Stock Strategies: The Warren Buffett Quality Stock Strategy

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Stock Strategies: The Warren Buffett Quality Stock Strategy

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When it comes to investment icons, none are larger than Warren Buffett. His patented stock strategy has helped him continually beat the market and become one of the wealthiest people on the planet. But while some analysts like to think of Buffett as a “value” investor, his stock investment strategy is actually something of a hybrid.

A typical value investor will seek out stocks that are undervalued. For some reason, these companies have been missed by the markets and their stock prices do not reflect their true or intrinsic value. Since no specific formula exists for calculating the intrinsic value of an organization, some fundamental analysis will have to be performed.

Value investors are always looking for the next good deal and need companies that are of high quality, undervalued, but poised to experience significant growth in the future. In turn, the market will eventually correct its valuation mistake and the price of the stocks should rise significantly. Warren Buffett, on the other hand, does not necessarily care if the markets ever correct their mistakes because he is not a typical value investor.

Warren Buffett is not looking to make any kind of quick turnaround on his investment. In it for the long haul, Buffett will hold stocks for 5 or 10 years before thinking about selling them – that is, he employs the “buy and hold” strategy as well. Even then, Buffett is not necessarily looking to profit off of his investments in terms of capital gains. Rather, the Warren Buffett quality stock strategy includes finding stocks based upon the overall potential of the companies themselves. He is more concerned with their ability to make money than anything else. Finding these quality stock investments is the hard part but something in which Warren Buffett seems to have a little problem.

Finding ‘Quality’ Stock Investments

Warren Buffett and those who follow his quality stock investment strategy are looking for quality companies. Past performance may not determine future performance, but it is a valuable tool to use when trying to determine the intrinsic value of a company. Consistent performance is critical to the long-term viability of a company and a key indicator of consistency is the rate of return (ROE) of shareholder’s equity. This will indicate what kind of return investors are getting on their investment and it can be useful in determining the overall health of the company when compared to the ROE of other companies in the same industry.

The ROE is calculated by dividing net income by the shareholder’s equity. Calculating the ROE for the past 7-10 years is a good way to see how consistently the company is delivering a satisfactory return on shareholder investment.

ROE = Net Income / Shareholder’s Equity

Another clue to the intrinsic value of a company is its debt burden. Avoiding excess debt is critical to sustaining growth and profitability which is why every quality investor wants to know the debt to equity ratio for any potential investment. Higher ratios indicate high debt burdens, uncertain earnings, and high-interest charges. The debt to equity ratio is calculated by dividing total liabilities by shareholder equity.

Debt/Equity Ratio = Total Liabilities / Shareholder’s Equity

Warren Buffett and quality stock investors also investigate the overall profitability of a company when gauging its intrinsic value. Are the current profit margins above market average? Have they been steadily increasing for the past few years? Sustained profitability is a key factor to a quality stock investment so the profit margins have to be acceptable and they must be increasing.

When a company is highly profitable, it usually means that it is running its business effectively. Profitable businesses are efficient and look for ways to stay ahead of market trends rather than react to them. Companies that are able to increase profit margins tend to be those that continually improve efficiency, increase productivity, and reduce expenses.

Profitability can be calculated by dividing net income by net sales. It is necessary to look back 5-7 years to see whether or not the profits are increasing at an acceptable level to be considered a quality stock investment.

Profitability = Net Income / Net Sales

In order for Warren Buffett to consider any company for his portfolio, he wants it to stand the test of time. Quality companies are those that can weather market trends and still not only maintain profits but increase them. Quality investors like to see a company around for at least a decade before taking a serious look at them. Remember, the quality stock is one that an investor will want to hold onto for 5-10 years – maybe more. Companies have a tendency to come and go quickly in these uncertain times. Given the fact that most of the technology companies have only been around for about a decade, most quality investors have only just begun considering them for their portfolios. While past performance does not ensure future growth, it is often the best tool an investor can use when trying to predict how the business will perform in the future. Quality investors like to see a company that has gone public for at least 7 or more years.

Even established companies that have shown increasing profits over the past 5-7 years, such as natural gas conglomerates, are not necessarily quality stocks in the mind of Warren Buffett. Such businesses rely on commodities for their sales and produce goods that are virtually the clones of their competitors. Therefore, their products are not really unique and have no natural competitive advantage in the marketplace. It is therefore very difficult for such businesses to outperform other companies in the same industry. Warren Buffett would not consider such companies to be quality investments especially since their earnings are derived from dwindling commodities that suffer severe fluctuations in both prices, and profits. Buffett and quality investors like companies that deliver consistent increases in profits, not unstable ones that can fluctuate greatly according to market forces beyond their control.

If a company has been performing well in recent years with increasing profits and shows great growth potential for the future while not relying on commodities for its revenues, Buffett might consider it a quality investment as long as it also has a low debt burden. But, critical to the quality investment stock strategy is finding companies that will continue to generate income. Finding undervalued stocks is central to this stock strategy and it is the part that Buffett does best but which cannot be replicated because he is not about to part with his formula for determining the overall intrinsic value of a company.

Determining the intrinsic value of a company is not an exact science and therefore requires a lot of fundamental analysis and a fair bit of intuition. The earnings, revenue, assets, track record, debt burden, and balance sheets all have to be examined carefully before making a decision.

The intrinsic value is especially difficult to calculate in this era of intellectual property. Intangible assets, such as brand, patents, and copyrights do not appear on a normal financial statement but they have value. This intangible value of a business must be added to assets when calculating intrinsic value. The liquidation value of a business will tend to be lower than the intrinsic value once the intangible elements are added into the equation.

Once a quality investor has studied the fundamentals and compared the business with others in the industry, he/she must then compare the intrinsic value with the market capitalization. The market capitalization will equal the current share price multiplied the total number of outstanding shares. If the intrinsic value is 25% or higher than the market capitalization, then Buffett and most quality investors would most likely consider this a good investment – so long as all of the other criteria have been met.

However, Warren Buffett and all quality investors fly in the face of the Efficient Market Hypothesis. This theory asserts that it is impossible to beat the market because the efficiency built-in it will make certain that all relevant variables are already taken into account when determining the current share price. Thus, no stocks are ever purchased below their true value nor sold above their true worth. Fortunately, there is a successful track record that spans decades in which Warren Buffett has continued to pick stocks that outperformed the rest of the market while making him one of the richest people in the world.