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Did You Know?
Did you know that a $10,000
investment in Berkshire Hathaway in 1965, the year
Warren Buffett took control of it, would grow to be
worth nearly $30 million by 2005? By comparison,
$10,000 in the S&P 500 would have grown to only
about $500,000. Whether you like him or not, Buffett's
investment strategy is arguably the most successful
ever. With a sustained compound return this high for
this long, it's no wonder Buffett's legend has swelled
to mythical proportions. But how the heck did he do
it? In this article, we'll introduce you to some of
the most important tenets of Buffett's investment
philosophy.
Buffett's Philosophy
Warren Buffett descends from the Benjamin Graham
school of value investing. Value investors look for
securities with prices that are unjustifiably low
based on their intrinsic worth. When discussing
stocks, determining intrinsic value can be a bit
tricky as there is no universally accepted way to
obtain this figure. Most often intrinsic worth is
estimated by analyzing a company's fundamentals. Like
bargain hunters, value investors seek products that
are beneficial and of high quality but underpriced. In
other words, the value investor searches for stocks
that he or she believes are undervalued by the market.
Like the bargain hunter, the value investor tries to
find those items that are valuable but not recognized
as such by the majority of other buyers.
Warren Buffett takes this value investing approach to
another level. Many value investors aren't supporters
of the efficient market hypothesis, but they do trust
that the market will eventually start to favor those
quality stocks that were, for a time, undervalued.
Buffett, however, doesn't think in these terms. He
isn't concerned with the supply and demand intricacies
of the stock market. In fact, he's not really
concerned with the activities of the stock market at
all. This is the implication this paraphrase of his
famous quote : "In the short term the market is a
popularity contest; in the long term it is a weighing
machine."
He chooses stocks solely on the basis of their overall
potential as a company - he looks at each as a whole.
Holding these stocks as a long-term play, Buffett
seeks not capital gain but ownership in
quality companies extremely capable of generating
earnings. When Buffett invests in a company, he isn't
concerned with whether the market will eventually
recognize its worth; he is concerned with how well
that company can make money as a business.
Buffett's Methodology
Here we look at how Buffett finds low-priced
value by asking himself some questions when
he evaluates the relationship between a stock's level
of excellence and its price. Keep in mind that these
are not the only things he analyzes but rather
a brief summary of what Buffett looks for:
1. Has the company
consistently performed well?
Sometimes return on equity (ROE) is
referred to as "stockholder's return on
investment". It reveals the rate at
which shareholders are earning income on their
shares. Buffett always looks at ROE to see
whether or not a company has consistently
performed well in comparison to other
companies in the same industry. ROE is
calculated as follows:
| = |
Net
Income |
|
| Shareholder's
Equity |
Looking at the ROE in just the last year
isn't enough. The investor should view the ROE
from the past five to 10 years to get a
good idea of historical performance.
2. Has the company avoided excess debt?
The debt/equity ratio is another key
characteristic Buffett considers carefully.
Buffett prefers to see a small amount of debt
so that earnings growth is being generated
from shareholders' equity as opposed to
borrowed money. The debt/equity ratio is
calculated as follows:
| = |
Total
Liabilities |
|
| Shareholders'
Equity |
This ratio shows the proportion of equity and
debt the company is using to finance its
assets, and the higher the ratio, the more
debt - rather than equity - is financing the
company. A high level of debt compared to
equity can result in volatile earnings and
large interest expenses. For a more stringent
test, investors sometimes use only long-term
debt instead of total liabilities in the
calculation above.
3. Are profit margins high? Are they
increasing?
The profitability of a company depends not
only on having a good profit margin but also
on consistently increasing this profit margin.
This margin is calculated by dividing net
income by net sales. To get a good indication
of historical profit margins, investors should
look back at least five years. A high profit
margin indicates the company is executing its
business well, but increasing margins means
management has been extremely efficient and
successful at controlling expenses.
4. How long has the company been public?
Buffett typically considers only companies
that have been around for at least 10
years. As a result, most of the technology
companies that have had their initial
public offerings (IPOs) in the past
decade wouldn't get on Buffett's radar (not to
mention the fact that Buffett will invest
only in a business that he fully understands,
and he admittedly does not understand what a
lot of today's technology companies actually
do). It makes sense that one of Buffet's
criteria is longevity: value investing means
looking at companies that have stood the test
of time but are currently undervalued.
Never underestimate the value of historical
performance, which demonstrates the company's
ability (or inability) to increase shareholder
value. Do keep in mind, however, that the past
performance of a stock does not guarantee
future performance - the job of the value
investor is to determine how well the company can
perform as well as it did in the past.
Determining this is inherently tricky, but
evidently Buffett is very good at it.
5. Do the company's products rely on a
commodity?
Initially you might think of this question as
a radical approach to narrowing down a
company. Buffett, however, sees this question
as an important one. He tends to shy away
(but not always) from companies whose products
are indistinguishable from those of
competitors, and those that rely solely on a
commodity such as oil and gas. If the
company does not offer anything different than
another firm within the same industry, Buffett
sees little that sets the company apart. Any
characteristic that is hard to replicate is
what Buffett calls a company's economic moat,
or competitive advantage. The wider the moat,
the tougher it is for a competitor to gain
market share.
6. Is the stock selling at a 25% discount
to its real value?
This is the kicker. Finding companies that
meet the other five criteria is one thing, but
determining whether they are undervalued is
the most difficult part of value investing,
and Buffett's most important skill. To check
this, an investor must determine the intrinsic
value of a company by analyzing a number of
business fundamentals, including earnings,
revenues and assets. And a company's
intrinsic value is usually higher (and more
complicated) than its liquidation value - what
a company would be worth if it were broken up
and sold today. The liquidation value doesn't
include intangibles such as the value of a
brand name, which is not directly stated on
the financial statements.
Once Buffett determines the intrinsic value of
the company as a whole, he compares it to its
current market capitalization - the current
total worth (price). If his measurement of
intrinsic value is at least 25% higher than the
company's market capitalization, Buffett
sees the company as one that has value. Sounds
easy, doesn't it? Well, Buffett's success,
however, depends on his unmatched skill in
accurately determining this intrinsic value.
While we can outline some of his criteria, we
have no way of knowing exactly how he gained
such precise mastery of calculating value. |
By investopedia.com
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