the company. The shorter-term earnings trend (3-5 year) should be better than the longer term trend (5-10 years) taking the overall economic conditions into account. Buffett finds more success focusing on the longer three to five-year averages as opposed to quarterly or yearly results.
- The company should have a consistent and robust return on equity that is achieved without excess leverage or tricky accounting.
- Operating margins, net profit margins and return on equity should all be above the industry averages.
- The company should carry little long-term debt measured according to industry standards.
- Prefer companies that have been producing the same product or service for a number of years.
- Invest in companies that have historically used their cash flow in ways that benefit the company and shareholders. These can include stock repurchase plans, purchases of related monopoly type businesses or paying reasonable dividends.
- Prefer larger companies, 1-2 billion and up. They tend to have a longer track record of growth and are able to better weather any market downturns.
Companies To Avoid
Here is a short list of the types of companies that are best to avoid.
- Turnarounds and hostile takeovers. Turnarounds rarely succeed.
- Companies that are diversifying into industries that aren’t core to their current operations or who seem to be buying commodity-type businesses. These companies rarely perform as well as expected going forward.
- Companies that sell commodity products/services.
Warren Buffett eschews companies that don’t have a distinct competitive advantage.
Consumers buying what they perceive to be a commodity type product or services make their decision based mainly on price. If two products are considered comparable and lack brand differentiation, it only makes sense to buy the one with the lowest price. Therefore, companies that sell commodity products or services are unable to raise prices without the fear and consequence of losing sales to a competitor. This is particularity hurtful during inflationary periods. In the midst of slow economies commodity companies also suffer because of excess market capacity due to all the competition.
The result is that they have low-profit margins, low return on equity and profits tend to be erratic with wild swings due to changing market conditions. Because of all these negatives, it is less desirable to invest in a commodity type company.
Buffett compares the potential returns of stocks to bond yields and likes to view stocks as bonds with variable yields.
Warren Buffett Stock Screen
Understanding Warren Buffett’s basic investment approach is not difficult. Primarily he’s looking for companies with a “monopoly” in the marketplace, a history of above-average earnings growth and the ability to deliver returns of 15% or more per year well into the future. At the very minimum, the stock has to be projected to out-perform bonds on a risk-adjusted basis to be considered for investment.
Because future growth projections are best estimates (guesses), Buffett uses a margin of safety in his calculations to make sure he still gets paid well if even if his numbers are off.
Here’s a quick screening process to find Buffett type stocks that can outperform the market;
- Market Capitalization of 1 billion dollars or higher.
- Positive gross operating income for the last five years, preferably 10.
- Operating margins, net profit margins and return on equity all above industry averages.
- Return on equity of 14 or higher.
- Debt to equity ratio is below the industry average
- Total liabilities to assets below the industry average
- Price-to-free-cash-flow ratio divided by the free-cash-flow growth rate is less than the industry average
Once the screen has created a list of qualifying stocks you have to add in other factors.
- Avoid turnarounds and hostile takeovers. Turnarounds rarely succeed.
- Filter out companies that are diversifying into industries that aren’t core to their current operations or who seem to be buying commodity-type businesses. These companies rarely perform as well as expected going forward.
- Look for companies that have been pro-investor. Have they had or are they announcing a stock buy-back or dividend increase? Have they made successful acquisitions in the past?
- Look for companies that have products and services that continue to be market leaders and in strong demand. Are they must have brands?
- Do you understand the company and the industry it’s in? Is there any reason not to expect that it will continue to be a monopoly within its industry and grow at a 15% or higher clip?
It takes a considerable amount of time and effort to properly evaluate stocks the Warren Buffett way. You have to analyze the industry the company is in, comb-over annual reports and financial statements and be able to accurately weigh possible future earnings scenarios. This is a difficult task for many people who already have other commitments.
If you would like assistance finding value stocks that outperform the market consider joining us at the Value Investors Association.