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Warren Buffett has consistently ranked highly on Forbes’ list of billionaires. It is not surprising that Warren Buffett’s investment strategy has reached mythical proportions. Buffet follows several important tenets and an investment philosophy that is widely followed around the globe.
He formed the Buffett Partnership Ltd. in 1956. Less than 10 years later, in 1965, he was in control of Berkshire Hathaway. In June 2006, Buffett announced his plans to donate his entire fortune to charity. Then, in 2010, Buffett and Bill Gates announced that they had formed The Giving Pledge campaign to encourage other wealthy individuals to pursue philanthropy.
In 2012 Buffett shared that he had been diagnosed with prostate cancer. He has since successfully completed his treatment.Most recently, Buffett began collaborating with Jeff Bezos and Jamie Dimon to develop a new healthcare company focused on employee health care. The three have tapped Brigham & Women’s doctor Atul Gawande to serve as CEO.
Buffett follows the Benjamin Graham school of value investing. Value investors look for securities with prices that are unjustifiably low based on their intrinsic worth. There isn’t a universally accepted way to determine intrinsic worth, but it’s most often estimated by analyzing a company’s fundamentals. Like bargain hunters, the value investor searches for stocks that they believe are undervalued by the market, or stocks that are valuable but not recognized by the majority of other buyers.
Warren 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 he looks for in his investment approach.
1. Company Performance
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 a company has consistently performed well compared to other companies in the same industry. ROE is calculated as follows:
ROE = Net Income / Shareholder’s Equity
2. Company Debt
The dept/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:
3. Profit Margins
A company’s profitability depends not only on having a good profit margin but also on consistently increasing it. This margin is calculated by dividing net income by net sales. For 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 mean management has been extremely efficient and successful at controlling expenses.
4. Is the Company 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. He will invest only in a business that he fully understands, and he has said he does not understand the mechanics behind many of today’s technology companies. Value investing requires identifying companies that have stood the test of time but are currently undervalued.
5. Commodity Reliance
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 it Cheap?
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 it’s Buffett’s most important skill. To check this, an investor must determine a company’s intrinsic value 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, which is 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.
The Bottom Line
As you have probably noticed, Buffett’s investing style is like the shopping style of a bargain hunter. It reflects a practical, down-to-earth attitude. Buffett maintains this attitude in other areas of his life: He doesn’t live in a huge house, he doesn’t collect cars, and he doesn’t take a limousine to work. The value-investing style is not without its critics, but whether you support Buffett or not, the proof is in the pudding. He is one of the richest people in the world, with a net worth of $81.7 billion as of 2018.