Although many view Buffett’s stock investing methods as very complex and confusing, his approach can actually be boiled down to four key rules.
A Stock Must Be Stable and Understandable
Although this might go against the grain of common conception, Buffett heavily relies on stable companies because they allow him to accurately predict the future cash flows of the business. This is essential because without being able to estimate these numbers, he’s unable to determine the true value of the business. Remember, at the end of the day, Buffett is buying companies that he believes are trading for less than what they are worth.
Buffett also doesn’t like to purchase companies that are difficult for him to understand. His opinion is that 1 share is no different than owning the entire business. Understanding this mindset, it becomes obvious why he wouldn’t like owning stock in a company that’s a new technology start-up or other businesses in this arena.
A Stock Must Be Managed by Vigilant Leadership
This is a very important tenant for Buffett because he’s of the opinion that vigilant leadership is managed by people that avoid excessive debt. Although it’s difficult for novice investors to intimately understand the characteristics of a company’s leadership, metrics can still be used. For example, if you look at a company’s debt to equity ratio, you can get a quick glimpse of the corporation’s history and whether they have over extending themselves. Buffett really likes to find businesses that are conservatively managed. Again this adds to stability and ultimately predictable future cash flows.
A Stock Must Have Long-Term Prospects
In an effort to avoid paying enormous capital gains, Buffett relentlessly seeks companies that have a durable competitive advantage. Although this might be difficult to find during reasonably priced market conditions, deals can always be found. The time for really capitalizing on businesses that meet this criteria is during recessions. There’s a reason Buffett says to be fearful when others are greedy and greedy when others are fearful.
A Stock Must Be Undervalued
This may be the most difficult part for new investors to implement. Buffett is well known for using an intrinsic value formula to calculate the value of his stock picks. For novices this might be a little hard starting out. In short form, Buffett values businesses by estimating how much the company will continue to earn into the future. After this estimation is complete, he then discounts that future cash flow by a reasonable discount rate. This difficult task is practiced by few and attempted by many.
This article may make Buffett’s rules look easy, but implementing this process over an extended period of time is difficult. Something else to consider is that all four of these rules must be met in order for Buffett to ultimately purchase stock.