Warren Edward Buffett, born on August 30, 1930, in Omaha, USA, is an American businessman and investor who managed to amass a personal fortune of more than $60 billion. This man is considered by many as the most successful investor the stock market has ever known and he is taken as a true role model in this field.
What’s so special about Warren Buffett’s investing strategy? and what does he know about the stock market that the other investors don’t know?
Buffett is a strong believer in the value-based investing model, which involves choosing stocks that appear to be trading for less than their intrinsic or book value, in other words, picking stocks that we believe are underestimated by the market. Buffett, like other believers in this model, recommends investing in companies that show strong earning potential and growth aptitude in the long term.
Assuming that the market overreacts to news, good or bad, the resulting stocks prices movements are misleading and do not reflect the firm’s long-term fundamentals, and this is where opportunities reside.
Value investors ignore the market trends and only care about the intrinsic value of stocks, in addition to using financial analysis methods to find “underestimated stocks”.
Although they all study financial performance and variables like revenue, earnings, cash flow, profits and the company’s business model, there is no agreed-upon method to find those stocks, every investor has his own perception, different investors can analyze the same valuation and come up with totally different decisions.
Warren Buffet’s investing strategy doesn’t really care about the supply and demand of the stock market, he instead looks at the company as a whole and analyses its potential in the long term, because he seeks ownership, not capital gain. He buys stocks that he definitely is going to hold in order to own a percentage of the company. This is why the market’s activities don’t actually matter for him, what matters is the firm’s ability to make money as a business.
Buffett’s strategy only considers firms that have been around for at least 10 years, in other words, firms that have stood the test of time. He also prefers investing in businesses that are into industries he fully understands.
What does Warren Buffett look for in his investment approach?
- Company Performance: to analyze the performance of a certain company, he looks at a very important measure called “return on equity” (ROE) that refers to the stockholders’ return on investment. ROE = Net Income ÷ Shareholder’s Equity. In order to have a good insight on the company’s performance and see whether it has consistently performed well compared to other companies in the same industry, the investor should view the ROE from the past five to 10 years and analyze historical performance.
- Company Debt: The debt-to-equity ratio (D/E) is another key characteristic to consider. It indicates the relative proportion of shareholders’ equity and debt used to finance a company’s assets. Debt-to-Equity Ratio = Total Liabilities÷Shareholders’ Equity. The higher the ratio, the more debt is financing the company and the more volatile the earnings are.
- Profit margins: a good profit margin that’s consistently increasing is the best indicator of the firm’s profitability. Profit margin=net income/ net sales.
- Commodity reliance: Warren Buffett’s strategy prefers to stay away from companies that rely only on one commodity or whose products are indistinguishable from those of competitors, he rather looks for companies that have characteristics that are hard to replicate by competitors, that’s what he calls “competitive advantage”.
- Is it cheap? and this is the key of value investing, finding the undervalued companies is the most important and probably the most difficult part of the strategy. Determining undervalued companies takes the ability to define the intrinsic value that is usually higher than the liquidation value. One of Buffett’s success secrets is his unmatched skill in determining the intrinsic value accurately.
We may agree or disagree with Warren Buffett’s approach, but one thing is sure, this guy managed to impose himself as one of the greatest stock market investors ever. And when we say one of the greatests ever, we are not being subjective, this is backed with numbers!