Warren Buffett is known as the “Oracle of Omaha” for good reason. When it comes to picking investments, he seems to possess almost supernatural powers. For over half a century, he has selected many of America’s most successful and durable companies, often purchasing them when nobody else would.
However, as you’ll learn in this article, there’s nothing supernatural about Buffett’s method. All of it comes down to painstaking analysis, familiarity with the company, and a long-term perspective.
Here you’ll learn some tips from the old master – you’ll find out how to invest in a “businesslike manner”, make sense of earnings and share prices, and pick companies whose products you understand. Maybe – just maybe – you’ll be the one who unearths the next big winner.
You should invest in a businesslike manner
Warren Buffett’s great mentor was a man named Benjamin Graham. Graham was a British-born American famous for a book called Security Analysis – it’s something of a sacred tome for generations of investors.
One of Graham’s central ideas was that investing is most intelligent when it is most businesslike. This idea shaped the young Warren Buffett’s philosophy, becoming an essential part of his investment strategy. What exactly does businesslike mean, though?
Essentially, it means thinking of the stock you’re going to buy as a business, and not as a speculative lottery ticket. As buying a company’s stock is about owning a part of that business, this isn’t such a big leap to make.
If you were thinking of buying a business, what would you look for? If you were wise, you’d want one that could give you high, predictable annual profits, with a minimal amount of risk.
Imagine you were going to buy your local drugstore. First, you’d dig through its books to see if the business was consistently profitable, and whether or not that might change. You’d look to see if a big competitor was on the horizon, or whether its products would still be in demand for a while. If everything still looked good, you’d enquire about the price.
Then, you’d compare the asking price with the store’s annual earnings to see what kind of return you’d get. Let’s say that the store’s price was $100,000 and its annual earnings $20,000 on average. That would be a 20 percent yearly return on your money. Next, you’d shop around and see whether or not a 20 percent return was the best you could find. If it was, then, and only then, should you make a purchase. You should think about your stock picks in exactly the same careful way as you’d approach buying this drugstore.
Investing like this also means thinking long-term, like a good businessperson. Unlike many on Wall Street, Warren Buffett prefers to hold a stock for a long time. Many speculators would rather make, say, a quick 35 percent return, rather than an annual, compounding 20 percent over a few decades. But by selling their stock early, they’d incur capital gains tax, which would reduce their 35 percent return to just 25 percent. Then, they’d have to reinvest, risking poorer investments as they move their money around.
Investing the Warren Buffett way means high, predictable returns over the long term. And, most of the time, the Warren Buffett way wins.
You should look for companies that are consumer monopolies
Throughout his investing life, Warren Buffett has identified exceptional businesses and stuck with them over the long term. From Coca-Cola to Hershey’s to Bank of America, he’s struck gold many times. While many people might see stock investing as a kind of gambling, luck has very little to do with Buffett’s success. Instead, he has consistently picked companies that have one thing in common. They are what are known as consumer monopolies.
What exactly is a consumer monopoly, then? A good illustration is a toll bridge. If you want to cross a river, and don’t want to swim across it or use a boat, you’ll have to use the bridge. Those collecting the toll have a monopoly over crossing the river. Unless there’s a similar bridge nearby, the toll bridge will attract the most business.
To tell whether or not a company is a consumer monopoly, Buffett asks himself a question: could he compete with the business? If money was no obstacle, could he set up a rival to take away its market share? For instance, could he set up a rival to the Wall Street Journal or Coca-Cola? In both cases, the answer is no. Investors love their WSJ, while any cafe, restaurant, or corner store absolutely has to stock Coke if it doesn’t want to lose sales.
People are wedded to both products because of something that John Hopkins University student Lawrence N. Bloomberg called consumer goodwill in his 1938 dissertation. Consumer goodwill, he argued, comes about through a superior product, convenience, courteous employees, great advertising, and, sometimes, like Coca-Cola, a secret ingredient. Both the Wall Street Journal and Coca-Cola are bulletproof consumer monopolies.
Consumer monopolies are also able to manufacture their products or services without relying too much on continuous investments in land, manufacturing plants, or equipment. They avoid high property taxes and maintenance costs and reap bigger profits instead. Take Coca-Cola or Marlboro cigarettes. Once they’ve built their factories, there’s not much that needs updating.
On the other hand, companies that require continuous big investments in physical assets – like, for instance, General Motors – incur heavy costs that dent their profits. To expand, they need to keep building new manufacturing plants and equipment. This stops them from monopolizing their space completely.
The bottom line? If you want to invest in big winners, choose consumer monopolies.
There are three types of businesses that make the best investments
So, as we’ve just discovered, the best kinds of investments are consumer monopolies. These businesses are like toll bridges, collecting mountains of profit. But what kinds of businesses make for good consumer monopolies? Looking at Warren Buffett’s investment portfolio, it’s possible to discern three different types of businesses that fit the mold.
The first of these are businesses that make products that wear out quickly or are used up fast. These businesses often have powerful brand recognition and merchants usually have to carry or use their product if they want to stay in business. This is especially true when the business is the only one providing that particular product, so retailers have no choice but to buy it at a price determined by the manufacturer.
Coca-Cola is a great example of this kind of business. Despite all of the imitators, there is only one Coca-Cola, and every good drinking establishment has to serve it.
The second kind of investments that Buffett prefers are communications businesses, without which manufacturers couldn’t advertise their products. They provide a continuous and repetitive service that manufacturers have to keep paying for. These might be TV networks, advertising agencies, or publications. To get their products in the minds of consumers, manufacturers have to use the toll bridge of the communications business.
The third type of businesses that interests Buffett are those that provide repetitive consumer services that are in constant demand. These services are often provided by unskilled, nonunionized workers, who are hired on a temporary basis. This keeps costs low, and profits high.
In the US, this includes firms like ServiceMaster, which provides maid services, pest control, professional cleaning, and lawn care, and H&R Block, which helps people get their taxes in order. These kinds of businesses, like all the best consumer monopolies, require little in the way of capital expenditure to keep the profits coming in.
You should learn to think of company earnings as part of your investment
Okay, now we’re going to get a little bit more technical.
One way that investors evaluate a stock is by looking at the earnings per share. You get this number by dividing the company’s earnings by the number of outstanding shares. So, if a company has earnings of $7.6 billion, and has 3.98 billion outstanding shares, you’d divide 7.6 billion by 3.98 billion to arrive at an earnings per share of $1.91.
For most investors, if this number is growing, then it’s a good sign, as it means the company is profitable. But unless those earnings are paid as dividends, most investors won’t feel that those earnings are their business.
Warren Buffett, however, is not most investors. He thinks of company earnings in a very unorthodox way. If he invests in a company, he believes that the corporation’s earnings are his, in proportion to how many shares he owns. So, for example, if he owns 100 shares of a company and the company earns $5 per share, then he believes that he has just earned $500.
Buffett believes that a company can either retain and reinvest earnings profitably, or pay them out as dividends. Either way, those earnings should directly benefit the shareholder. Because of this belief, Buffett has a special interest in what management chooses to do with earnings. And if you’re a serious investor, so should you.
Unlike many Wall Street investors, Buffett prefers companies to retain their earnings rather than paying them out as dividends. He reasons that if a company pays out dividends, then the investors will have to pay capital gains tax and lose some of their profit.
On the other hand, if the business can profitably reinvest earnings, and increase the underlying value of the company, then this should be reflected in the stock price. Investors can then continue to hold a stock that increases in value over many years.
Take Buffett’s own business, the multinational holding company, Berkshire Hathaway. In the early eighties, the company traded at $500 a share. Today, it’s worth over $400,000 per share! This is because Buffett was able to reinvest retained earnings and increase the value of the company. Berkshire Hathaway has never paid a single dividend.
As earnings are such a vital part of your investment, it’s important to have trustworthy and competent management. If the company does retain its earnings, you should look to see if it employs them profitably, or squanders them on expensive folly. If it’s the latter, then you should run a mile from the business, and the stock.
Stock price and the rate of return are important criteria when choosing investments
In Warren Buffett’s thinking, the price you pay for a stock is critical.
That might sound obvious, but many investors forget this, and simply purchase shares at any price, hoping they will go up in value. That’s speculating, rather than investing. To invest like Warren Buffett, you have to buy the right stock at the right price.
This is because the price you pay determines the rate of return. For example, if you pay $100 for a stock and the per-share earnings are $20, then your rate of return is 20 percent. However, if you pay $200 for the same stock, then your rate of return shrinks to 10 percent, and so on. Quite simply, the higher the stock price, the lower the rate of return, and the lower the stock price, the higher the rate of return.
It’s vital, then, that you purchase a stock when the price is right for the kind of return you’re looking for. But in order to determine the rate of return, you’ll need to be able to reasonably predict the company’s future earnings.
Let’s take an example from Buffett’s own investment career. In 1979, he began buying shares in a company called General Foods. In total, he bought 4 million shares at an average price of $37 per share.
By looking back over its recent history, Buffett was able to see that General Foods’ earnings per share, or EPS, had been growing steadily at an average annual rate of 8.7 percent. At the time he purchased the company stock, the EPS was $4.65. So, in the next year, if there was no great disaster, he could reasonably predict that company earnings would grow to $5.05 a share. This means that, as he paid $37 per share, he would get an initial rate of return of 13.6 percent.
In reality, Buffett had been conservative with his predictions: General Foods went on to have an EPS of $5.12. But his calculations gave a very good idea of the kind of return he might expect.
If you’re serious about choosing good investments that give high, steady returns, you’ll definitely need to consider the stock price alongside the EPS. It’s a crucial formula.
You should only invest in what you really understand
When Warren Buffett is asked about Bill Gates, he’ll gush over Microsoft’s cofounder. He thinks he’s one of the smartest and most creative minds in the business world. He’ll say that Microsoft is a brilliant company. But because computer software isn’t his forte, he can’t invest in the company. It’s not within what he calls his circle of competence.
This is an important insight. When you invest, you should understand what you’re getting yourself into. Perhaps, unlike Buffett, technology is in your circle of competence. In that case, you might comfortably invest in Microsoft or Apple, for example. If not, you should start with products or services that you’re familiar with.
For instance, you could note what you buy at the supermarket, or check your bathroom cabinet or refrigerator. What do you find there? Which restaurants do you eat at regularly? Many of Warren Buffett’s best investments have been in companies that make simple, popular products – those like Gillette, Kraft Foods, and McDonald’s.
Then, when you’ve found a few companies you really “get,” it’s time to do some more detailed research. There are lots of free resources that allow you to read up on company finances, management, and any relevant news stories.
You can often read a company’s annual report on its website, or you can call and request a copy. You can find key financial information in resources like Value Line and Moody’s, which can be accessed online and in print. From publications like this, you can determine some of the key metrics we’ve discussed here, like annual earnings and EPS, that are so crucial to Warren Buffett’s investment approach.
As well as financial information, it’s important to research the company management. By digging into old news stories and doing a little private detective work, you should soon build a good picture of them. If they appear trustworthy, competent, and have a long-term, shareholder-oriented approach, then you could be onto a good thing. For instance, did they take pragmatic business decisions when times were hard? Or did they fritter away company profits on failed ventures?
If you can find a consumer monopoly whose product you really understand, which has growing EPS, and which has management that appears solid, then you might have found something that Warren Buffet himself might invest in. Are you ready to take the next step?
The best kinds of investments are consumer monopolies. These are businesses that dominate their sector and provide popular and necessary services and products. These companies aren’t as difficult to discover as you might think – some of them, like Coca-Cola and Procter & Gamble, you might find from products in your refrigerator or bathroom cabinet. In fact, your best investment is one you understand best.
Before you do invest in a company, though, you should check that the stock is at the right price for the kind of returns you’re looking for. You should also pay special attention to earnings per share, to make sure that the business is consistently profitable. Finally, always think like a businessperson, not a Wall Street speculator.