Before emulating the value investing strategies of Warren Buffett, you ought to understand how he learned about investing in the first place.
Most readers will know that Warren Buffett himself follows the investment principles of Benjamin Graham. Graham was a successful investor and author, and later a mentor to Buffett, who was his student at Columbia University before working for Graham after graduation. Graham’s book The Intelligent Investor is one of the best-known books on value investing.
Warren Buffet advocates many of the strategies taught to him by Graham. The strategy means looking for stocks that have an intrinsic value higher than their market price. This is the core tenet of value investing itself. And this leads to the discussion of intrinsic value and its calculation.
The most current iteration of the Benjamin Graham Value Formula (updated in 1974) provides a partial basis for Warren Buffett’s principles of investing.
The formula is as follows:
V (Value) = EPS * (8.5 + 2g) * 4.4/ Y
- V = Value (Intrinsic Value)
- EPS = trailing 12-month earnings per share of the company
- 8.5 = P/E ratio of an assumed zero-growth company
- g = long-term growth rate of the company.
- 4.4 = yield of average high grade corporate bonds in 1962; and
- Y = Current yield on AAA corporate bonds
Warren Buffett has taken Graham’s approach and defined his own set of investing strategies. But the heart of Buffett’s strategy still determines intrinsic value as a first step.
Buffett-style investors logically come to the question of how to regard a stock that is priced lower than it should be. Ultimately, Warren Buffett has to believe that the stocks he invests in will later be recognized by the market for their intrinsic value. At that point a given stock’s market value should approach its intrinsic value.
That is a simplified version of his approach. And the Graham equation above is one of the many ways to invest like Warren Buffett.
So, what other value investing strategies can be used to invest like Buffett? Well, there are certain metrics to consider if you want to find stocks like he does.
Warren Buffett doesn’t believe in efficient markets, until he does.
Confused? Apologies. That was intentionally contradictory. Warren Buffett invests in companies that he believes are undervalued by the markets. But, if he invests in an undervalued company, he must believe market sentiment will reverse, right? Otherwise, he’d be perpetually disappointed because those undervalued stocks would never show any return. That is, he would buy them in their undervalued state and that’s where they’d remain.
Therefore Warren Buffett believes that the markets are inefficient in the short term, but recognizes value in the longer term. This idea that markets price a security near its intrinsic value is referred to as the efficient market hypothesis.
So, Buffett searches for stocks which disprove the efficient market hypothesis now, but which will prove the market’s efficiency later. To put it another way, he believes that the markets will come around to change its mind on those securities.
Seek That Which is Established
The Oracle of Omaha seeks companies with an established record of high ROE. Return on Equity is really a measurement of return on stock. ROE is a simple calculation that consists of determining how much (what percentage) of net income is returned of shareholders’ equity.
ROE = Net income after tax/ Shareholders’ equity
Warren Buffett searches for companies that have high ROEs relative to their industry peers. Buffett also considers ROE over a longer time period which could exceed a decade.
A point to consider for investors is that net income can be influenced by leverage within a given company. Take as an example, Company A and Company B within the same industry. Both Company A and Company B have a 12% ROE. So you might think equal size investments in these two companies would do equally well.
But investors who assume Company A and Company B are equal quality-wise may be wrong. If, for example, Company A has more debt, the quality of its earnings is lower than that of Company B. This is true because more debt equals more risk. In any case, Warren Buffett seeks a record of quality ROE as a value investing strategy.
This value investing strategy is really a continuation of the previous point. So, to invest like warren Buffett you need to look not only at the ROE. Investors also need to consider debt relative to equity. Remember that Warren Buffett prefers companies that have a high ROE with a low amount of leverage. The Debt to Equity ratio is a key metric in doing so, and the formula for calculating D/E is:
(short term debt + long term debt + fixed payment obligations)/Shareholders’ Equity
It has been mentioned that Buffett seeks investments in companies that have a D/E ratio of less than 0.5. Debt is leverage which acts as a double-edged sword depending on the prevailing economic environment.
In strong economies debt acts as leverage to provide returns on investments. Conversely, in slower economies debt acts as a deterrent. Highly leveraged companies cannot utilize debt to generate returns as easily and servicing debt remains a burden.
Thus, Buffett chooses equities on the more conservative end of the D/E spectrum.
Cash In/Cash Out
Another strategy Buffett utilizes is the identification of another financial metric. This one is the current ratio. Like the previous two, it’s deceptively simple but richly telling.
The current ratio is calculated as:
Current Assets/Current Liabilities
That’s fairly straight-forward — businesses, like people, preferably have more assets than they do liabilities. The word current is defined as a year’s time or less. There’s a long list of assets that qualify as being current. But essentially, this means ones which can be converted to cash quickly. Thus, Buffett is really looking for liquidity and solvency in the securities he invests in. This is analogous to being capable of paying one’s bills on time.
Competition, Castles and Moats
Buffett’s idea here is about seeking competitive advantages that in essence make the castle walls unscalable, so to speak. The idea of competitive advantage is somewhat amorphous, which makes it difficult to identify.
A moat can take the form of patent protection and intellectual property rights which preclude competition. But patents and intellectual property are relatively easy to identify. A moat could also exist in the form of consumer recognition of a brand name. Investors can also find indexes of brand recognition by name with relative ease.
Moats are Obvious and Not Obvious
Yet a moat could also be something more subjective like quality of management, which is extremely difficult to identify. That is, investors are going to have a very difficult time looking at the management team at Company A, comparing that to Company B, and identifying which company truly has a moat in the form of management.
At other times competitive advantage is readily identifiable by things like sheer size. Companies often gain a moat simply by being the 800 lb. gorilla in the room. It is very difficult for new entrants to combat the strength of a Walmart (NYSE:WMT) or an Intel (NASDAQ:INTC), for example.
The Oracle’s Words on Moats
Here’s how Warren Buffet himself describes his company’s approach to moat identification:
“The most important thing you can know, what we’re trying to do is we’re trying to find a business with a wide and long-lasting moat around it, protecting a terrific economic castle with an honest lord in charge of the castle. And in essence, that’s what business is all about… What we’re trying to find is a business that, for one reason or another — it can be because it’s the low-cost producer in some area, it can be because it has a natural franchise because of surface capabilities, it could be because of its position in the consumers’ mind, it can be because of a technological advantage, or any kind of reason at all, that it has this moat around it.”
The overarching theme is that a stock’s value is derivative of competitive advantage over the long term.
Warren Buffett is staunchly American. He has been advocating that investors purchase shares of U.S. companies for a long time. Buffett’s belief in American equities is an extension of his belief in U.S. monetary policy and U.S. economic strength and global position.
He famously stated “Buy American. I am” in an op-ed piece in the New York Times in the depths of the global financial crisis in 2008. He has stated this ethos again and again and remains a proponent of American business.
This isn’t to say that Berkshire Hathaway (NYSE:BRK.A,BRK.B) hasn’t or won’t invest in foreign equities. But the majority of its holdings are American. Of course, investors can’t simply choose random American stocks on the strength of the U.S. However, this gives insight into the mindset Buffett has toward sources of value.
Takeaway on Warren Buffett’s Value Investing Strategies
Warren Buffett is methodical in the way that he evaluates companies before purchasing them. That much should be clear to even the most casual spectator. To invest like him, you should consider the principles that he filters through companies with.
Some of these are objective, hard and fast indicators like ROE or Debt to Equity ratios. And some of these are more qualitative and subjective in nature including ideas like moats and competitive advantage.
There may be no exact checklist Berkshire Hathaway follows. But as an investor if you want to approach stock analysis as Warren Buffett does, consider building a checklist of your own. Investing in this way removes a lot of the guesswork, and promotes objectivity over subjectivity.
On the date of publication, Alex Sirois did not have (either directly or indirectly) any positions in the securities mentioned in this article.