How to Invest like Warren Buffett

By Nathan on The Capital

Photo by Sharon McCutcheon on Unsplash

Warren Buffett is the most famous and arguably the most successful investor who has ever lived. Having achieved an average compounded annual return of close to 20% it is easy to see why people would want to be able to invest like Buffett. Buffett's strategy is really quite simple. Putting it into practice, however, is much more difficult. So how do you invest like Warren Buffett?

Warren Buffett essentially looks for companies with 6 characteristics. He looks for businesses that:

1. Are understandable.
2. Have favourable long term prospects.
3. Have competent management.
4. Are financially stable.
5. Are undervalued.
6. Have an economic advantage

Rule 1: The company is simple and understandable.

Buffett only buys companies if he understands what they do. He calls this staying within his circle of competence.

You don’t have to be an expert on every company or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.

If you look at the companies Buffett has invested in you will notice that many of the companies are simple and understandable. He has invested in The Washington Post, GEICO, Gillette and Coca Cola. All of these companies have simple business models. The Washington Post sells Newspapers. Geico sells insurance, Gilette sells razors and Coca Cola sells syrup.

If you want to invest like Warren Buffett then you need to invest in only companies that you understand. Personally I would not invest in companies that manufacture semiconductors because I couldn't explain what one is let alone how a business that manufactures them makes money.

Rule 2. The company must have favourable long term prospects

You may notice another thing about the companies I mentioned earlier. They all make or sell something that will or was expected to be around for the next 50 years.

Buffett invested in the Washington Post in the 1970s. While print newspapers have gone out of fashion The Washington Post continues to sell print Newspapers.

Geico still sells insurance, Gilette still sells razors and Coca Cola still sells syrup and they will likely continue to do so for the next 50 years.

Rule 3. The company must have competent management.

There are three ways management must prove to be competent

1. They must the rational
2. They must be honest
3. they mustn't follow the herd

Management must be rational. They must make decisions that make sense. The most important job of management is the allocation of capital or profits. When a company makes a profit it has 3 main choices.

1. they can pay shareholders a dividend
2. they can reinvest the money back into the business
3. or they can make new acquisitions

Deciding where are how much profits should be used on each of the 3 choices is a reflection of how rational the management is.

Management must be honest. It is important that management is honest with shareholders. Management is often quick to boast their successes but will shy away when they make a mistake. Honest management will willingly admit mistakes. One way to see if management is being honest is by reading back through annual reports. Management will outline their future goals and plans in the annual report. By reading through old reports you can check to see if they followed through with their plans.

Management mustn’t follow the herd. A company may fail to change direction when it should. The management team may simply become “yes men” agreeing with everything the leader says. or they may simply copy their competitor's every move. Management should change direction if needed, they should challenge the status quo and they should always try to outperform their competitors.

Rule 4: The company must be financially stable

Being financially stable usually requires maintaining low levels of debt. While Buffett has no set rules for debt levels a basic rule to go off is that a company should own more than it owes. This would mean having a Debt to Equity Ratio of less than one. Companies with high debt are at a higher risk of going under.

To learn about the Debt to Equity Ratio read my article here.

Another characteristic of a financially stable company high-profit margins. A financially stable company should be able to cut costs to ensure profit margins remain high.

Rule 5: the company must be undervalued

Buffett only buys companies if he believed they are undervalued. This is how a Value Investor invests. If he thinks something is worth $1 he will only pay 50c for it. A company is undervalued if its stock price is less than its intrinsic value. It unknown how Buffett calculates intrinsic value but there are several ways including P/E ratio, Price to Book ratio and Discounted cash flow analysis.

To learn more about calculating intrinsic value read my article How to calculate intrinsic value.

Rule 6: The Company must have a moat

Buffett's ability to recognize moats is what separates him from the average investor. A moat is an economic advantage over your competitors. Moats allow companies to out-compete their competitors allowing them to produce greater profits for a greater period of time. Without a moat, a profitable company will attract competitors. These competitors will take market share from the company reducing the companies revenue and profitability. With a moat, the company will be able to fend off competitors protecting their revenue and profitability.

To read more about moats read my article What is an Economic Moat

Summary

Warren Buffett has 6 Rules for Picking Stocks

He looks for businesses that:

1. Are understandable.
2. Have favourable long term prospects.
3. Have competent management.
4. Are financially stable.
5. Are undervalued.
6. Have an economic advantage

If you would like to learn more about Warren Buffett’s investing strategy I would recommend reading The Warren Buffett Way by Robert G. Hagstrom

The Warren Buffett Way (Book)

Want to read more like this? Head over to Down Under Investor

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