How Does Warren Buffett Choose Companies To Invest In?

  • Warren Buffett’s key investment principles include the concepts of economic moat, margin of safety, rationality of management and investment in areas of expertise.
  • Buffett has used these concepts to make his investment decisions while constantly avoiding speculation.
  • Returns made by Warren Buffett through value investing principles are a testimony to the soundness of his principles.
warren buffett coke
Daniel Acker/
Bloomberg

"To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these."

Warren Buffett is renowned for his investing principles, his insightful quotes and is often dubbed as the “Oracle of Omaha”. After meeting Benjamin Graham he was drawn towards the principle of value investing. By looking at the intrinsic value of stock and keeping a margin of safety he would make investments in the stocks of various businesses which gave him high returns. Warren Buffett is currently the chairman of Berkshire Hathaway Inc. which is a holding company investing in diverse businesses.

Warren Buffett’s business career spans most of the post WW2 era. Over a period of time he developed and followed his investing principles including value investing which gave him enormous wealth and made him one of the wealthiest people in the world. The “Oracle of Omaha” has investing principles which are based on a couple of tenets in different fields like finance, management, operations and overall company fundamentals. Although these principles are very simple they form the bedrock for all his investments and should be a good guiding tool for future investors to find the intrinsic value of a stock.

Buffett's Choice Of Investments

His first rule of investing is to limit investments to a “circle of competence”. This means that he invests in only those businesses which he understands completely. According to the “Oracle of Omaha” all investments require adequate analysis for which one requires to know the inside out about a business. Many investors get good results when the times are good, bad decisions are more visible when the things go down.

“After all, you only find out who is swimming naked when the tide goes out”

Using this rule he has methodically avoided investing in technology stocks because he did not have sufficient knowledge regarding this sector. He finally invested in a technology stock after decades of avoiding them in 2011, when a staggering amount of $13 billion was invested in IBM to purchase a 5.4% stake. This makes use of his basic rule that a company should have been generating good and sustainable free cash flow in the past for at least a decade. He avoided any other newer technology majors in favor of IBM due to the long term continuous IT services deal which it has with other companies. This provides IBM with sustainable revenue flow over a long term.

Buffett's Management Principle

“When we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever.”

Buffett often quotes that the first question he asks about the management of a company is whether they are honest with the shareholders. It might seem as a very gullible perspective however behind it is a simple concept. In today’s highly complex management arena it is easier for a management to simply hide their mistakes by cooking the books or use other fraudulent means to augment earnings. If the management is forthright with the shareholders about bad decisions taken then it shows that it is sincere and serious on turning around the company.

Another question he asks is whether the management is rational. It might have grandiose plans for the company however the business plans should reflect the reality of their position in the market and the requirement of the products and services of the company in the overall economy. Finally he asks whether the management keeps to its core strength or replicates its competition. A good example of this is Coca Cola (KO). The company has steadfastly concentrated on its core strength of building a good brand and having a strong distribution network which allows its huge product line to be available in every nook and corner of the world. After viewing the company’s performance Buffett made a sizable investment in Coca-Cola purchasing a 6.3% stake in 1988 which has increased to 8.8% stake after share repurchases and further investments. This has been one of the most profitable investments of Buffett giving returns of over 1700% since 1988 against 680% by S&P 500 index.

Buffett's Financial Principle

"I try to buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will.

Warren Buffett uses a technique which is quite different from other financial analysts to value a firm. Most of the financial community is hooked to earnings per share which follows the earnings made by the company for every share outstanding whereas Buffett likes to use Return on Equity (ROE). He also measures the leverage used by a company to make sure it does not have excess debt to equity ratio. This allows him to invest in firms at an opportune time. This helps him in finding the intrinsic value of the stock.

Buffett likes firms which have a consistent record of bringing in good amount of free cash flow to equity (FCFE). This shows the overall stability and sustainability of the business and its ability to manage changing economic undercurrents. Finally he developed the word “MOAT” to define one of the essential things he sees when investing in a company. The word moat was used during medieval times when castles used to have a wide ditch along its outer wall typically filled with water. This made it difficult to attack the castle and made the defense much stronger against enemy attack.

This concept is used by Warren Buffett to analyze companies. A company which can keep its competitors at bay through branding, better products, innovation, geography or any other means can be said to have a wide moat. This would make it difficult for competitors to usurp its profits and allow for a more stable and sustainable business.

Berkshire versus S&P500 stock chart
Fig 1: BRK.A stock versus S&P 500 data by Amigobulls

Buffett Avoids Speculation

"Nothing sedates rationality like large doses of effortless money."

During his long tenure of over half a century in the investing world he has abstained from certain sectors. This has to do with his first principle of avoiding businesses in which he is not competent and about value investing. Technology sector has been one of those sectors which have received almost no investment from Warren Buffett.

This factor was discussed by him in detail during the tech boom of late 90’s. Internet millionaires were being created at lightning speed and many experts asked Warren Buffett for the reason why he was avoiding the technology boom. He replied that he would not like to play in a game in which his opponent has great advantage. By not being the 100th, 1000th or even 10,000th smartest person to analyze the technology sector he claimed he would eventually not be able to make decent returns. By following this principle he was able to avoid the dot com burst which wiped the wealth of many investors.

Conclusion

Warren Buffett has not only been a major wealth creator of our time but also has an impact on the overall economic thinking through his annual shareholder letters, interviews and involvement in public debates. At the age of 84 he still goes to work without fail and provides a great role model for budding investors and businessmen.

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