How Warren Buffett Picks Stocks: 3 Winning Tips
Warren Buffett is often considered one of the world’s greatest investors. The irony, of course, is that what sets him apart isn’t necessarily any particular knowledge. He doesn’t have anything profound to say about the economy, economics, or any related fields, such as statistical analysis or mathematics. What he has is an arsenal of simple principles and the discipline to follow them. As a result, he has become one of the world’s wealthiest individuals.
In what follows, I outline a couple of his principles. By the end, it should become clear why he is so successful and how you can be, as well.
1. Invest within your circle of competence
Investors think that they can outsmart the market by finding the next big thing. Whether it’s social media, 3-D printing, or rare earth metals, it is incredible how a few news stories and stock price increases can create an entire group of people devoted to a particular sector of the economy. But at the same time, these people probably don’t know much about these sectors. Do retail investors honestly know how a 3-D printer work, or how a computer chip works? Probably not. But that doesn’t stop them from buying 3D Systems (NYSE:DDD) or Intel (NASDAQ:INTC). While they may make money, they won’t do so because they understand their investments.
Buffett’s response to these investing frenzies is to invest in what you know. While you probably don’t know how a computer chip works or why Intel makes computer chips that people want to buy, you probably know, for instance, why Coca-Cola (NYSE:KO) is such a popular drink: It tastes good and the company has exceptional marketing. Thus, Coca-Cola falls within your circle of competence even if you don’t know the company’s secret formula. All you need to know is why the company is successful, and you can postulate with relative certainty that this success will continue into the future.
Investing in companies that make simple products that you understand may be boring, but it is a winning approach that can generate a lot of value over time.
2. Buy wonderful companies at a fair price
The full saying is that it is better to buy a wonderful company at a fair price than a fair company at a wonderful price. When you are investing, you find value not just by looking at the numbers but by looking at intangible features as well such as management. A company that is well managed and that has a reputation for providing a quality product is worth more than a company lacking these qualities. The former company is positioned to take market share from the latter, and it is better positioned to withstand economic weakness. As a result, from a long-term perspective, it is better to pay a higher price-to-earnings ratio for the shares of a high-quality company than to pay a low price-to-earnings ratio for a low-quality company.
3. Be greedy when others are fearful, and be fearful when others are greedy
Once you have decided which companies to buy using the first two pieces of advice, you need to know when to buy them. As with anything else you buy, you want to get a good price. However, the market fluctuates wildly and frequently, and this adds an emotional element to investing that this piece of advice helps you avoid. When stocks go down, people often assume it is for a reason (i.e., the downturn is justified). Similarly, when a stock rises, people often assume that it is because the company is improving. But market price fluctuations do not have any necessary correlation to a company’s fundamentals. As a result, you want to pick out companies to buy and then wait for the hit prices that you feel make them worthwhile investments.
This piece of advice depends on the first two mentioned. You cannot be confident in buying a falling stock, especially if it goes down even more after you’ve first bought it, unless you are confident in the company’s underlying business. For this to take place, you need to understand how and why the company makes money, how and why it will continue to make money, and what makes it such a great company. If you can figure this out, then you can have the confidence to buy when there is proverbial blood in the streets.
Interested in more Buffett knowledge? From a previous article, here is Buffett’s ‘Powerhouse Five’ — “a collection of large non-insurance businesses” that together make up a cornerstone of Berkshire Hathaway’s empire:
1. MidAmerican Energy Holding
MidAmerican Energy Holding is — well, a holding company that Berkshire owns the vast majority of. It’s important to remember that the holding company owns a business named simply MidAmerican Energy Company, which is just one of many energy companies such as PacifiCorp, CalEnergy Generation, Northern Natural Gas Co., and — most recently and perhaps most importantly — NV Energy, which make up the holding company’s portfolio.
NV Energy is an energy holding company serving approximately 1.3 million electric and natural gas customers in Nevada. Combined with MidAmerican Energy Holdings, Berkshire owns the largest U.S. utility company in the United States with 8.4 million total customer accounts and total assets of approximately $66 billion. Berkshire owns utilities in Nevada, California, Oregon, Idaho, Utah, Wyoming, Washington, Iowa, Illinois, Nebraska, and South Dakota.
“This acquisition fits nicely into our existing electric-utility operation and offers many possibilities for large investments in renewable energy,” said of the deal in his 2013 letter to shareholders, adding that, “NV Energy will not be MidAmerican’s last major acquisition.” Utility companies fit nicely under the umbrella of reliable “big chunks of earnings powers” that Buffett has targeted for the future of Berkshire.
2. BNSF Railway
BNSF (or, Burlington North Santa Fe) is a vertebrae in the backbone of the U.S. economy. The company operates one of the largest railroad systems in North America, and serves most of the western region of the U.S. Berkshire purchased the company in late 2009 “amidst the gloom of the Great Recession,” as Buffett puts it in the company’s 2013 annual report.
“At the time, I called the transaction an ‘all-in wager on the economic future of the United States,’” Buffett wrote — and that bet is paying off. If we’re sticking with human biology, another apt analogy may be to describe BNSF as part of the circulatory system. At least, it’s the analogy that Buffet prefers. In the 2013 report, Buffett wrote that BNSF carries about 15 percent of “all inter-city freight … Indeed, we move more ton-miles of goods than anyone else, a fact establishing BNSF as the most important artery in our economy’s circulatory system.”
BNSF reported revenues of $22 billion in 2013, up about 5.8 percent from 2012, and net earnings of $3.8 billion, up about 11.8 percent from 2012.
3. ISCAR Metalworking
Iscar is an Israeli toolmaking company with operations in more than 60 countries around the world. Berkshire purchased an 80 percent stake in the company in 2006 for about $4 billion, making it the first time Berkshire had acquired a company based outside of the U.S. Berkshire purchased the remaining 20 percent of the company in 2013 after the Wertheimer family, which founded the company, elected to sell the stake.
“As a truly international business, IMC is a top performer in its industry, with exposure to European, Asian, and Latin American markets, as well as significant opportunities for growth as it continues to penetrate the North American market,” commented Buffett when the deal was announced. “My partner Charlie Munger and I have been impressed by IMC’s simple and profitable business model. With this acquisition, we have the benefit of investing in a stable business with very significant growth prospects.”
Speaking in 2008, when he was attending a ribbon-cutting ceremony at an Iscar facility in China, Buffett said that, “Iscar is a dream deal. It has surpassed all the expectations I had when buying the company, and my expectations had been very high.”
4. Lubrizol Corporation
Lubrizol, founded in 1928, is a Cleveland-based company that also makes stuff that people, you know, actually use. Lubrizol is a designer and manufacturer of specialty chemicals, producing additives and advanced materials for everything from engine oil and industrial polymers to hair conditioners and toothpaste. The company has product lines that touch dozens of markets and are used in the essential day-to-day activities of many businesses and consumers.
Berkshire announced the purchase of Lubrizol in March 2011. Berkshire paid about $9.7 billion for the company, which generated $5.4 billion in revenue the year before the purchase was announced. That year, Lubrizol generated about 35 percent of revenue from North America, 30 percent from Europe, and 30 percent from Asia and the Middle East, giving the company an enormous and sturdy footprint. The company also reported a 34 percent return on equity that year and a gross margin of 33 percent.
“Lubrizol is exactly the sort of company with which we love to partner – the global leader in several market applications run by a talented CEO, James Hambrick,” said Buffett at the time of the purchase. “Our only instruction to James: just keep doing for us what you have done so successfully for your shareholders.” Hambrick, who has been with the company since 1973, is still CEO.
5. The Marmon Group
The Marmon Group is one of those companies that makes stuff. In particular, it makes useful stuff that people actually use, like electrical and industrial components for transportation equipment, as well as some transportation equipment itself, such as tank cars (big storage cars for trains.)
Berkshire purchased 60 percent of the Marmon Group for $4.5 billion in 2007, and has been rounding out his ownership ever since. At the time, it was Buffett’s largest non-insurance acquisition. The deal, which famously took just two weeks to complete, was likely helped by the fact that Buffett was acquainted with the family that owned it.