How to pick stocks like warren buffett
Gaining through the value investing techniques of the foremost global investor
Description
Warren Buffett's investment strategy focuses on buying quality companies trading at reasonable valuations. Specifically, he looks for companies with strong competitive advantages, consistent earning power, high returns on equity, little debt, and competent management teams.
He takes a long-term perspective, often holding stocks for decades, and aims to pay less than intrinsic value to provide a margin of safety. This disciplined approach allows him to minimize losses while maximizing gains over time. Rather than trying to time the market, Buffett searches for great businesses that he can understand and hold "forever," not worrying about short-term price fluctuations.
By tuning out market noise and focusing relentlessly on business fundamentals, Buffett has compiled an unparalleled investment record that most investors try, but fail, to replicate.
Table of contents
01Principle one: wise investment mindset
Power of Compounding Drives Growth
Warren Buffett has mastered the art of buying and holding stocks for extended periods rather than actively trading them. His rationale for this long-term approach is that while stock prices may fluctuate in the short run, over longer time horizons there is a strong correlation between price and intrinsic value. No factor impacts the growth in value of a stock portfolio more powerfully over time than time itself. Wise investors therefore practice patience, choosing firms with strong fundamentals and allowing ample time for the stock price to rise steadily alongside the company's growing earnings. Compounding further amplifies the gains from outperforming the broader market. If the market advances 10% annually on average and an investor assembles a portfolio returning just 2-3 percentage points higher each year, the end result after 30+ years of compound growth will be tremendous. As Buffett puts it, "Time is the friend of the good business, the enemy of the poor." Watching excellent companies raise their sales and profits year after year is an investor's dream. Their intrinsic value consistently moves higher in tandem, with the stock price rising in lockstep. Over long periods, the magic of compounding kicks in, enabling one's net worth to snowball by ever greater absolute amounts annually. Or in Buffett's words, "The inescapable fact is that the value of an asset, whatever its character, cannot over the long term grow faster than its earnings do."
Buy Low and Watch Costs
To enhance returns beyond the general market's performance, Warren Buffett uses three straightforward strategies. First, he buys stocks only when their market price is below the actual value of the company, because these undervalued stocks will likely grow the most over time. Second, he invests in only as many companies as he can realistically monitor - typically 10 to 15 stocks maximum. This allows him to closely track each company's financials. Third, he eliminates all unnecessary costs by minimizing commissions, avoiding frequent trades, and automatically reinvesting dividends. These simple, common sense principles are often ignored by many investors, who make things more difficult for themselves. As Timothy Vick states, "The investor who can rationally assess a company's prospects and pounce when the price is right has an unbeatable edge over investors who simply follow the herd." Furthermore, Warren Buffett warns that "Investors have been so oversold on diversification that they put too little into companies they thoroughly know and far too much into others they barely understand. Buying a company without sufficient knowledge may be even riskier than having inadequate diversification." Buffett also emphasizes, "I put heavy weight on certainty. Risk factors don't make sense to me. It's not risky to buy securities at a fraction of their true worth."
Maximize Gains Over Long Term
Warren Buffett intensely avoids short term trading activities. To him, the ideal holding period for stocks is indefinitely, as rapid trading wastes money better used to build wealth over the long term. By buying and holding stocks for many years, not only are transaction costs eliminated, but continuity in evaluation methods exists. There's no need to frequently develop new ways to measure growth in value. Progress can simply be determined by year-to-year price changes. As Buffett states, "Most of our large positions are going to be held for many years, and the scorecard on our investment decisions will be provided by long term business results, not by prices on any given day." He adds, "Just as it would be foolish to focus unduly on short-term prospects when acquiring an entire company, we think it equally unsound to become mesmerized by near-term earnings when purchasing small pieces of a company." Buffett estimates that investors waste over $100 billion a year on trading costs and advice on whether they should trade their stocks. He laments, "In other words, investors are dissipating almost a third of everything the Fortune 500 is earning for them by handing it over to various types of 'helpers.'" Instead, Buffett wants shareholder-partners to profit from the underlying business, not from the "foolish behavior of their co-owners." As an investor himself, Buffett explains his edge: "I am a better investor because I am a businessman, and a better businessman because I am an investor." Finally, Buffett derides the legions of market predictors, stating, "Thousands of experts study indicators night and day, and they can’t predict markets with any useful consistency, any more than fortune tellers could tell the Roman emperors when the Huns would attack."
02Principle two: astute investment analysis
Value based on discounted earnings
Warren buffett uses a simple approach to determine a business's value - he calculates it based on current book value and earnings, the possibility of future earnings growth, and the risks involved in generating those future earnings. Once he determines a value, buffett decides if the stock price is reasonable. If so, he invests; if not, he passes. Essentially, buffett first asks "how much is the whole business selling for?" - if offered a 5% stake for $10,000, he would multiply that by 20 to value the whole business at $200,000. Next, he determines if it's a "good buy" at that price based on expected future earnings. Buffett hasn't learned to solve difficult business problems; he avoids them by identifying small hurdles to step over rather than big ones to clear. He correctly assumes valuation standards are universal across industries - internet companies should be valued by the same measures as railroads, utilities, retailers, etc. All businesses are worth the present value of their expected future earnings. If they won't earn money eventually, they have no value.
Book value best growth metric
Warren buffett intensely focuses on growing the book value of berkshire hathaway, believing that increasing intrinsic value and earnings will follow, leading to a higher share price. Likewise, buffett seeks companies with rising book value, using it to evaluate management competence since book value is completely within their control, unlike day-to-day stock price. For buffett, per-share book value changes are the most meaningful and reliable performance measure. A growing number of high-grade managers now feel it’s acceptable to manipulate earnings to please wall street. Indeed, many ceos think not only is this manipulation okay but actually their duty, wrongly assuming their constant purpose is to encourage the highest possible stock price. To pump the price, these ceos strive for operational excellence. But when operations disappoint, they resort to unadmirable accounting tricks to manufacture desired earnings or enable future manipulation.
Return on equity predicts growth
Warren buffett believes the most reliable predictor of a company's future success is its return on equity (roe). A high roe leads to strong earnings growth, increases in shareholders' equity, grows a company's intrinsic value, and raises its stock price. When evaluating roe, consider that a high roe with little debt is better than a high roe with significant debt. Different industries have different debt levels and roe rates. Stock buybacks can enhance an otherwise inferior roe. Roes reflect economic conditions and business cycles. Restructuring charges, asset sales, and one-time gains also impact roes. Buffett strongly believes a company's roe trend correlates to its future earnings trend. By focusing on roe, investors can forecast future earnings fairly accurately. An outstanding, rapidly growing company's stock may be overpriced today, but in ten years could quadruple. The key is not whether it's 35% overpriced now, but that it will be worth much more later.
03Principle three: religiously avoid losses
Lock in gains, remove market risk
Warren buffett's success stems as much from what he avoided buying as what he purchased. The decisions to sell certain assets, and the timing of those sales, contributed as prominently to his returns as choices to buy and hold coca-cola, geico or gillette stocks. Buffett excelled at avoiding losses across his entire portfolio, despite occasional mistakes on individual stocks. He was prepared to patiently wait on the sidelines for better conditions before becoming an active buyer. Generally, buffett assessed stock to bond yield ratios, pace of market climbs, p/e ratio growth sustainability, the economy's state, and whether fundamentals supported higher stock prices. He only bought when earnings yields exceeded bonds yields, expected corrections when prices grew too quickly or p/e ratios were unsustainable, loaded up during depressions, and sold when the economy peaked. Higher prices needed sound economic fundamentals. The market simply provided reference points for foolish offers. Buffett invested in businesses, not just stocks.
04Principle four: follow investment rules
Trust your judgement
We must think independently and avoid blindly copying others, even very smart people. It constantly impresses me how many highly intelligent individuals just mimic others without thinking critically. I never gain insightful ideas by merely talking to other people. If you have logically concluded something based on facts and are confident in your judgment, take action on it even if others waver or disagree. Your correctness lies in your data and reasoning being sound, not in the crowd concurring. You are not right or wrong contingent on the majority disagreeing with you. You are right because your information and rationale are accurate.
Never accept price blindly
In any competition, whether involving money, intelligence or physical ability, having opponents who believe trying is pointless is an incredible advantage. Nowadays in investing, most professionals and academics discuss efficient markets, dynamic hedging, and betas. Their interest in these complex ideas is understandable since techniques that seem mysterious clearly have value to someone providing investment advice. After all, what medicine man ever became famous and wealthy by simply suggesting "take two aspirins"?
Common sense over academic ideas
Warren buffett believes that to be a successful investor, understanding complex financial theories is unnecessary. In his view, only two well-taught courses are needed: how to value a business and how to think about market prices. Most business schools focus their finance curriculums on more complicated subjects like beta, efficient markets, modern portfolio theory, option pricing and emerging markets. However, buffett thinks investment students do not need to learn these topics. He has seen no trend toward value investing in the 35 years he has practiced it. Buffett states that humans strangely like to make easy things difficult, which explains why few adopt the simple but effective value investing strategy. In short, buffett argues that the keys to investment success are business valuation and understanding market psychology, not complex financial models. Mastering these basic concepts can enable students to beat both the market and most professional money managers.
Ignore daily fluctuations
Warren buffett believes people tend to make investment decisions based on a stock's price movement rather than its underlying value. He thinks it's unwise to invest in things you don't understand or simply because they did well recently for someone else. Buffett argues that buying a stock just because its price is increasing is the "dumbest reason in the world" to invest in it. Buffett takes a long-term approach to stocks. He buys stocks with the mindset that stock markets could potentially close for years after he purchases them. So he focuses on the quality and value of the underlying businesses, not on short-term price fluctuations. This allows him to hold stocks for many years and wait out any market corrections or crashes if needed.
Avoid relying on forecasts
I have zero interest in projections or forecasts. They promote a deceptive sense of accuracy. The more meticulous they seem, the more you should doubt them. We never examine projections, but we deeply examine track records. If a company has a poor track record yet a bright future, we'll decline the chance. We spend virtually no time considering macroeconomic influences. We simply attempt to concentrate on enterprises we feel we grasp and where we like the valuation and management. We try to appraise rather than predict purchases.
Buy company piece, not just certificate
Investing attitudes differ between speculators and investors regarding stock price changes. Speculators aim to profit by predicting and capitalizing on share price ups and downs. Investors focus more on acquiring and keeping suitable stocks at good valuations over time. Market swings matter to investors because lows present buying opportunities and highs signal times to refrain from purchases. For investors holding excellent businesses long-term, expect normal price vacillations without overreacting to major rises or drops. The key is to concentrate on company fundamentals, not daily stock movements, when assembling a quality portfolio. Patience and discipline help investors endure volatility while speculators chase gains from constant trading. Ultimately, contrasting motivations divide those chasing temporary price spikes versus those targeting enduring business value.
Related books
