Key points
While Buffett picks stocks based on a number of reasons, he often favours companies with unique propositions that are hard for competitors to match.
Like a lot of investors, Buffett’s a big fan of holding investments for the long term and letting them ride out market volatility.
To learn more about Buffett’s approach, you need to understand concepts including the margin of safety, retained earnings and economic moats.
Warren Buffett’s investment strategies are studied by amateur and professional investors around the world – and for good reason. The CEO of Berkshire Hathaway has achieved almost double the S&P 500’s average stock market return over the last 40 years.
Value investing is at the core of Buffett’s strategy. In other words, he’s generated returns by identifying companies that are priced lower than their expected value and held on to those stocks long enough for their price to appreciate substantially.
There’s more, however, to Buffett’s approach. Here, we break down and explain some of the tactics he’s used to generate his impressive returns.
The margin of safety is a metric deployed by value investors, and something Buffett has celebrated as a cornerstone of his investing.
Many value investors will have analysed a stock’s fundamentals to determine the value they believe it’s actually worth. This is called its “intrinsic value”. These investors won’t purchase said stock unless its price is a certain level below this value. The difference between the purchase price and the intrinsic value is the margin of safety.
Let’s say you’re about to take a short flight. You’re certain you can arrive at the airport an hour before your journey and still be able to board. But you chose to arrive two hours before instead. That extra hour is your margin of safety.
"By only purchasing an asset way below what you think it’s actually worth, you’re hoping to limit your downside risk. You believe it will rise to at least its intrinsic value – and may even think it will surpass that – but you’ve given yourself some wiggle room if the stock underperforms."
The same principle applies when using this metric to invest. By only purchasing an asset way below what you think it’s actually worth, you’re hoping to limit your downside risk. You believe it will rise to at least its intrinsic value – and may even think it will surpass that – but you’ve given yourself some wiggle room if the stock underperforms what you think it’s worth.
Buffett’s view is that strong stocks with good fundamentals will weather market volatility and provide long-term returns.
Gains occur not because of a sudden spike in stock prices, but due to steady growth and compounding over many years. If a company is doing well in terms of its financial performance, Buffet would advise to stick with it instead of selling every time the broader market falls.
He’d add that, over the long term, markets have historically moved upwards, and strong financial companies often ride or lead this trend. Remember, however, that past performance is not a reliable indicator of future returns.
"Buffett refrains from buying companies that don’t have a distinguishable product or a competitive advantage over their peers."
Buffett refrains from buying companies that don’t have a distinguishable product or a competitive advantage over their peers. Instead, Buffett prefers companies with a distinct offering that people really like.
Stocks that fall into this category are said to have an economic moat – a strong brand presence or USP that makes it hard for others to enter the same industry and compete with them. Just like a moat around a medieval castle, this protects companies, making it harder for competitors to copy business models and piggyback on success.
We can see this when looking at one of Buffett’s most well-known investments – Apple. Products like the iPod (R.I.P.), iPhone and iPad are hard to beat. Just think about the lines outside Apple Stores on product launch days. Very few competitors have been able to replicate the company’s success. Its “moat” is very deep.
Divide net income by net sales and you get a profit margin.
Healthy profit margins mean companies have a bigger buffer between making and losing money. If margins are small, even a tiny increase in costs, or reduction in sales price, could mean profitability is under threat.
Buffett looks to buy companies with the highest profit margins in their respective industries – though they also have to match his other buying parameters.
Debt-to-equity is calculated by dividing a company’s total liabilities – i.e., what it owes creditors – by its shareholder equity. It’s a good indication of whether an organisation is operating/expanding using its own money or borrowing capital to do so.
Buffett typically prefers firms that have lower debt-to-equity ratios relative to their peers. Debt means having to make interest payments – and lots of it means lots of payments. If a company struggles to repay its debts, it’s unlikely it’ll be able to return cash to shareholders.
If a company can grow its revenue year after year, it likely shows its products or services are in demand. Additionally, consistent growth in a firm’s earnings per share often shows its products and services have an enduring appeal to customers, even if prices are raised.
While both metrics are regularly signs of a healthy business, they can also be the result of smart accounting or irregularities. That’s why Buffett often looks for evidence of both metrics rising in lockstep over a long-term period.
Some of Buffett’s favourite long-term investments are in companies that don’t pay a dividend (or pay only a small one). These firms instead chose to keep the money they make in the business. This capital is called retained earnings.
While many successful companies choose to pay out profits in dividends, Buffett prefers when firms use their retained earnings to enable growth. His logic is that companies that are successful over the long term invest in themselves.
Saying this, not every company in Buffett’s portfolio follows this strategy, which brings us nicely on to…
When strong companies with cash reserves don’t see an opportunity to grow, they can opt to buy back shares. Buffett is also a fan of this, providing the price at which shares are bought back represents good value.
Companies may buy back shares in order to maintain their stock price – they’re effectively creating demand for outstanding equity. Reducing the number of shares outstanding can also improve financial metrics.
For example, if a company’s earnings remain the same, but there are fewer shares outstanding due to a buy back, that will mean higher earnings per share.
Buffett has used the above strategies to pick plenty of winners. However, he’s also admitted that he’s stopped himself from buying certain stocks because he didn’t understand their products or technology.
For investors that lack the time to research or analyse stocks, Buffett is a big proponent of low-cost passive index funds and even owns a couple in his portfolio. While you may not have Buffett’s deep pockets, you can invest like him, even if that means buying a solitary ETF.
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