There is a great article about Warren Buffett’s approach to investing from The American Association of Independent Investors (link). The article is from January 1998 but the advice is timeless. Below is a summary of his approach. The article itself is a quick and easy read, well worth your time.
The Warren Buffett Approach
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.
• 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 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.
Stock monitoring and when to sell
Does not favor diversification; prefers investment in a small number of companies that an investor can know and understand extensively. Favors holding for the long term as long as the company remains “excellent”—it is consistently growing and has quality management that operates for the benefit of shareholders. Sell if those circumstances change, or if an alternative investment offers a better return.