Warren Buffett is one of the most popular investors in the world today. Born in 1930, he is the fourth-richest person in the world (as of December 2019). Since 1970, he has been the Chairman and the largest shareholder of Berkshire Hathaway and is often referred to as the ‘Oracle’ or ‘Sage of Omaha’ by many media houses.
As an investor, he is known as a persistent value investor and has had amazing success for his clients over the years. Today, I am going to share an investment checklist that Warren Buffett uses to make investment decisions. Let’s see what the checklist says!
In this article
1. Understanding the Business
Buffett believes that all investors must invest in businesses that they understand well. You must know how the business/industry works to be able to understand the developments and how they can impact your investments. Also, the said company should have simple processes that allow you to assess its performance and growth.
Sometimes, a company can record phenomenal growth due to sheer luck or a sudden shift in demand in the market caused by external macroeconomic factors.
For example, in the current pandemic, all health-related products are doing well. However, does this mean that they are good companies to invest in?
Buffett believes that you should buy stocks of companies that have a history of delivering returns consistently with the same set of products. This highlights its market strength.
He prefers companies that are solid, consistent, and boring as opposed to untested and excessively innovative. Hence, he tends to avoid companies that are undergoing a major change or reorganization, as that indicates instability. He also tries to avoid businesses that solve complex market problems and prefers simpler companies that are consistent.
3. Long-term Prospects
Stock investing is a long-term process. Hence, it is important to consider the long-term prospects of the company. A simple way of determining the long-term prospects of a company is by asking three simple questions:
Q1. Does the company provide a product/service that the market needs?
Q2. Can customers easily replace the said product/service?
Q3. How tightly is the industry regulated?
Buffett believes that companies that offer products/services that are desired, not easily replaced, and not stringently regulated tend to do better over the long-term. You can assess the qualitative factors using tools like Porter’s Five Forces and the quantitative factors using ratios like P/E, D/E, etc. Companies with favorable long-term prospects should be preferred.
Also Read: Analyzing Stocks with Porter’s Five Forces
1. Rational Cash Management by the Company
According to Buffett, how a company’s management exercises logic in capital allocation determines shareholder value. He thinks that most companies lack this quality. Buffett looks at how the company treats its profits. There are three broad options –
- Reinvest the profits back into the company
- Buy growth through acquisitions
- Distribute the funds to the shareholders via dividends
Buffett believes that companies that share profits with their shareholders should be preferred as they seek to increase shareholder value as opposed to pocketing all profits.
Companies can make mistakes. However, if the company tries to cover up its errors as opposed to being transparent with its shareholders, then Buffett recommends that investors must be wary before investing in them.
The best way to assess this is by attending an Annual General Meeting and assess how the management responds to the concerns raised by shareholders. Also, you can get an idea about the candidness by merely listening to the management to announce the financial results.
Does the management resist the institutional imperative?
According to Buffett, the institutional imperative is the tendency of the management to copy the behavior of its peers without putting any thought into it. He recommends looking for companies that are innovative and strategic without imitating their competitors.
In many companies, managers display institutional imperative since they are afraid of going against the herd. Hence, they find comfort in following what everyone else is doing even though it costs them growth.
Remember, these are qualitative factors that require paying close attention to the reports and announcements made by companies.
1. Focus on Returns on Equity
While analyzing a company’s financials, Buffett prefers to focus on the returns that the management generates on the equity capital (ROE) as opposed to the overall earnings per share (EPS). ROE and EPS are profitability ratios that can help an investor understand the profitability of their investments.
While ROE measures the returns a shareholder is getting on his investments, EPS measures the net earnings of the company that can be attributed to each share.
2. Owner’s Earnings
The owner’s earnings are the cash flow available to shareholders and are also known as FCFE (Free Cash Flow to Equity). This is a measure of how much cash is available to the shareholders after paying all debts, expenses, and reinvestment.
In other words, it is the measure of the usage of equity capital. Buffett uses this measure to assess the company’s ability to generate cash flow for its shareholders.
3. Huge Profit Margins
This is an essential factor that investors must consider before investing in a company. Buffett ensures that he invests in companies that have a consistent record of generating good profit margins. Since an increase in profits includes reducing expenses too, this factor helps in finding companies with efficient management teams.
One dollar retained = One dollar market value generated
Buffett believes in investing in companies that display a clear intent of generating wealth for its shareholders. He ensures this by assessing if the company has managed to generate $1 of market value to shareholders for each $1 retained by it over time.
This is the quickest and simplest way to determine the economic attractiveness of a company. It also helps you understand if the management has generated value for its shareholders.
1. Value of the Business
There are several ways of determining the intrinsic value of a business like P/E ratios, P/B values, etc. However, Buffett prefers to calculate the value of a business by calculating the future net flow of a company that is discounted back using an appropriate interest rate. He values companies that have exhibited stable and consistent returns in recent years.
Can you purchase a business at a significant discount to its value?
Even if you identify the right business to invest in, you need to figure out the right time too. Buffett always ensures that after finding the intrinsic value of a company, he creates a safety margin to absorb any short-term price fluctuations and endeavors to purchase the stock at a price much lower than its indicated value.
There you have it! Warren Buffett’s famous investment checklist – decoded and simplified for you. If you have ever wondered what makes investors like Warren Buffett click, then this is a good place to start.
To quote Benjamin Graham: ‘Investing is most intelligent when it is most businesslike.’ Needless to say, to be a successful investor, you need to start thinking like a businessman and buy shares only if you believe that the company has the right combination of finances, mangers, products and competitive edge to succeed and grow in the future.