” If a business does well, the stock eventually follows.” Quote by Warren Buffett
The Early Days
In Warren Buffett’s early days, he worked along side Benjamin Graham and learned the strategies Benjamin used.
These early days provided Warren Buffett with valuable experience in evaluating the financial condition of companies and provided Warren with the idea that stocks were actually business which produced a product or service.
While Warren Buffett was effectively trained by Benjamin Graham, Warren began analyzing past investments made and noticed that some of those bargain priced stocks which were then sold actually continued to grow and their stock price continue to increase.
Warren realized that the companies with the most promise were what Warren Buffet referred to as consumer monopolies.
These companies have a long-term competitive advantage over their competitors.
This led Warren Buffett to form his own version of value investing – one with a longer time frame than Benjamin’s tactic of sell as soon as the stock became slightly overvalued.
Warren’s value investing strategy was in stark contrast to the speculative strategies he used with his investment partnerships in those early days.
These partnerships were more like modern day hedge funds.
With this new perspective, Warren Buffett began to place a lot more emphasis on the future growth prospects of a business and reasoned that a steadily growing business would be worth more in the future and that the future stock price would reflect this.
With this long-term approach, Warren reasoned that the returns would be greater than the shorter term approach he had been using.
Warren Buffett’s view was that – people who want to get rich quickly, will not get rich at all. There is nothing wrong with getting rich slowly.
This is the cornerstone for Warren Buffett’s approach to business and investing – Don’t be in a hurry, it takes time.
The value investing strategy presented here is based on Mary Buffett’s book Buffettology which depicts Warren Buffett’s version of value investing.
Buy Businesses – Not Stocks
Warren Buffett observed that the vast majority of stock market investors had a short-term outlook – they would buy on good news and sell on bad news.
Warren was not interested in the popular investment themes as these stocks were inevitably overvalued, with their stock prices driven way above what the was justified for the business.
When stock prices peak and sell-off; the market then undervalues the long-term value of business.
The price paid for a stock determines the long-term return achieved and in order to maximize returns Warren would only buy when the stock’s price was at a reasonable level.
His primary tactic is buying a company for a lower price so it will provide more earnings per dollar paid.
Warren views the company’s earnings as actual profit made, just like a private business owner.
What is important to Warren Buffett is management’s ability to grow earnings over the long-term as this is the key to increasing the stock price.
While stocks spend a fair amount of time overvalued, several factors cause the stock price to become undervalued.
These factors include a stock market correction, an industry correction and a problem or issue with the business itself. The best buying opportunities arise when all these factors occur at the same time.
Warren Buffett uses the 10-year bond as a benchmark to determine whether a stock is worth buying at its current stock price. In effect he values stocks like bonds.
After Warren Buffett buys a stock he does not care what happens to the future stock price and is not concerned with the value Wall Street places on the stock. Warren’s view is that when earnings increase over the long-term, then the stock price will follow those earnings over the long-term and there is then no reason to track the stock price on a daily basis.
Warren’s view is that he bought a business and the stock price is only important when he wants to sell the stock.
The Consumer Monopoly Business
Warren Buffett observed that certain types of businesses had a greater chance of growing their earnings over the long-term.
While various industries had periods of strong earnings growth, they also had periods of little or no earnings growth.
Warren was interested in businesses which would continue to grow well into the future.
Certain types of businesses have a greater chance
of growing their earnings over the long-term
From his analysis, Warren concluded that the successful business had a long-term competitive advantage over its competitors, which Warren attributed to a strong consumer brand.
Warren referred to such a business as a consumer monopoly. These types of businesses tend to have higher profit margins and more reliable future earnings growth.
The reason Warren likes the consumer monopoly type of business is that they have the power to overcome most bad news events.
This is because of brand loyalty – the consumer will still buy their product or service and the business continues to receive its revenue.
The consumer monopoly business is in a unique position – if customers want that product, they have to buy it from that company – just think of McDonald’s, if you want their hamburgers where else can you by them.
While the consumer monopoly business typically has a steady earnings growth history, they are still subject to business cycles to a certain degree.
It is during these business downturns where Warren Buffett likes to buy these consumer monopolies.
Look for Value and Growth
Warren Buffett looks for businesses which are easy to understand. He wants to see a product or service which the consumer wants or needs.
These businesses are more likely to have a steady earnings growth history.
A ten year summary of earnings per share gives a good feel for a company. Warren looks for a strong upward trend over the last ten years with a temporary setback in last recent year.
The last earnings reported will likely disappoint the market and typically sell the stock price down.
Warren Buffett is not interested in companies with widely fluctuating earnings, he likes to see a smooth upwards progression in earnings with a setback every now and then.
These setbacks are where Warren Buffett looks to buy stock. Essentially all companies experience a setback in their earnings growth at some stage.
Since Warren is a value investor buying on a temporary setback in earnings, he wants businesses which are financially sound and can weather any short-term financial issues.
While Warren Buffett analyzes past earnings data, this is primarily done so he came project the earnings forward into the future.
Businesses with a steady earnings growth will more likely produce sustainable earnings growth into the future.
The reason Warren emphasis future earnings growth is so that the business will be worth more in the future, which Warren requires so that the stock price will follow this growth.
The reason Warren Buffett avoids businesses with erratic historical earnings is that it’s impossible to project their earnings forward.
Warren wants to know with a high degree of certainty what the future earnings growth of a business will be – he does not like to speculate on future earnings growth.
To arrive at a likely future stock price range, Warren uses the average PE ratio over last ten years.
Warren Buffett looks for companies with little debt as these can more readily weather any difficult financial times. Companies which can retain earnings and not spend it all on maintaining current operations are able to reduce debt.
Warren likes companies with high rates of return on stockholders’ equity. Companies with a consumer monopoly are more likely to retain earnings.
In addition to reducing debt, they can make share repurchases which is something that Warren looks for.
Share repurchases increases the earnings per share since there are now fewer stockholders to share those earnings with – Warren looks for value and likes to see an additional return from the retained earnings.
Warren Buffett looks for companies that build their business from within rather than through acquisitions. He also looks for companies that do not pay ridiculous salaries and excessive stock options to their key employees.
Nowadays Warren Buffett likes to buy stocks at a reasonable price rather than the bargain prices he used to buy at in his earlier days.
When he gets the opportunity he buys when a scandal, big loss or bad news causes the stock price to drop.