Are you interested in unlocking the secrets of one of the most successful investors of our time? Welcome to my deep dive into the investment strategy of Warren Buffett, the Oracle of Omaha. In this article, I quantify Buffett’s approach to selecting investments that have guided his unparalleled success and earned him a spot among the world’s wealthiest individuals.

Rather than fixating on short-term price movements and market trends, Buffett’s strategy is centered on evaluating the fundamental strengths of businesses with a keen eye for long-term profitability and growth potential. We’ll explore how he assesses companies based on their understandability, enduring competitive advantages, reliable management, consistent earnings power, and attractive valuation.

Whether you’re a novice investor just starting or a seasoned pro looking to refine your strategy, there’s something to learn from Buffett’s investment philosophy. His approach provides valuable lessons about patience, due diligence, and the importance of understanding a company’s fundamental value. Keep reading to discover how to apply Buffett’s principles to your investment decisions and potentially build long-term wealth.

Buffett Explains He Buys Businesses, Not Stocks

Below is a part of a transcript of an interview that Warren Buffett did with Charlie Rose:[1]

Warren Buffett explains his trading and investing journey, “When I was 11, I picked stocks. I had the whole wrong idea. I was interested in watching stocks, and I thought stocks were things that went up and down, and I charted them. I read books on technical analysis. I read Edwards and Mackey; I think that was the classic then. Hundreds and hundreds of pages, and I read that whole thing over and over again. I read everything and thought for the first eight years, I thought the important thing was to predict what a stock would do and predict the stock market. Then, I read Ben Graham, you know, when I was 19 or 20, and I realized that I was doing it exactly the wrong way.”

“But it didn’t hurt that I had that background and everything, and I rejiggered my mind. When I read the book ‘The Intelligent Investor,’ from that point, I never bought another stock. I bought businesses that happened to be publicly traded. But I became an owner of a business, and I did not care whether a stock went up or down the next day, or the next week, or the next month, or the next year. And I didn’t have any idea what it would do. I didn’t know what the stock market would do, but I knew businesses.

What Type of Businesses Does Warren Buffett Invest In?

Warren Buffett, one of the most successful investors of all time, is known for his specific investment style. He follows the principles of value investing, a strategy pioneered by his mentor, Benjamin Graham, and adds the growth dynamic taught by Phillip Fisher. Here’s what Buffett typically looks for when deciding to invest in a business:

1. Understandable Business: Buffett prefers to invest in businesses he understands, often referred to as staying within his “circle of competence.” This includes having a clear idea of how the company makes money and its potential for continued profitability.
2. Long-term Prospects: Buffett looks for companies that will still be profitable many years from now. He often asks whether a company’s products will still be in demand 10, 20, or even 30 years down the line.
3. Competitive Advantage: Also known as a moat, this could be a brand name, patent, cost leadership, superior distribution network, or other factors that protect the company from competitors.
4. Capable Management: Buffett invests in businesses run by competent, honest, and passionate management. He believes in the principle of “buying a business, not a stock,” so he must trust the business’s people.
5. Attractive Valuation: Even if a business meets the first four criteria, Buffett won’t invest if the price isn’t right. He looks for opportunities to buy businesses at a price below their intrinsic value and often uses financial ratios such as the price-to-earnings (P/E) ratio as part of his assessment.
6. Consistent Earnings Power: Buffett prefers companies that show consistent profitability over time. He typically avoids companies with highly unpredictable earnings streams.

Warren Buffett pays keen attention to a company’s intrinsic value – that is, the perceived or calculated value of a company, including tangible and intangible factors, using fundamental analysis.

One of the critical components of intrinsic value is a company’s discounted future cash flows. This represents the present value of the total cash that can be taken from a business during its remaining life. When Buffett examines a company, he estimates the cash flows it will produce in the future and then discounts those at an appropriate discount rate to determine their present value.

Warren Buffett’s approach compares the company’s intrinsic value (including the present value of its future cash flows) to its current market capitalization (the total value of all its shares at the current share price). If his analysis suggests that the company’s intrinsic value is significantly higher than its current market capitalization, he sees it as undervalued. In such cases, the stock reflects discounted future cash flows.

Buffett’s approach implies that he is buying a dollar’s worth of future earnings for less than a dollar in today’s terms. This is based on the fundamental principle of “buy low, sell high,” except Buffett rarely sells his investments, preferring to hold them for a long time; his favorite holding time is forever.

This is not to say that Buffett only considers cash flows. He also looks at the company’s competitive advantages, quality of management, and market position, among other things. But the core of his philosophy involves calculating the intrinsic value mainly based on discounted future cash flows and comparing this with the current market price. If the market price is significantly lower, it’s an indicator that the investment might be worthwhile.

These principles have guided Buffett’s investment decisions over the decades, leading to substantial long-term returns and helping him become one of the wealthiest individuals in the world. His investment choices have ranged across various sectors, including insurance (GEICO), food and beverage (Coca-Cola, See’s Candies), rail transport (BNSF), utilities and energy (MidAmerican Energy), and technology (Apple), among others.

Key Takeaways

• Focus on comprehensible businesses: Warren Buffett emphasizes investing within your “circle of competence.” Stick to industries and businesses you understand thoroughly.
• Long-term durability: Buffett scrutinizes companies for their enduring nature. He selects companies that he believes will continue to be profitable in the distant future.
• Defensible competitive advantage: He invests in firms with a substantial competitive edge or ‘moat’ that can safeguard their market position from rivals.
• Exceptional management: Buffett believes in investing in businesses operated by trustworthy, skillful, and zealous leadership.
• Favorable valuation: Warren Buffett buys businesses whose stock prices are lower than their intrinsic value, ensuring a margin of safety.
• Steady profitability: Companies with consistent earnings power are a preference for Buffett.

Conclusion

In a nutshell, Warren Buffett’s investment strategy can be likened to picking winning horses, not betting on the fastest laps. Rather than selecting stocks based on short-term price movements, Buffett opts for businesses with durable competitive advantages, sound management, and stocks priced less than their intrinsic value. The takeaway from Buffett’s strategy is that long-term wealth is built not by chasing quick wins but by patiently investing in businesses that can sustain profitability over an extended period. His approach emphasizes understanding the business, assessing its long-term prospects, and paying a fair or bargain price, illustrating that successful investing is more about company analysis and less about stock prediction.