How Warren Buffet Picks Stocks

This information is collected after watching several Warren Buffett interviews that I’d encourage you watch too. It took me over 3 days to watch the interviews, make notes and write this article. Here is what Warren Buffett takes into consideration while picking stocks:

1. Fundamentals – Yeah, Technicals – No

Buffett does not follow technical indicators. He works purely on fundamentals, and to be specific, on the intrinsic value of a company. This involves analysing financials and making a judgment call about future potential, which is explained below.

2. Consistent Return on Equity

Checks the past performance and pays attention to the Return on Equity (ROE). The company should have performed consistently over the past few years and should have generated a healthy return on equity (net profit/equity capital).

For example, In India the current rate of bank FD interest is 6.9% while corporate bond yields pay up to 12%. So if you were to judge the ROE of a company, you can say that anything between 8%-9% post tax in these times of stagflation should be a healthy return.When market conditions turn favorable, investors can expect a higher return.

3. Interest Coverage Ratio

The company’s interest coverage ratio must be healthy. This ratio reflects on the company’s ability to service its debts.

For example, if a company has obtained of 1 crore at 10% interest, it’s interest liability works out to 10 lakhs per year.

Now if its EBITDA is 10 lakhs (or lower), it implies that the company is in trouble because it will have no profits leftover (after paying interest) for providing depreciation (a non-cash charge), meeting contingencies, providing for extraordinary losses or for rewarding its shareholders.

On the other hand, if the company’s EBITDA is in excess of 20 lakhs, it will have sufficient ¬†cash left over after paying interest.

Banks usually lend money only if the company’s interest coverage ratio is MINIMUM 2.0. That means the company’s EBITDA must be at least twice that of the interest it pays.

4. Debt Equity Ratio

Let me explain this with an example:

Assume your assets are valued at 1 crore, and you are making 10 lakhs per year.

Now you want to borrow 50 lakhs for a new venture that will start generating meaningful revenues after 6 months.

Commonsense says that (a) you cannot borrow more than how much interest you can afford to pay, and (b) in any case, you cannot borrow more than 1 crore, which is the value of your assets.

Assuming the rate of interest to be 12%, you will be required to cough up 6 lakhs per year. Your profit is 10 lakhs per year, and in such a case the lender will be happy to loan you the amount of 50 lakhs.

So, your total assets (or, equity + reserves) are 1 crore and the maximum loan you can afford to take for business is 50 lakhs. Anything more will stress out your income until the new venture starts paying.

This is the Debt-to-equity ratio that Warren Buffet analyzes while evaluating a stock.

Companies that borrow within their means indicate management that is responsible. Therefore debt-free companies, companies that carry a debt of up to 100% of their equity + reserves are investable so long they are profit making.

In the analyst’s world, a company can take debt of up to 200% of its equity and reserves, and anything above that is risky.

5. Product + Pricing Power

Though the world is intensely competitive, some products are unique. For example, even though the tomato ketchup market is fiercely competitive, Heinz ketchup stands out from the crowd and that is one reason why Buffet invested in the stock. He knew that whatever competition Heinz would face in the future, it would sail through because people love its product and will pay the price.

This implies that companies that own strong brands or brands that have the potential to make a mark in the market, will dominate the market.

The lesson here is to pick profitable companies that either own strong brands or brands that have the potential to break on through and stand out from the crowd.

6. Attractive Pricing

There’s no use buying a company that is trading at a high PE because that would involve nursing the stock for a long time before making any gains.

The company that you identify must be available at a discount.

In today’s liquidity driven markets, most stocks are unreasonably priced and chances are that you may discover a great stock, but you won’t get it at a discount.

So this is a call you have to make depending on your reading of the market.

7. Vigilant Leadership

Buffett invests in companies that are proactively managed by a group of professional leaders.

Well, out here in India, you will mostly see the founder’s sons, daughters and wife included in the management team and they will be described as visionaries who will take the company forward into the next century.

Professionally-managed companies like Infosys, Maruti, Cyient, HCL Tech, etc., are too few and far in between.

Still, you can always check around the management team before buying into a stock and make your decision.

8. Intrinsic Value

The intrinsic value of a company is an estimate of what its current price should be after working a mathematical equation that takes into account the company’s estimated growth and profits, and the discount percentage.

It is tough to calculate the intrinsic value for a layman and I recommend you use this Intrinsic Value Calculator.

Summing Up Warren Buffet’s Investment Strategies

These are the principles that Warren Buffet follows. Given that Indian markets are experiencing a massive bull run, you may not find undervalued stocks. So, the idea is to pick reasonably or close-to-reasonably valued stocks after applying these principles. Good luck.

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