This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
There's a reason so many investors want to own Warren Buffett stocks.
The so-called Oracle of Omaha has trounced the market in his long history an investor. Berkshire Hathaway (NYSE: BRK.A) (NYSE: BRK.B) has nearly doubled the annual return of the S&P 500 for nearly 60 years, and thanks to the magic of compounding, that means Berkshire has returned more than 100 times what the S&P 500 has in that time frame.
Luckily, for investors, Warren Buffett's playbook is wide open, and he's made it clear what kinds of stocks he favors. Here are five simple questions to ask to determine if a stock would get the Buffett stamp of approval.
1. Does it have an economic moat?
Buffett's favorite concept in all of investing may be the "economic moat," or what most investors call a sustainable competitive advantage. Buffett once said, "The most important thing [is] trying to find a business with a wide and long-lasting moat around it, protecting a terrific economic castle with an honest lord in charge of the castle."
As he alludes to in that statement, this key attribute protects the company from competitors. Buffett likes stocks with well-known brands such as Coca-Cola or Apple; companies with limited competition and barriers to entry, like the railroad BNSF that he acquired a decade ago; or companies with strong market share and recurring revenue, like GEICO.
If you want to know if it's a Buffett stock, ask yourself if the company can withstand competition over a long period of time.
2. Does it produce cash?
Buffett doesn't generally waste his time with unprofitable growth stocks. He looks for companies that generate cash.
Buffett likes to own businesses like insurers that produce cash in premiums that come in advance of claims. He refers to this as a "float" that allows him to reinvest that cash in stocks. He also likes sectors such as energy (for example, Chevron stock), which generate high levels of cash flow when oil prices rise. Buffett's a fan of banks and financial companies like Bank of America and American Express that have reliable profit generation from commercial lending, and he's known to invest in utilities and healthcare, which tend to generate steady cash flows.
What you'll find among almost every Buffett stock is that they produce reliable cash flow, and many of them pay a dividend.
3. Does it have a long track record?
Warren Buffett doesn't generally chase the latest trends whether they be dot-com stocks in the 1990s or cloud software stocks more recently.
Instead, he prefers to own companies with long track records and operating histories. Often, he's studied these companies for years, or is well-acquainted with their brands. With Coca-Cola, for example, he had seen its success for 50 years before becoming an investor. When Buffett decided to invest in tech, he bought stock in IBM, because he'd followed it for decades and understood the business. While that investment didn't pan out, it nonetheless reflects Buffett's approach of studying a company for a long time.
Similarly, in financials, he prefers legacy banks over fintech, because banks have proven their business models over long periods of time. Not only are they less risky, but they also generate reliable cash flow.
4. Does it outperform in bear markets?
Historically, Berkshire has best demonstrated its fortitude during bear markets. Buffett hoards cash to buy stocks when they're cheap, and he's known for taking advantage of sell-offs like during the financial crisis when he took a high-yielding stake in preferred stock in Bank of America. Berkshire has also outperformed the stock market by a wider margin in bear markets, including this year.
Because many of Buffett's favorite stocks have stood the test of time, they tend to do well in bear markets, and many of his favorite industries -- including consumer staples, insurance, utilities, and healthcare -- are known for being recession-resistant.
Buffett doesn't exclusively buy recession-proof stocks. He owns cyclical stocks in industries like energy, banking, and industrials, but in general, he prefers to buy stocks that can outperform in bear markets or at least have demonstrated an ability to recover from them.
5. Is it a good value?
Finally, Buffett is a classic value investor. He wants to buy stocks that are trading below their intrinsic value, which is typically estimated with a discounted cash flow model.
The quality of the company is more important to the Berkshire chief than the price. He has famously said, "It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
However, if he finds a stock he likes, he'll only buy it if he believes it's a good value at the current price. In the bull market during the 2010s, Buffett often lamented that stocks had become too expensive. With prices now down, it wouldn't be surprising to see Berkshire deploying its cash hoard, which is currently worth more than $100 billion.
This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
