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 Buffett's thoughts on how to
pick stocks.
As an investor can you really afford not to study how he 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 him. 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 described in his February 29, 2008 letter to shareholders
what he looks for in a company to buy.
In Warren'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 it in Warren's own words.
You can read all of 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.