Forbes magazine proclaimed Warren Buffett as the world’s richest man. If an investment tycoon can go from re-selling a six-pack of Coke to having almost three times the shareholder equity in the company, his methods and strategies are worth a second look.
The Basic Elements of Warren Buffett Investing
Much of what is discussed here is derived from the former daughter in-law of Warren, Mary Buffett, in her co-authored book Buffettology. What are the key elements to his investing strategy?
- Qualitative analysis
- High current and projected earnings (in relation to share price)
- Timing … well, sort of
Is that really all? The 320 pages of Buffettology are rife with windy explanations of what price-to-earnings ratios are and how the government switched out gold for paper currency during war times. But when you simmer down the excess, we are essentially left with these three key elements.
Warren Does Qualitative Analysis
Warren Buffett is noted for such famous quotes as:
- “If a business does well, the stock eventually follows.”
- “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
- “Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”
Clearly, he strongly believes in qualitative analysis or in aspects of a company that are not reflected in financial ratios derived from balance sheets. He is relentless in his hunt for finding a quality company – which is something you simply cannot do with a stock screening tool.
Beyond picking sharp management, and a company he would love to own for life (and he just might do that), what are some other qualitative aspects he looks for?
- A business with a monopoly and a strong brand-name
- Generally not a commodity-selling business with stiff competition
- Freedom to adjust prices to inflation
- Boring, repetitive services
- Products with long-term viability that are consumed or used up quickly
It is simply too far beyond the scope of this short article to discuss how to scuttlebutt a business to ensure a high quality company exists. Perhaps his attention to picking the best companies is one of the top reasons people invest with Warren Buffett.
Static and Forecast Earnings
What surprised me in my research of Warren Buffett was the lack of an absolute valuation model. All the price projections I found were based on relative ratio analysis. In a nutshell, this is how Mary Buffett claims he projects the future price of a stock.
- Annual retained earnings dividend by share price is your annual profit ratio
This is simply based on the price-to-earnings ratio.
- P/E of 5 = 20% annual profit
- P/E of 10 = 10% annual profit
- P/E of 20 = 5% annual profit
- P/E of 100 = 1% annual profit
So the lower the P/E ratio, the higher the annual rate or return is for the shareholder. But this leads to the question: why would such a wonderful company with great earnings be trading at such low valuations? One reason could be if it dispersed a very high dividend payout ratio. But Warren doesn’t believe in dividends, according to his former daughter in-law, as this kills growth opportunities.
Next, Warren forecasts future earnings at a certain date and then multiplies this by the current price-to-earnings ratio. A quick example:
- Stock XYZ has a P/E of 10 and earns $1 per share
- Stock XYZ is forecast to earn $3 per share in five years
- Stock XYZ should rise from $10 to $30 in five years time assuming static P/E ratio
There are two weak spots with this model.
- The first is the problem of a reliable earnings forecast. The stock market would be an easy money-maker if we were able consistently forecast earnings. Our ‘new economy’ is making that task very difficult.
- Secondly, the assumption is that the price-to-earnings ratio will remain static – or hopefully go up. But what proof is there that the P/E ratio will not fall? Is the safety in picking low P/E stocks hoping they will not go lower?
Timing the Market
This is perhaps one of the most important aspects to actually making money. Qualitative and fundamental analysis is for the purpose of finding stocks that should appreciate over time. The proof of how well this strategy works is in the market trading environment. If you bought shares of Coca-Cola in 1998 for over $87, how happy would you be in 2011 with a loss of 28%? Clearly, timing is vital. Oddly enough, it is almost impossible to find Warren Buffett’s concrete criteria of when to buy and sell stocks.
It is easy for an analyst to suggest buying low and selling high, but exactly how is that done when no absolute valuation of the company is available? If all fundamental analysis is relative, the values can perpetually shift against you. Price-to-earnings can drop as these are built on perceived worth and not in any intrinsic value. It is a personal guess that Warren uses some form of technical analysis to determine stock trends, but this is unproven as of yet.
One suggestion in the book, Buffettology, is to buy when a great company with a rosy future has a bad year. This is easier said than done since when a company enters into financial trouble, institutional investors are not so confident of the final outcome. In addition to this, if low earnings become the norm instead of a seasonal blip, you have purchased a boat anchor.
Trading the Warren Buffett Way?
While there is no doubt that the ‘Oracle of Omaha’ is one of the most famous and successful investors of all time, there are too many unanswered questions about the real trading methodologies of Warren Buffett for the average person to try and mimic.