Who hasn’t heard of Warren Buffett, one of the world’s wealthiest people who consistently ranks among the top billionaires according to Forbes magazine? As of October 2020, his net worth was estimated to be $80 billion. 1 Businessman Warren Buffett is also well-known for his charitable contributions. The fact that he is one of the world’s most successful investors, however, is probably his most well-known accomplishment.
Because of this, it is not surprising that Warren Buffett’s investment strategy has attained legendary status. Buffett adheres to a number of fundamental principles as well as an investment philosophy that is widely followed around the world. So, what exactly are the secrets to his extraordinary success? Continue reading to learn more about Buffett’s investment strategy and how he’s been able to amass such a large fortune through his investments.
The Most Important Takeaways
- In his value investing, Buffett adheres to the Benjamin Graham school of thought, which seeks out securities whose prices are unjustifiably low in comparison to their intrinsic value.
- Rather than concentrating on the intricacies of supply and demand in the stock market, Buffett looks at companies as a whole.
- Some of the factors Buffett considers are the performance of the company, the amount of debt the company has, and the profit margins.
- In addition, whether or not a company is publicly traded, how reliant it is on commodities, and how cheap it is are all important considerations for value investors like Buffett.
Buffett’s Biography in Condensed Form
Warren Buffett was born in Omaha, Nebraska, in the year 1930. He developed an early interest in the business world and in investing, particularly in the stock market, when he was a child. Buffett began his academic career at the Wharton School of the University of Pennsylvania before returning home to complete his undergraduate studies at the University of Nebraska, where he received a bachelor’s degree in business administration. Buffett later attended Columbia Business School, where he earned a master’s degree in economics, before returning to work.
Buffett began his professional career as an investment salesperson in the early 1950s, but it wasn’t until 1956 that he established Buffett Associates. In 1965, he was in control of Berkshire Hathaway, which he had founded less than ten years earlier. Buffett announced in June 2006 that he would be donating his entire fortune to charitable causes. 2 Then, in 2010, Buffett and Bill Gates announced the formation of the Giving Pledge campaign, with the goal of encouraging other wealthy individuals to engage in philanthropic endeavors.
Earlier this year, Buffett revealed that he had been diagnosed with prostate cancer.
Since then, he has completed his treatment without incident. Buffett has most recently begun working with Amazon CEO Jeff Bezos and JPMorgan Chase CEO Jamie Dimon on the development of a new healthcare company that will focus on employee healthcare. 5 Atul Gawande, a doctor at Brigham and Women’s Hospital, has been named chief executive officer by the three organizations (CEO).
Buffett’s Business Philosophy
Buffett is a follower of the Benjamin Graham school of value investing, which he founded. When it comes to investing in stocks, value investors look for securities that are trading at a discount to their intrinsic value. Although there is no universally accepted method of determining intrinsic worth, it is most often estimated by examining a company’s financial statements and other fundamentals. Value investors, like bargain hunters, look for stocks that they believe are undervalued by the market, or stocks that are valuable but are not recognized as such by the majority of other buyers, and then buy them.
Buffett takes this approach to value investing to an entirely new level. The efficient market hypothesis is not supported by a large number of value investors (EMH). According to this theory, stocks always trade at their fair value, making it more difficult for investors to either buy stocks that are undervalued or sell stocks that are overvalued. They do believe that the market will eventually begin to favor those high-quality stocks that have been undervalued for a period of time.
Market-beating investors such as Warren Buffett believe that the market will eventually reward high-quality stocks that have been undervalued for a certain period of time.
Buffett, on the other hand, is not concerned with the intricacies of the stock market’s supply and demand dynamics. In reality, he isn’t particularly concerned with the activities of the stock market. “The market is a voting machine in the short run, but a weighing machine in the long run,” he famously paraphrased a Benjamin Graham quotation: “In the short run, the market is a voting machine,” he implied. 6
He considers each company as a whole, and so he chooses stocks solely on the basis of their overall potential as a company when making investment decisions. Buffett is not interested in capital gains; rather, he is interested in ownership in high-quality companies that are extremely capable of generating earnings over the long term. In making an investment in a company, Buffett isn’t concerned with whether or not the market will eventually recognize the value of the investment. He is primarily concerned with the company’s ability to generate profits as a business.
Buffett’s Approach to Business
When Warren Buffett evaluates the relationship between a stock’s level of excellence and its price, he asks himself a series of questions to determine whether the stock is undervalued.
Take note that these are not the only things he analyzes, but they do provide an overview of what he looks for in his investment approach.
1. The Performance of the Organization
Return on equity (ROE) is also referred to as stockholder’s return on investment (SROI) in some cases. It reveals the rate at which shareholders earn income from their investments in the company. Buffett evaluates a company’s return on equity (ROE) to determine whether it has consistently outperformed other companies in the same industry. 8 The return on investment (ROI) is calculated as follows:
ROE is calculated as Net Income minus Shareholder’s Equity.
Just looking at the return on equity (ROE) for the past year is not sufficient. In order to evaluate historical performance, the investor should look at the return on equity (ROE) over the previous five to ten years.
2. The Debt of the Corporation
The debt-to-equity ratio (D/E) is another important factor that Buffett takes into account when evaluating a company. Rather than borrowing money, Buffett prefers to see a small amount of debt, which allows earnings growth to be generated from shareholders’ equity rather than borrowed money. 9 The D/E ratio is calculated in the following manner:
The debt-to-equity ratio is calculated as follows: Total Liabilities minus Shareholders’ Equity.
This ratio indicates the proportion of equity and debt that a company uses to finance its assets; the higher the ratio, the greater the proportion of debt that is used to finance the company’s assets rather than equity. The presence of a high level of debt relative to equity can result in volatile earnings and high interest expenses. In order to conduct a more stringent test, investors may elect to use only long-term debt in the calculation above rather than total liabilities.
Profit Margins are the third factor to consider.
Profitability of a company is dependent not only on having a high profit margin, but also on maintaining and increasing it consistently. This margin is computed by dividing net income by net sales and multiplying the result by 100. Investors should look back at least five years in order to get a good indication of historical profit margins and profitability. A high profit margin indicates that the company is running its operations efficiently, but increasing profit margins indicate that management has been extremely efficient and successful in keeping expenses under control.
4. Is the company a publicly traded one?
Buffett typically considers only companies that have been in business for at least ten years before making a decision.
The vast majority of technology companies that have gone public in the past decade would not have appeared on Buffett’s radar as a result of this decision. He has stated that he does not understand the mechanics of many of today’s technology companies, and that he only invests in businesses that he understands completely himself. 11 Identification of companies that have withstood the test of time but are currently undervalued is necessary for value investing.
History should never be underestimated for its predictive ability. This demonstrates the ability (or inability) of a company to increase shareholder value over time. Maintaining perspective is important because a stock’s past performance does not imply its potential future performance. The job of the value investor is to determine whether or not the company can continue to perform at its previous levels. It is inherently difficult to determine this. Buffett, on the other hand, is clearly very good at it.
Remember that public companies are required to file financial statements on a regular basis with the Securities and Exchange Commission (SEC), which is an important point to keep in mind. 12 These documents can assist you in analyzing important company data, such as current and historical performance, in order to make important investment decisions for your company.
5. Reliance on Commodities
At first glance, this question appears to be a radical approach to narrowing down a company’s potential customers. Buffett, on the other hand, believes that this is an important question. He tends to steer clear of companies whose products are virtually indistinguishable from those of competitors, as well as those that rely solely on a commodity such as oil and gas (though this is not always the case). Buffett believes that if a company does not offer anything that distinguishes it from another firm in the same industry, there is little that distinguishes it from the competition. An economic moat, also known as a competitive advantage, is any characteristic of a company that is difficult to replicate, in Buffett’s opinion. 13 As the moat grows in size, it becomes increasingly challenging for a competitor to gain market share.
6. Is it a good deal?
The real kicker is this. While it is possible to find companies that meet the other five criteria, determining whether or not they are undervalued is the most difficult aspect of value investing. Moreover, it is Buffett’s most important ability.
In order to do so, an investor must first determine the intrinsic value of a company by examining a variety of business fundamentals, such as earnings, revenues, and assets. The intrinsic value of a company is typically higher (and more complicated) than the liquidation value of a company, which is the amount of money a company would be worth if it were broken up and sold today. Because intangibles, such as the value of a brand name, are not directly stated on the financial statements, the liquidation value does not include them.
After determining the intrinsic value of the company as a whole, Buffett compares it to the company’s current market capitalization, which is the company’s current total worth or price.
It appears to be straightforward, doesn’t it? Buffett’s success, on the other hand, is predicated on his unrivaled ability to accurately determine the intrinsic value of an asset. While we can sketch out some of his criteria, we have no way of knowing how he came to have such a precise grasp of the art of calculating value in the first place.
What’s the bottom line?
As you’ve probably noticed, Buffett’s investing style is similar to that of a bargain hunter when it comes to shopping. It represents a pragmatic and down-to-earth outlook. Buffett maintains this attitude in other aspects of his life as well: he doesn’t live in a mansion, he doesn’t collect cars, and he doesn’t ride in a limousine to and from the office. Those who oppose Buffett’s value investing style are not without reason, but the proof is in the pudding, regardless of whether you agree with him.