Finding Stocks the Warren Buffett Way – Part 1

Like most successful stock pickers, Warren Buffett thinks that the efficient market theory is absolute rubbish. Buffett has backed up his beliefs with a successful track record through Berkshire Hathaway, his publicly traded holding company. Maria Crawford Scott examined Warren Buffett’s approach in the January 1998 issue of the AAII Journal. Table 1 below provides a summary of Buffett’s investment style. In this article, we develop a screen to identify promising businesses and then use valuation models to measure the attractiveness of stocks passing the preliminary screen.

Buffett has never expounded extensively on his investment approach, although it can be gleaned from his writings in the Berkshire Hathaway annual reports. Many books by outsiders have attempted to explain Buffett’s investment approach. One recently published book that discusses his approach in an interesting and methodical fashion is “Buffettology: The Previously Unexplained Techniques That Have Made Warren Buffett the World’s Most Famous Investor,” by Mary Buffett, a former daughter-in-law of Buffett’s, and David Clark, a family friend and portfolio manager [published by Simon & Schuster, 800-223-2336; $27.00]. This book was used as the basis for this article.

Monopolies vs. Commodities

Warren Buffett seeks first to identify an excellent business and then to acquire the firm if the price is right. Buffett is a buy-and-hold investor who prefers to hold the stock of a good company earning 15% year after year over jumping from investment to investment with the hope of a quick 25% gain. Once a good company is identified and purchased at an attractive price, it is held for the long-term until the business loses its attractiveness or until a more attractive alternative investment becomes available.

Buffett seeks businesses whose product or service will be in constant and growing demand. In his view, businesses can be divided into two basic types:

Commodity-based firms, selling products where price is the single most important factor determining purchase. Buffett avoids commodity-based firms. They are characterized with high levels of competition in which the low-cost producer wins because of the freedom to establish prices. Management is key for the long-term success of these types of firms.

Consumer monopolies, selling products where there is no effective competitor, either due to a patent or brand name or similar intangible that makes the product or service unique.

While Buffett is considered a value investor, he passes up the stocks of commodity-based firms even if they can be purchased at a price below the intrinsic value of the firm. An enterprise with poor inherent economics often remains that way. The stock of a mediocre business treads water.

Finding Stocks the Warren Buffett Way – Part 2

Finding Stocks the Warren Buffett Way – Part 3