Who Really Knows How Buffett Chooses Stocks?

For all the books and articles out there, there is no clear guideline on how Buffett selects stocks. The key difference between Buffett and other gurus is that he has never clearly stated his process or checklist.

As strange as it might sound, Buffett is like my mother.

Growing up, when I asked her how much salt I needed to put into the stew, she would answer the way most mothers or good cooks do.

“Just enough” she would say with a knowing smile.

In the same way, Buffett makes a lot of decisions based on instinct and pattern recognition which is something he can’t truly quantify and something that you and I have trouble grasping.

He doesn’t run spreadsheets (unfortunate because I would beg him to endorse mine haha) or perform valuation calculations.

And because of this, many value investors and authors have sought out to come up with their own ideas on how Buffett chooses stocks.

How Buffett Chooses Stocks to Invest In

This AAII article from 1998 goes into great detail of the types of companies that Buffett likes to invest in.

It’s 4 pages of full text so if you don’t want to read it, I’ve grabbed the most important section from the paper.

Aside from the obvious Buffett mantra of invest in businesses, it discusses in good detail, the selection criteria for Buffett stocks.

The Warren Buffett Stock Picking Approach

Buffett’s Philosophy and style

Investment in stocks based on their intrinsic value, where value is measured by the ability to generate earnings and dividends over the years. Buffett targets successful businesses—those with expanding intrinsic values, which he seeks to buy at a price that makes economic sense, defined as earning an annual rate of return of at least 15% for at least five or 10 years.

Universe of Stocks

No limitation on stock size, but analysis requires that the company have been in existence for a considerable period of time.

Criteria for Initial Consideration

Consumer monopolies, selling products in which there is no effective competitor, either due to a patent or brand name or similar intangible that makes the product unique. In addition, he prefers companies that are in businesses that are relatively easy to understand and analyze, and that have the ability to adjust their prices for inflation.

Other Factors

• A strong upward trend in earnings
• Conservative financing
• A consistently high return on shareholder’s equity
• A high level of retained earnings
• Low level of spending needed to maintain current operations
• Profitable use of retained earnings

Valuing a Stock

Buffett uses several approaches, including:

• Determining the firm’s initial rate of return and its value relative to government bonds: Earnings per share for the year divided by the long-term government bond interest rate. The resulting figure is the relative value—the price that would result in an initial return equal to the return paid on government bonds.

• Projecting an annual compounding rate of return based on historical earnings per share increases: Current earnings per share figure and the average growth in earnings per share over the past 10 years are used to determine the earnings per share in year 10; this figure is then multiplied by the average high and low price-earnings ratios for the stock over the past 10 years to provide an estimated price range in year 10. If dividends are paid, an estimate of the amount of dividends paid over the 10-year period should also be added to the year 10 prices.

How Buffett Analyzes Financial Statements

Combine the methods from above with how Warren Buffett analyzes and interprets financial statements and you have a powerful “Buffett toolset”.

A Buffett Screen?

If you are itching to take it one step further, how about applying this Buffett screen I found in a Seeking Alpha article.

• ROE: 5-year Avg. >= 17%
• Return on Invested Capital: 5-year Avg. >= 17%
• Pre-tax profit Margin: 5-year Avg. >= 1.2* Industry Avg. Pretax Margin: 5-year Avg.
• Price/cash flow ratio <= 0.8* Industry Average price/cash flow ratio
• Price/cash flow ratio >=0.1
• Debt to Equity Ratio <= 0.8*Industry Average Debt to Equity Ratio
• Income per employee >= 1.1* Industry Average Income per employee