investing

How Warren Buffett Picks Stocks

October 27th, 2014

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This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

I don't look to jump over 7-foot bars: I look around for 1-foot bars that I can step over. - Warren Buffett

When I first read the above quote, I was pretty new to investing. So when I read it, it didn't make any sense to me.

Warren Buffett is widely regarded as the most sophisticated investor alive. He has expertise in accounting, finance, economics, regulation, as well as intimate knowledge of many industries. By all accounts, he uses his knowledge in all of these areas before he makes a single purchase of stock. So how can he describe any of his investments as a 1-foot bar?

But as with so many of his other quotes, the meaning of this particular quote became clear as I researched more and more stocks on my own. In this article, I'll explain what I believe he means. As you'll see, this quote only makes sense in light of how Buffett chooses investments such as stocks.

Charlie Munger is Buffett's right hand man at Berkshire Hathaway. In an interview with the BBC, this is how he describes their investment methodology.

We have to deal with things that were capable of understanding and then, once were over that filter we need to have a business with some characteristics that give us a durable competitive advantage and them, of course, we would vastly prefer management in place with a lot of integrity and talent and finally, no matter how wonderful it is, its not worth an infinite price. We have to have a price that makes sense and gives a margin of safety considering the normal vicissitudes of life Its a very simple set of ideas and the reason that our ideas have not spread faster is theyre too simple. - Charlie Munger

In summary, Buffett and Munger have 4 criteria when they look for an investment. Let me explain each one.

Understandable

Buffett looks for companies that he can understand thoroughly. By thoroughly, I mean that he knows how the product is made, what its strengths and weaknesses are compared to its competition, how each company is organized, etc. In other words, he seeks to understand as much as the CEO would.

However, everyone has limits on how much they can understand, even for smart guys like Buffett. For example, despite the fact that he's best friends with Bill Gates, and despite Bill Gates' efforts to teach him, Buffett never felt that he understood Microsoft enough to feel comfortable investing in it. To gauge Buffett's level of comfort with technology, you only need to visit Berkshire Hathaway's official website.

You can guess why Buffett avoids companies he doesn't thoroughly understand. If you don't understand it, how can you forecast how the company will do in the long term? If you can't forecast the future, how can you estimate your return on investments?

Now, other professional investors similarly try to understand companies they invest in. But here's the thing: some companies are easier to understand than others. For example, you can understand Wrigley much more easily than you can understand Facebook. You pretty much know what Wrigley will sell in 10 years time, but Facebook? It's anyone's guess how much and in what way they'll make money in 10 years time.

To understand Facebook, professional investors will throw lots of money on experts and analysts to try to get some sense of what Facebook's future will look like, but even then, they will only partly succeed at best. In contrast, Buffett doesn't even try, and he instead only chooses to invest in companies like Wrigley.

Durable Competitive Advantage

Once Buffett understands a company, he asks himself if that company has a durable competitive advantage, otherwise known as an economic "moat".

The reason why he looks for a moat again comes down to being able to forecast the future. If you invest in a company without a moat, you run the risk of having a competitor come in and take away some profits.

As an example of a company without a moat, think of your neighbourhood restaurant. A few years ago in London, ON where I live, there used to be only one sushi restaurant in my neighbourhood, called Wonder Sushi. We always had to wait in line to get at seat at Wonder Sushi, because the place was always packed. But since then, a few more sushi restaurants had set up shop, and now, when you go into Wonder Sushi, you can normally see some empty tables.

While it's possible to invest successfully in a company without a good moat, doing so would take a lot more work. You would have to monitor the competitive landscape constantly, so you won't be left holding the bag when a new competitor emerges. You would also have to make sure that such companies have great management all the time, because it's easier to mismanage such companies.

Contrast this situation with a company like Coca-Cola, which has a very good moat. Buffett apparently used to tell Bill Gates that a "ham sandwich could run Coca-Cola". Investing in such companies require less smarts and energy.

Management

Even if Buffett thinks a ham sandwich can run a company, he would still insist on having management with integrity run the company. After all, a ham sandwich can't devise plans to stab you in the back. On the other hand, a smart CEO with ulterior motives can line his or her own pocket at the shareholders' expense.

Company management often try to "lie" to the public using accounting tricks, in order to inflate their share prices. Most of the time, companies use legal means to achieve their ends but sometimes, they use illegal means, such as what Enron used.

Again, it's possible to invest successfully in companies run by dishonest management, particularly if you believe that accounting tricks and other tricks will end up inflating share prices. In this case, you could buy shares before prices go up, and sell them once prices are inflated.

However, again, it's very tricky to predict where share prices will go in the short term, because there are other factors you have to consider that would affect prices. Also, you would again have to monitor the investment very carefully, because smart, dishonest human beings can do unpredictable things. It's far simpler to just decide not to participate in stocks with shady management.

Price

If you follow the three criteria above, you will only be left with companies whose cash flows you can forecast more predictably. However, buying companies with predictable cash flow won't do you any good if you decide to pay too much for them.

For instance, let's say you analyzed a company and that you believe the company will earn $1 per share every year, like clockwork. If you buy each share at $100 per share, you will only generate 1% return on your investment. On the other hand, if you buy each share at $10 per share, you will generate 10% return on your investment.

Therefore, it makes sense to only buy shares in companies at prices you believe will result in good returns. Also, once you buy them, it makes sense to keep them until share prices go high enough that they no longer become attractive.

Summary

Now that you understand how Buffett chooses his investments, I hope that you can now appreciate what he means when he says he looks for "1-foot bars". Using each investment selection criteria outlined above, he steers himself away from investments that take a lot of complex analysis and active monitoring, in favour of companies that you can just sit on.

However, that's not to say that investing itself is simple. It takes a lot of knowledge and effort to understand a business as thoroughly as he does. Remember, he researches a company to the point that he understands it as well as its management. Figuring out the true earning capacity of a company and its true value requires expert knowledge in accounting, economics and other disciplines.

However, some companies are more difficult to analyze than others, so whenever possible, Buffett likes to stick to simpler more obvious situations. Because by doing so, he's following Rule #1 in investing: Never lose money.

This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.