Warren Buffett

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Warren Buffett's Investment Strategy

The general approach Buffett follows is value investing. The goal of value investors is to identify securities with an unjustifiably low price relative to their intrinsic value. The intrinsic value of a company can be determined by many methods. It is common for value investors to examine a company’s fundamentals before investing. A value investor is similar to a bargain hunter in that they look for undervalued stocks, or stocks that are valuable but are underappreciated by the majority of buyers.

Rather than looking at stocks individually, Buffett takes a holistic view of companies and selects them based solely on their overall potential. In order to make money, Buffett does not seek capital gains, but rather companies that have the ability to generate earnings over the long term. Investors like Buffett are not concerned with whether the market recognizes the value of their investments. Warren Buffett is concerned with the company’s ability to make money. A number of metrics are considered by Warren Buffett when selecting companies, including:

Undervaluation

Determining whether a stock is undervalued can be challenging. Several business fundamentals are required to find a company’s intrinsic value, including earnings, revenues, and assets. Since the liquidation value disregards intangible assets, such as a brand’s value, determining intrinsic value is more difficult. It is therefore necessary to conduct both, quantitative and qualitative analysis to determine intrinsic value. It may be worthwhile to hire a specialist to perform these analyses, since the analyses require experience and a broad range of knowledge. Choosing the best shares for your portfolio is a task that is best accomplished by a good, specialized wealth manager, who is capable of analyzing the intrinsic value of a company.

Buffett compares the intrinsic value of the company with the current market capitalization. The investment is worthwhile if it is lower than the intrinsic value. It is Buffett’s ability to determine the intrinsic value of a company that ultimately determines the success of his investment strategy.

Return on Equity (ROE)

Return on Equity (ROE) is a measure of a company's financial performance. It is calculated by dividing net income by equity. Since equity is equal to a company's assets minus its liabilities, ROE is considered to be the return on net assets. Return on equity is considered a measure of a company's profitability and the efficiency it generates profits. Sometimes return on equity (ROE) is also referred to as return on shareholders' capital. It provides an indication of how much shareholders are earning from their shares. In other words, return on equity is used to see if a company has consistently generated good returns compared to other companies in the same industry. As an investor, the return on equity should be considered over a longer period of time.

Debt-Equity-Ratio

The Debt-Equity-Ratio measures the indebtedness of a company. The Debt-Equity-Ratio is calculated by dividing total liabilities by shareholders’ equity. Therefore, the percentage of debt financing the company’s assets is calculated. Liabilities exceed assets when the Debt-Equity-Ratio is greater than 1. In the event of a sudden rise in interest rates, a high ratio indicates that the company may not be able to service its debts.  A ratio below 1 means that a larger portion of a company's assets is financed by equity. Buffett prefers low debt so that earnings growth is generated from equity rather than borrowed money.

Profit Margins

One of the most commonly used profitability ratios is the profit margin. The ratio measures the degree of profitability of a company. The profit margin indicates how much of the sales are profits. Basically, the number shows how much profit the company makes per franc it sells. Good profit margins are not enough to ensure a company’s profitability; a growing profit margin is even more important. Therefore, several years should be considered in the analysis. A high-profit margin indicates that the company is managing its business well, and an increasing profit margin means that management has been efficient and successful in controlling costs.

Stock Exchange Quotation

The companies Buffett generally considers are those that have been publicly traded for at least ten years. Consequently, Buffett is not interested in most technology companies that have gone public in the past decade. According to Buffett, he doesn’t fully comprehend the mechanics behind many of today’s technology firms and invests only in businesses that he knows well. The goal is to identify companies that are undervalued today but have stood the test of time. The Securities and Exchange Commission (SEC) requires that publicly traded companies provide audited financial statements. These financial statements can help in analyzing the companies.

Competitive Advantage and Dependence on Commodities

Warren Buffett tends to avoid companies whose products are no different from those of their competitors, and those that rely exclusively on a commodity such as oil and gas. The large investment he made in Occidental Petroleum proves the exception rather than the rule. Warren Buffett’s flexibility and learning abilities are also demonstrated by his investment in Apple. When looking at a company, Buffett emphasizes that it is different from its competitors. The competitive advantage makes it more difficult for competitors to gain market share.