Warren Buffett is, inarguably, one of our greatest living investors, having amassed a personal fortune of billions of dollars and having turned a medium-sized textile company into one of the most successful wealth-building enterprises in generations.
As much as some may want you to believe that his success was the result of a “secret sauce,” or Wall Street mysticism, the fact of the matter is that his formula is deceptively simple, and his success is a function of disciplined use of that simple, reliable strategy over years and decades.
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The Surprisingly Simple Warren Buffett Stock-Picking Formula
When Warren Buffett started his own investment company in the late 1950s, his initial investments in Berkshire Hathaway, a textile manufacturing company based in New Bedford, Massachusetts, and GEICO General Insurance Co. became huge successes and provided the foundation to generate large investment profits and cash flows. The profits and cash flows were then invested in additional stocks. This simple formula snowballed into millions and then billions of dollars in capital under management.
That formula has seven simple steps:
- Be Patient. Wait for the right time to buy. Patient investors are the best prepared when opportunities emerge. Because of market turbulence, stocks of great companies become available at very cheap valuations. This doesn’t mean buying stocks and forgetting about them! Tracking performance is key and so is getting out when necessary (when your stock is overvalued or trouble is on the horizon). Invest only in companies that will outperform for decades. Follow this approach and you will gradually develop an outstanding stock portfolio like Warren Buffett.
- Buy Companies at Bargain Prices. Warren Buffett is a true value investor. Buying companies cheap is what Buffett’s value investing criteria are all about. Purchase stocks below their intrinsic value and fill your portfolio with these companies. Pay less attention to earnings per share. Look for solid return on equity, high operating margins and low debt. In addition, look for companies that generate lots of cash and have a consistent operating history during the past 10 years.
- Go Against Conventional Wisdom. Attempt to be fearful when others are greedy and to be greedy only when others are fearful. Going against the crowd can be an effective way to make money. For example, it’s too early to know how it’ll turn out, but Buffett recently acquired a sizeable stake in insurance company Chubb (CB) while paring down his stake in Apple (AAPL).
- Stick with What You Know. Stay within your circle of confidence. If you don’t understand what a company does or how it makes money, avoid it.
- Be Self-Confident. You must be able to act without affirmation from others (or the market) on your investment decisions.
- Buy Companies with Competitive Advantages. Warren Buffett calls this an “economic moat,” which gives a company barriers or protection from its competition. Examples of competitive advantages include high capital costs for rival companies to enter a business, a strong brand identity or patent protection.
- Believe in America. Warren Buffett has faith in the long-term prosperity of U.S. companies. This allows him to make investment decisions that are not based on where we are in economic cycles.
Don’t be fooled, however. The Warren Buffett stock-picking formula is simple, but it’s not easy. Patience may be one of the most difficult concepts for any stock selection formula. And there’s no question that you have to do some homework.
The Secret Behind the Warren Buffett Stock-Picking Formula
Buffett’s seven-part investing formula isn’t much of a secret these days. It’s a formula that most successful value investors follow. Behind that formula, however, is an interesting philosophy.
In an interview, Nicole Buffett, Warren Buffett’s granddaughter, talked about five sayings that her grandmother, Warren’s wife, used to drill into her kids and grandkids. They’re pretty basic, which is what you’d expect from a down-to-earth, value-investing family, but they’re also pretty good.
- Show up.
- Tell the truth.
- Pay attention.
- Do your best.
- Don’t be too attached to the outcome.
Now, the first four are exactly the kind of sentiments you’d find embroidered on a satin pillow in your grandmother’s house. But number five is a more profound and unexpected piece of advice and a great lesson for all investors.
Investing always requires a leap of faith. You can do all your homework on a stock, check the fundamentals, analyze the chart, read the coverage from analysts and commentators (and newsletters like ours), and calculate its potential for hours on end. But eventually, you have to make the decision to push the buy button.
And once you do, that’s when Warren Buffett’s formula comes back into play. If the outcome (share price performance) isn’t there, reassess the process. If the process is sound, it’s time to remain optimistic and practice patience.
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*This post is periodically updated to reflect market conditions.