11 most important Warren Buffett’s stock picking tips, especially 7th one. 17


 

Warren Buffett- Third richest man and probably the sexiest old man in the world.

cover WB

Women idolize him.

 

I don’t need to explain much what kinds of man Warren Buffett is. He is the legend.

 

I briefly introduced who Warren Buffett is by introducing his famous quotes.

50 most insightful Warren Buffett quotes that you need to read to be rich.

 

This is the man who grew his net worth of over $5,000 to $58,500,000,000 when he became 83 years old and now it stands at $65,000,000,000 at age of 85. To put it in context, you have to make $2,500,000 everyday for next 71 years then you will reach $65,000,000,000. Can you see why I am saying he is the sexiest old man alive?

 

net worth of WB

 

 

Throughout my life, I have learned not only valuable investing lessons to grow my networth overtime from him but also serious life lessons to be a less greedy and decent enough old man.

nwgraph

Thanks to Warren Buffett, I have been able to achieve a moderate success of growing my net worth.

 

I just finished reading through The Warren Buffett Way by Robert G. Hagstrom and wanted to share his 11 most important stock picking tips from the book that you should consider before buying any stocks. As you can see from my net worth chart and performance, so far his strategies are working although I am still at the entry level from Warren Buffett’s value investing standard. It will only get better as I digest through more and more of his life dedication of finding solid investments.  Here we go.

 

1. Is the business simple and understandable?

The first question Buffett asks is whether he understands the business of the stocks that he buys. He made billions off of owning Coca Cola and Coca Cola’s main operation is extremely simple. It sells various drinks around the world using its extensive distribution networks. He believes that success is correlated to how well people understand stocks that they buy and that’s how he distinguishes between investors and traders. Before making any purchase decisions, Buffett understands how a target company generates revenue, how much expenses it incurs, its cash flows, corporate structures, pricing flexibility, branding and capital allocation needs.

1 coke

These are all brands of Coca Cola. Amazing brands throughout.

 

It is not really about how much you know but how realistically define what you don’t know. He says

“Invest in your circle of competence. It is not how big the circle is that counts; it is how well you define the parameters”

 

Research about companies you are interested in buying. Read powerpoint investor presentation, management discussion and analysis, annual reports, management information circular etc…  Once you have sufficient understanding of how the company makes money then move on to the next question.

 

2. Does the business have a consistent operating history?

Buffett hates purchasing companies that are either trying to turn itself around or changing its direction.

He said

“Severe change and exceptional returns usually don’t mix”

A constantly positive net incomes and cash flows over the years are a good indicator that company is doing a great job and has a potential to become a multi baggers. Although past performances do not guarantee future outcomes but it is reasonable to say that the trend would continue.

Let’s say you are interested in the following two companies and have to choose only one. Which one will you choose?

 

Company A’s earning per share Company B’s earning per share
Year 1 $1.56 $4.12
Year 2 $1.78 $3.55
Year 3 $1.82 $-0.32
Year 4 $2.01 $0.41
Year 5 $1.89 $-0.50
Year 6 $2.25 $4.11
Year 7 $2.32 $2.58
Year 8 $2.68 $2.99
Year 9 $2.41 $-4.11
Year 10 $2.99 $0.25

I am quite sure you would be interested in Company A and so would be Buffett.

You would be able to predict what Company A’s earnings will be in Year 11 but you wouldn’t be able to for Company B. Company A’s earnings are stable and are in an upward trend. Company B may have some investment merits but Warren would only be interested in Company A.

 

I typically gather last 10 years of earnings and cash flows per share info to see whether the numbers give me comforts I need before buying any stocks. If something stinks, I don’t waste a single minute and move on to next candidate. If l like it, I dig a bit deeper into quarterly and annual reports. You can find a quick snapshot of 10 years performance in Morningstar.

2. CSU

Can you see Constellation Software Inc’s consistent performance?. It grew its EPS from $-0.06 to $8.36 during last 10 years period. Its free cash flow per share grew from $1.29 to $24.01. (source:morningstar)

 

 

3. Does the business have favorable long-term prospects?

Buffett makes sure to understand whether a product or service that is provided by a company is 1) desired 2) no close substitute and 3) not regulated. The traits would allow the company to control the prices and occasionally raise them without losing market share. The pricing flexibility is one of the most important characteristics of a great business.

Do you know Warren bought BNSF Railway for $44 billion in February 2010? Railroad is a monopoly because two railroads cannot be operating the same railways. At long range freight services, there will be only 1 option for customers which create a very strong monopoly. I have been buying railways such as Union Pacific, CSX and Norfolk Southern as well. I have Canadian Pacific and Canadian National Railways in my watch list.

bnsf

Look at BNSF’s railway map. Railways basically operate as a monopoly/duopoly.

 

This is where the terms ‘moat’ or ‘competitive advantage’ are used heavily. Buffett looks for durable/sustainable competitive advantage from a company.

He says

“The definition of a great company is one that will be great for 25 to 30 years”

I am very certain BNSF will be operating in 25-30 years and do very well.

 

Then what are bad businesses? A bad business typically provides a product or service that is virtually indistinguishable from the products of its competitors. Unless a company created a strong brand names, the following commodity or commodity types of businesses’ are more susceptible to be bad investments such as oil, gas, copper, lumber, gold, computer chips, cars, airline services, some bankings, some insurances etc…

 

I have some stocks that are considered to be bad commodity or commodity like businesses that are mentioned above but I don’t consider them as great long term investments (except a few) but more of temporary value trades.

 

4. Is management rational?

“A great rational management typically is a master of capital allocator”

Buffett says.

That means great management must have a distinctive skill sets to understand its own business and decides whether reinvest the earnings or return money to shareholders.

 

Two scenarios for management

  1. When the management can earn a return higher than the cost of capital by reinvesting the return, then the management should reinvest all earnings.
  2. When the management cannot earn a return higher than the cost of capital by reinvesting the return, then the management has 3 options.
    1. Continue to reinvest at lower return (which is a big no no for me).
    2. Buy growth through acquiring growing companies (Can be profitable but Warren does not like it as much because growing companies aren’t not cheap and integration can be very costly).
    3. Return money to shareholders by raising dividends or buying back its shares.

In this case, Buffett loves the third option. You see a lot of mature blue chip companies use the third option to boost shareholder returns over time.

buyback dividend

 

 

5. Is management candid with its shareholders?

Well… Buffett admires managers who are honest with the financial reports admitting mistakes and sharing successes. He says that you should read their annual filings and feel the tone of the management to evaluate their candor. He believes that too many managers are excessively optimistic than honest that serve their own interests in the short term but no one’s interests in the long term.

 

Take a look at Berhershire annual letter of 1989 where you can see how he shares his own mistakes.

http://www.berkshirehathaway.com/letters/1989.html

 

Buffett does not like managers using term EBITDA (Earning Before Interest Tax Depreciation and Amortization) in their annual reports. Here is what Buffett says about EBITDA.

A year before that in 2002, it was pretty much the same when it came to EBITDA. It amazes me how widespread the use of EBITDA has become. People try to dress up financial statements with it. We won’t buy into companies where someone’s talking about EBITDA. If you look at all companies, and split them into companies that use EBITDA as a metric and those that don’t, I suspect you’ll find a lot more fraud in the former group. Look at companies like Wal-Mart, GE and Microsoft — they’ll never use EBITDA in their annual report. People who use EBITDA are either trying to con you or they’re conning themselves. Telecoms, for example, spend every dime that’s coming in. Interest and taxes are real costs.

 

Here is another great annual letter to read from the Amazon’s founder, Jeff Bezos which we all can learn a lot from.

4 greatest leader

2015 Jeff Benzo’s Letter to Amazon Shareholders

 

 

6. Does management resist the institutional imperative?

Buffett defines institutional imperative as tendency of imitating others no matter how bad it is. That herd mentality, nasty human nature is what really kills the returns of companies.

“If all my competitors are doing it then we should do it too”

Management just does not want to look foolish by not imitating the competitors. Mindless imitation of their peers will get them killed and that’s what Buffett really avoids.

herd mentality

 

 

7. Focus on return on equity (ROE), not earnings per share (EPS)

Buffett thinks that earning per share is a halfway measure and that there is no reason to get too excited about a company that increases its EPS by 10% if at the same time it is growing its earning base by 10%. He says it is not different from putting money in a saving account and letting the interest compound.

 

Buffett prefers ROE which measures how much profit a company makes with the shareholders invested money. It is calculated by simply.

ROE= Net Income / Equity

Or you can do a 3 step DuPont analysis (more important when you want to understand how a company increases its ROE)

7 dupont is this company familiar

Yup. One of Dupont’s employee came up with the analysis. I consider this to be one of the most important investing formulas of all.

ROE= Margin x Asset Turnover x Leverage= (Net Income/Sales )  x (Sales / Assets) x ( Assets / Equity)

  • Margin measures operating efficiency of business (management can increase it by either boosting sales or decreasing expense)
  • Asset turnover measures how efficiently management uses its assets to generate sales (higher ratio means the company is making higher sales per dollar of assets)
  • Leverage measures how much company borrowed money (i.e. how leveraged the company is)

Let’s go through some examples here.

 

Company A-

High leverage

Company B-

Some leverage

Company C-

No leverage

Margin 20% 40% 60%
Asset Turnover 30% 30% 50%
Leverage 5.0 2.5 1
ROE 30% 30% 30%

On the surface, all 3 companies seem extremely profitable and has well run operations as all of them have enormous 30% of ROE however what’s more important here is to understand what really helped ROE reaches 30%.

 

Company A has only 20% of margin and 30% of asset turnover however due to its reliance on debt to grow, it has 30% of ROE.

Company B’s margin is twice better than company A and has the same asset turnover ratio but it borrowed only half of the money compared to Company A creating ROE of 30%.

Company C does not rely on leverage to juice their returns but its margin is spectacular and the management is really using its asset extremely efficiently creating ROE of 30%

It is amazing to see how all of them has ROE of 30%.

 

If Company A had leverage of Company B’s then its ROE would only be 15% and if it had leverage of Company C’s then its ROE drops to 6%.

What if Company C had leverage of Company A? then its ROE becomes 150% making it as a super investment.

I will pick Company C in a heartbeat and so will Buffett.

 

Buffett believes that a business should achieve good ROE while employing little or no debt. On top of that highly leveraged companies are exposed to changes of economic environment (such as interest rate changes, economic downturns etc…).

To conclude, you are better to stick to a high quality companies that create high ROE while using little debt.

See Gilead Science. Its super high net margin makes it as a super strong ROE company.

GILD ROE

 

 

8. Calculate owner earnings.

Buffett prefers to use owner earnings which is calculated by

Net income + Depreciation & amortization + Depletion – necessary capital expenditures

Buffett is trying to focus on normalized earnings here by using the formula.

 

I prefer to use free cash flow in that case which is defined as

Free Cash flow= operating cash flows – necessary capital expenditures

Free cash flow measures cash generated after deducting necessary capital expenditures to maintain & provide services to create returns

 

As I stated about me section, I am a CPA and I know how earnings from income statements are susceptible to various tools often employed by management for their short term interests. But it is much harder to play with cash flows. You probably have noticed from my previous stock analyses that I always research cash flows of any stocks before I purchase them.

I love when companies make solid cash flows but show net loss turning off investors thus pull back the stock prices temporarily 🙂 That’s when you buy a high quality super investment at discount.

 

9. Look for companies with high profit margins.

Buffett praises managements that relentlessly attack on unnecessary expenses. Sales can mean nothing if the business cannot turn that sales into profits. It is all about controlling costs.

He says

“Really good manager does not wake up in the morning and say, ‘this is the day I am going to cut costs’ any more than he wakes and decides to practice breathing”

Good manager always attack on unnecessary expenses.

Always compare your target stocks to other stocks that are in the same industry. Trust me, there is always one that has a higher profit margin than others and typically the difference comes from having lower overhead.

E. Hunter Harrison became CEO of Canadian Pacific railway on June 29, 2012. Since then he was all about reducing overhead costs and increasing efficiency of his railcars to increase profit margins. You can easily see how he has been doing.

9cp railway

Look at increasing margin. Isn’t it amazing?

 

 

10. What is the value of the business?

There are so many different methods that people employ to value a stock before purchasing. Price to earnings ratio can be useful. Low price to book value can be another tool to use. Dividend yields and discounted future dividend payments may be good tools (I never use dividend related methods to value businesses though)

 

What’s the best way to value a stock?

Warren’s favorite is ‘Discounted future cash flows’ This means net cash flows expected to occur over the life of the business discounted at an appropriate discount rate. I used discounted future cash flow several times from my job during annual goodwill impairment testing and when our company acquired another companies.

 

Ok. Let’s go through simplified boring calculation here.

Let’s assume this company is expected to make $10 in year 1, $12 in year 2……and $20 in year 6 and dissolve itself after 6 years of successful operations.

discount

I converted all future cash to present value by discounting it at 5% and if you add all of them up, you get the fair value at $74.69 and that’s how much you are supposed to pay for the entire business. Discount rate basically means cost of borrowing (it is like a mortgage rate when you get a house. So house= investment, mortgage rate= discount rate here).

I don’t want to make things complicated here turning off of you but the key takeaway is Discounted cash flows method is a great tool to value stocks.

 

 

11. Can the business be purchased at a significant discount to its value?

When you identify businesses that you understand with great ROEs, low leverage, solid and honest management with consistent operating history then you should keep a stock watch list of 10–20 stocks and when opportunity arises (when some stocks from the watch list become cheaper than others) then you should consider buying it.

 

Benjamin Graham, Warren’s mentor, often used the term called

“Margin of Safety”

Ben Graham taught Warren the importance of measuring margin of safety before buying stocks.

Margin of safety is the difference between its fair value and current market value.

If what you pay for is less than what you get then you have a margin of safety. Of course the bigger it is the better for investors.

11margin of safety

Two benefits if you buy stocks showing greater margin of safety.

Firstly, the margin of safety protects you from a downside price risk. Let’s say the market is extremely irrational in a way that values $10 asset as $5. The market may even punish it further to $4 but the loss becomes only 20%. If you purchased the $10 asset at $15 then the market punished it to $4 then your loss is close to 75%. That’s your margin of safety. Buy it when it is cheap.

 

Right, don’t be confused between solid companies that are temporarily priced down and Value Trap

Value trap is a stock that appears to be cheap because the stock has been trading at low multiple of earnings, cash flow or book value for an extended time period. Companies, and even sectors, can be doomed, because of situations such as the inability to survive competition, the inability to generate substantial and consistent profits, the lack of new products or earnings growth, or ineffective management. Often, a value trap appears to be such a good deal that investors become confused when the stock fails to perform (Investopedia.com).

 

I love bad news a lot as long as the news is temporary and not sustaining. You will often find hated group of stocks or hated industries. (e.g. health care and pharmaceutical stocks are being hated now due to a political pressure) and that’s where real money can be made. Make sure fundamentals of the stocks that you are purchasing are strong!

 

Secondly, the margin of safety often provides extraordinary stock returns. If we cleverly purchases unfairly undervalued stock, then the stock price will slowly trend upward as the price will eventually catch up to the true value of the business. That’s when you start to see multi baggers.

 

That’s it. 11 tips that will help you greatly in investing and growing your net worth.

All of the tips are really priceless. You don’t need to be a rocket scientist to understand what he meant. I am following hit suit and making some serious progress to be financially independent.

It is not really hard as long as we apply our common senses, strong determination and plentiful of patience into our investing activities. I strongly recommend you to read books about him if you are serious about investing and want to be financially independent. The Warren Buffett Way by Robert G. Hagstrom is a good starting point.

 

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