Billionaire Warren Buffett is known above all else for finding great companies at discount prices. He's also known for widely sharing his wisdom and advice. But turning these words of wisdom into investment opportunities can be difficult. So here’s some help.
Find a good company
Buffett may be known as a value investor but he always starts with a good company.
“It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” — 1989 Letter to Shareholders
First of all, start with a company that you understand. It should be clear how a company makes money and what its competitive advantage is. Then look for good management. If you don’t have access to management or the expertise to assess them like Buffett, what can you look at? Focus on Return on Equity instead of Earnings Per Share. Return on Equity is a good measure of management’s ability to create shareholder value. Look for companies with a consistently high Return on Equity relative to their peers. And look for companies that are conservatively financed. You can measure this by looking at a company’s Debt-to-Equity Ratio. Lower is better.
“Most companies define “record” earnings as a new high in earnings per share. Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5% increase in earnings per share. After all, even a totally dormant savings account will produce steadily rising interest earnings each year because of compounding. Except for special cases (for example, companies with unusual debt-equity ratios or those with important assets carried at unrealistic balance sheet values), we believe a more appropriate measure of managerial economic performance to be return on equity capital.” —1977 Letter to Shareholders
Get a good price
Once you have identified a good company, it’s time to figure out if you can buy it at a good price.
“We insist on a margin of safety in our purchase price.” — 1992 Letter to Shareholders
There are a number of valuation metrics that you can use to determine if a stock is overpriced or underpriced. Look at Price-to-Book Value which will tell you the price of the company relative to its liquidation value. If the number is below 1.0 it is trading at a discount to the book value. Also, look at the Forward Price-to-Earnings Ratio. This metric compares the stock price to the expected future earnings. Compare the Forward Price-to-Earnings Ratio to the company’s peers and relative to historic levels. If this number is lower than it has been historically and compared to the broader market, the stock is relatively cheap.
Buy and hold and hold
Buy and hold is more than just a strategy. To Buffett, it is an investment philosophy.
“Individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions. The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit.” —2013 Letter to Shareholders
Identifying Buffett-quality investments is only half the battle. Most people fall short by trying to time the market. They get in and out at the wrong times causing trading losses and they lose money on transaction fees.
Buy companies you want to hold forever. Build your position slowly over time. And when the stock gets hit hard, don’t get scared and sell, consider buying more.
"When we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever." —1988 Letter to Shareholders
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