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How Warren Buffett picks his winners

Most people (and certainly most investors) have heard of Warren Buffett. Not only is he the third richest human on the planet, with a net wealth of approximately US$82.5 billion, he is also regarded as one of, if not the greatest investors of all time.

He is also a popular figurehead of the value investing movement. Buffett’s company Berkshire Hathaway Inc. (NYSE: BRK.A)(NYSE: BRK.B) holds an annual shareholder meeting in May, and it is regarded as somewhat of an investing pilgrimage to make the journey to hear the great man speak and answer questions.

Outside of these meetings, Buffett is known for his grandfatherly persona and love of a simple turn of phrase or anecdote to explain good investing habits to his thousands of fans.  

When Warren Buffett offers his view on the economic or investing hot button issues of the day (which is thankfully quite often), I’m sure even his naysayers secretly listen, alongside most of the investing world.

But how does Buffett do it? How does he consistently outperform the legion of fund managers that Wall Street employs, and handsomely so? Well, that’s what we’re going to look at today.

Warren Buffett’s humble beginnings

Warren Buffett was not born rich, but he has said that he always knew he would be. Buffett started his investing career at the feet of the famous Benjamin Graham – author of one of the most honoured tomes in a typical investors’ library, The Intelligent Investor.

When Buffett set out on his own, he fell into buying a failing textiles mill named Berkshire Hathaway back in 1963 (Buffett has actually said that he bought the mill out of spite after its old owner short-changed him on a deal).

Buffett transformed the textiles company into an investing powerhouse over the following decades, which according to Berkshire’s 2016 annual report, has achieved an average annual growth in book value of 19% since.

What’s the first thing Buffett looks for?

Far from being mysterious, Warren Buffett has one of the most consistent investing playbooks out there.

Let’s take a look at some of Berkshire’s current portfolio, as of Berkshire’s most recent filing.

  • Apple, Inc. – Berkshire’s largest position is worth approximately US$56.66 billion (yes, Berkshire owns about 5% of Apple) and makes up about 24% of Berkshire’s entire portfolio
  • Bank of America Corp – the second largest Berkshire Hathaway holding as well as the US’s second largest bank, comprising about 13% of the company’s portfolio
  • The Coca-Cola Company – Coke is worth almost 10% of Berkshire’s total holdings. Warren Buffett loves Coke himself (rarely seen in public not drinking a can) but loves the stock even more, considering he has held it since the 1980s.
  • American Express Co. – Perhaps Buffett’s oldest continuous investment, he picked up this payments giant way back in 1963 and has never left home without it since. Today, AMEX makes up 9% of Berkshire’s total portfolio.
  • Kraft Heinz – This one is probably Buffett’s worst stock, with Kraft Heinz losing nearly 20% of its value since Buffett helped engineer the Kraft/Heinz merger back in 2015. Today, this company makes up roughly 5% of Berkshire’s holdings.

For those readers who are good at maths, you would have noticed that this isn’t the entire Berkshire portfolio, but most of the company’s other major holdings are other US banks and airlines, so we will stick to these core stocks for now.

The most consistent trait with all of these stocks from my view is… branding. All of these companies have very powerful brands that are recognised throughout the world (with the exception of Bank of America).

And what’s more, each company is arguably the purveyor of choice for the majority of its potential customers. Buffett would call this branding power a ‘moat’ or ‘intrinsic competitive advantage’ that the company has over its competition.

Sure, some people like Pepsi, but a lot more will choose Coke, even though it’s more expensive.

Sure, Apple’s iPhones are the most expensive phones on the market, but that doesn’t stop the hundreds of millions of iPhone users around the world from buying them.

And I don’t know about you, but if I wanted to impress someone with a credit card, I would take a centurion-emblazoned AMEX any day (not that I’m into that).

Buffett understands consumer behaviour more than anyone, and he knows a phenomenal brand when he sees it.

What else does Buffett look for?

But this is only half of the Buffett magic. There is, of course, more to beating the pants off the market over six decades than knowing a good brand.

In his 2014 letter to shareholders, Buffett outlined six additional criteria that he uses to assess investments.

They are (and I’m quoting here):

  1. Large purchases
  2. Demonstrated consistent earning power (future projections are of no interest to us, nor are “turnaround” situations),
  3. Businesses earning good returns on equity while employing little or no debt,
  4. Management in place (we can’t supply it),
  5. Simple businesses (if there’s lots of technology, we won’t understand it),
  6. An offering price (we don’t want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown).

So what I can gather from this list are another three essential qualities that a business must possess if Warren Buffett might be interested, apart from a fantastic brand.

Points Two and Three point to rock-solid fundamentals – a business has to be healthy, well established and growing if it is to be considered for Berkshire’s portfolio.

Point Four – Buffett doesn’t want to change a company’s management, but this also means that the management has to be of exceptional quality as well – an ‘ain’t broke, don’t fix it’ situation.

Point Six – Buffett (as a value investor) always waits for the right price before buying and will often wait years before doing so – what he calls buying $10 notes for $5. After all, the great investor’s most famous quote is “be fearful when others are greedy and greedy when others are fearful.”

Foolish takeaway

Of course, no one on the planet can emulate Buffett, all we can hope to do is learn from him and try to invest a little better ourselves using his lessons. By looking at our own companies and asking ourselves ‘what is my company’s moat’, ‘am I buying this company on sale’, or ‘is the company run by good management’, we might invest a little better.

Here’s one more Buffett quote for the road (this one is from Berkshire’s 1996 Letter to Shareholders):

Investment students need only two well-taught courses – How to Value a Business, and How to Think About Market Prices. Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now… put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.

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Sebastian Bowen has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of and recommends Berkshire Hathaway (B shares). The Motley Fool Australia's parent company Motley Fool Holdings Inc. has the following options: long January 2021 $200 calls on Berkshire Hathaway (B shares) and short January 2021 $200 puts on Berkshire Hathaway (B shares). The Motley Fool Australia has recommended Berkshire Hathaway (B shares). We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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