Warren Buffett is a living legend. He needs no introduction.
During his 54-year tenure at Berkshire Hathaway, Buffett has generated consistent returns for his shareholders.
His rules have redefined the world of investing.
His uncanny ability to distill investment ideas into simple and solid ground rules has made him a popular investment guru. Many investors around the world are trying to follow these rules to match its success.
The relationship between Buffett and value investing
The Oracle of Omaha has always resisted the temptation to invest in what is supposedly going to be the ‘next big thing’. No wonder he stayed away from cryptos!
He has the odd predisposition to always pick the best undervalued stocks that turn out to be profitable long-term investments.
To understand his investment mindset, we need to dig into his past.
Warren Buffett’s investment principles were developed at Columbia Business School under the guidance of major value investor Benjamin Graham. His book ‘The intelligent investor is widely accepted as the bible of value investing.
Now you may be wondering why Buffett’s own company Berkshire Hathaway doesn’t follow the advice he gives other potential investors. His portfolio includes equity investments in companies such as Coca Cola, American Express and Wells Fargo.
To the average investor, these stocks are certainly not undervalued, nor do they represent the principles of value investing that Buffett claims to follow as his guiding principle.
Well, when these stocks were bought, they ticked all the right value investing boxes.
How to find undervalued stocks the Warren Buffett way?
According to Warren Buffett, the way to identify undervalued stocks is through value investing.
This is essential to minimize the risk of loss. Most importantly, the principles of value investing are almost a foolproof investment style.
In general, investors know Buffett as one of the best stock pickers. But you have to dig really deep to understand that value investing isn’t really about choosing stocks.
It is Warren Buffett’s mindset that leads him to choose undervalued but profitable stocks.
This result is a by-product of value investing.
Your goal is undoubtedly to follow in his footsteps. To do that, you need to follow the three basic principles of value investing.
#1 Holding time
In Warren Buffett’s own words, his favorite time to hold is “forever.”
Here you need to understand the difference between a trader and an investor.
The trader buys stocks because they are only interested in short term profits or intraday trading profits.
On the other hand, investors look at long-term gains and buy stocks with the intention of holding them for years.
To be successful with the Warren Buffett way, investors must first move away from the trader’s mindset and adapt to the investor’s mindset.
#2 Quality stocks
Warren Buffett believes that “if the company does well, the stock will eventually follow.” Hence why Buffett only invests in companies with strong and robust fundamentals.
Typically, these companies are managed by a strong leadership team, have fairly high promoter stakes, and can sustain themselves in the long run by having an edge over their competitors.
Finally, they must have an excellent product or service offering and be loved by their customers.
These are the kind of businesses that will last forever.
#3 Undervalued Stocks
So now you have the quality stocks you’ve combined with a long-term strategy. Will this be enough to make a profit in the future?
The problem with this strategy is that the gains will be average and the hold time can be way too long.
Therefore, to make the strategy more foolproof, you need to integrate a third angle that will help you pick the right stocks.
This is known as price valuation, which allows you to find the best quality stocks that are undervalued and will yield profits in the future.
Buffett’s methodology to identify undervalued stocks
Warren Buffett will only buy quality stocks that are available at discounted price levels. But the question is how does Buffett or anyone else know if the price has been cut or not?
To understand the price appreciation of a stock, Buffett looks at the following.
#1 Intrinsic Value
Intrinsic value estimation should form the basis for all equity investment decisions.
But the problem with this is that most investors don’t know what intrinsic value really is and how they should estimate it.
Those not well versed in intrinsic value will look at the company’s price charts and view it as the intrinsic value instead.
Often the market value of shares is too high. It only indicates what the investor has to spend to acquire one share of the company. But it doesn’t say whether the price the investor pays is fair or not.
So, how do you know the fair share price?
The fair price of a stock is when the market price is less than the estimated net asset value of the stock.
Read our guide to intrinsic value to better understand the concept.
#2 Understand the business
Why do most people start investing in stocks? The ability to get reasonably good returns when the price trend moves upwards.
The idea, of course, is to buy low and sell at a high price.
But there is a problem with this scenario. Rarely can the average retail investor accurately estimate the ups and downs of the market. Very few people really know how to time the market movements.
That’s why Warren Buffett focuses instead on stocks that offer long-term value.
This presents a new challenge for the ordinary investor. How do you know which stocks offer long-term value?
Looking at these parameters will get you there.
High return on invested capital (RoCE)
Ideally, the companies you have shortlisted should have a high RoCE.
RoCE is nothing but an estimate of how much profit the company can generate based on the invested capital. Companies that show a high RoCE for a reasonable amount of time are eligible on your list of stocks to invest in.
Quality of management
This is an important point to consider when using the Warren Buffett methodology for selecting undervalued stocks.
Buffett places great emphasis on the quality of the leadership team that runs the company and is responsible for management and operations.
In his words, Warren Buffett likes managers who “act and think like a company owner.” The reason behind this is that such managers will always work towards the ultimate goal of increasing shareholder value.
But how will a lay investor measure the quality of the company’s top executives? Easy. By carefully reading the annual reports and checking for rational use of capital.
It is within the purview of the company’s senior managers over the use of the company’s “retained earnings.” The way they choose to trade will determine whether building shareholder value in the long run is an option.
A seasoned investor like Warren Buffett will look at how these mature companies use this capital outlined in the annual reports. It gives him great insight into the character, honesty and transparency of senior management.
The other parameter that investors should pay attention to in the annual reports is their candor in reporting the results.
With Buffett’s trained eye, he will carefully review the messages shared in the report by the chairman, director (MD), chief executive officer (CEO) and chief financial officer (CFO).
If the reports discuss both achievements and failures, this is a big tick in Warren Buffett’s book.
Using the stock screener to find undervalued stocks
Now that you know the steps, here’s how to filter stocks that fall under the Warren Buffett category.
Consider companies with a higher market capitalization as these will be established companies.
Check the company’s PE plural and price to book value.
Return on Equity (ROE) must be greater than 15% (for consistent years).
The debt to equity must be less than 1.
Earnings growth over five years should be high (the higher the better).
Applying these filters, an initial list of stocks should get you started…
For Equitymaster’s powerful stock screener, we specifically designed a screen that takes Buffett’s filters into account.
Check out the Warren Buffett Stock Screener here.
Final words: Keep it simple
Investors like Warren Buffett keep repeating that you should invest in companies or assets they understand.
This means innovating and not blindly following market trends, analyst recommendations or what other investors are doing.
It means looking at companies that offer sustainable competitive advantages and have a margin of safety.
It’s that simple.
Have fun investing!
Disclaimer: This article is for informational purposes only. It is not a stock recommendation and should not be treated as such.
This article is from Equitymaster.com
(This story was not edited by DailyExpertNews staff and was generated automatically from a syndicated feed.)