Legendary investor Warren Buffett needs no introduction. The Oracle of Omaha is one of the most closely followed investors across the globe, and has global adminration for amassing wealth through suitable stock selection. While he, and his firm Berkshire Hathaway (BRK.B), is known for consistently following value investing principles, the common investors do have questions about what underlying strategies or methods the legend has been using for making the right stock selection. In this article, we look at a few of the known stock picking indicators used by Warren Buffett.
Warren Buffett's Value Investing in Stock Selection
Most of the methods or indicators used by Warren Buffett can be broadly categorized as Value Investing. Sounds simple and very common term, but its not easily understandable, let alone be followed. Let's try to break it down into simpler usable investment practices. Lets start with a quick one-line introduction to value investing: It was a concept made popular by another legendary investor named Benjamin Graham, and it focuses on intrinsic business value of a stock which is estimated using company's financials reports, like the profit and loss and income statements. Here is the break-up of the principles in detail.
Performance of the Company
Return on Equity (ROE) is one of the key measures to look at while assessing a stock. The company's ROE typically represents its financial performance and is computed by dividing the net income by shareholders' equity. In this case, the shareholders' equity is equal to a company's total assets minus its debt. Therefore, the ROE is considered to be the return on net assets, and ROE thereby provides for a key indicator of profitability of a company for its shareholders' equity. It is advisable to look for at least five years of past ROE while assessing a company. The more the number of years of good, positive and increasng ROE figure, the better its prospects appear to be. One must also compare this ROE record with the ROE of the company's top competitors in the same industry sector, to ascertain relative performance of a company worth investing.
Debt is always a liability for a company - irrespective of the low- or high-interest that needs to be paid on it. It is possible that a company may have raised debt at two percent interest, and using that capital it may be generating 10 percent resulting in net gain of eight percent. However, the debt needs to be repaid - sooner or later. Therefore, a key matrix that Buffett recommends to look at is the ratio of debt to equity for a company. A large value of this figure will indicate the company has high debt capital compared to its equity capital, and should be avoided. Companies with high debt also have most of their income go towards debt servicing (like, interest payment on debt), instead of that income being given to shareholders as dividends, or being utilized for investments in other business projects by the company. Therefore, it is advisable to avoid high debt companies for investment.
Earnings from Shareholders' Equity
Shareholder equity is calculated as a companies's total assets minus its total liabilities - that is, whatever assets are left for the shareholders after all the debts have been paid off. If this figure is positive, it indicates a healthy state of the company representing the firm has enough assets to cover its liabilities. However, if this figure is negative, then the company's liabilities exceed its assets, and shareholders may not have anything left for themselves when the debtors lay their claim on company's assets. Buffett recommends investing in companies with low values of debt and higher values of shareholders' equity making them the two key indicators used for successful stock picking.
At the end of the day, profits matter. The profit margin are a standard figure which represents how much percentage of sales has turned into profits. For instance, if a business reports 40 percent profit margin, it means it is earning a profit of $40 for each sale of $100 it makes. Buffett recommends that profit margin should be checked over past several years, and an increasing trend in this figure is a positive indicator to pick a company for investment. An increasing figure over the years also indicates that the company management is skilled at keeping the operating costs in check, thereby increasing the profitability for the company.
Additionally, one can also check the earnings per share to make an assessment of how much a per share profit a company is able to make.
The Bottom Line
Apart from advising 'What to do,' it is also important to focus on 'What NOT to do.' Buffett also advises against giving in to the impulsive temptations of putting your hard-earned money in the so-called 'Next Big Thing.' It essentially means avoiding the short-term price movers, or the new kids on the block who appear to be world-changers typically found in the technology sector, or those which seem to offer guaranteed profits. At the end of the day, what matters is investor's own discipline irrespective of what Buffett, Munger or Graham of this world advise. Follow advise judicially and wisely with strict disciplined approach to win in the long term.
Following is a list of top 10 stocks which are part of the S&P 500 index, and have the highest EPS values.