Warren Buffett has a knack for finding high-return equity investments. Between 1965 and 2020, the holding company Buffett runs, Berkshire Hathaway, delivered a compound annual gain of 20%. That’s nearly double the S&P 500‘s annual growth of 10.2% in the same timeframe.
Fortunately for the investment community, Buffett likes to share his methods with the masses. In early 2008, he outlined four traits he and his fellow Berkshire leader Charlie Munger use to identify investable companies:
Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag.
Below is a closer look at those four traits and how you can apply them to your own investing.
1. A business we understand
Buffett has long expressed the importance of investing within your circle of competence. Investing in a company you understand has these advantages:
You have a better sense of that company’s strengths and weaknesses.
You can make better, faster decisions and judgments when you receive new information.
You are more connected to the investment. Your position is more than something you hope will be profitable; it’s a business you enjoy following.
2. Favorable long-term economics
Favorable long-term economics boil down to strong returns on invested capital today, plus a hefty competitive advantage to protect those returns over time. The advantage could be the industry’s most efficient cost structure or a brand that’s beloved by consumers around the world.
Whatever the advantage, it must be lasting. A competitive advantage that’s easily copied or dismantled fails the long-term test.
This is one reason Buffett prefers stable industries over industries in flux. Change, whether in regulations, demand, or technology, can weaken competitive advantages in ways that are hard to predict.
3. Able and trustworthy management
In the absence of scandal, it’s hard for individual investors to evaluate the trustworthiness of corporate leaders. But you can evaluate a leadership team’s ability, often by way of the company’s results and culture. Questions to research include:
Has management been consistent and disciplined with respect to growth initiatives?
Have they executed on stated strategic priorities?
How has the company performed in economic downturns?
How does the leadership team protect and enhance the company’s competitive advantage?
How has leadership addressed the company’s weaknesses?
What do the employees say about their leaders?
4. Sensible price tag
Buffett is a value investor. He invests in quality businesses when the price tag is lower than the company’s intrinsic value.
As an example, as tech stock prices were falling in the first quarter of 2022, Buffett snatched up 3.7 million shares of Apple. The iPhone maker was already the largest position in Berkshire Hathaway’s portfolio.
Notably, Berkshire Hathaway’s cash on hand had reached $144 billion before the tech sell-off. So Buffett could have easily bought more Apple shares last year, but he chose not to.
In an interview with CNBC, Buffett admitted he’d made the buy after Apple dipped — presumably because it fell into “sensible” territory. He also said he would’ve bought more if the share price hadn’t rebounded.
This aspect of Buffett’s approach is particularly relevant now, as the S&P 500 flirts with a 14% decline on the year. The downturn has likely ushered in lower share prices for some of your favorite stocks, too.
Keep it simple
Buffett likes investing in great companies with good leaders at low prices. Notably, he can also explain what makes a company investable in one sentence. His clarity is as inspiring as his methods.
There’s value in defining your own investment approach in clear, simple terms. It’ll help you stay focused and make more aligned decisions. You’ll need that focus if you’re hoping to make like Buffett and outpace the long-term returns of the S&P 500.
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Catherine Brock has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Apple and Berkshire Hathaway (B shares). The Motley Fool recommends the following options: long January 2023 $200 calls on Berkshire Hathaway (B shares), long March 2023 $120 calls on Apple, short January 2023 $200 puts on Berkshire Hathaway (B shares), short January 2023 $265 calls on Berkshire Hathaway (B shares), and short March 2023 $130 calls on Apple. The Motley Fool has a disclosure policy.