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Stock Strategies
The Warren Buffett Quality Stock Strategy
by InvestorGuide Staff (Write for us!)
(Click on the links within the article to get definition of that word)
A typicalvalue investor will seek out stocks that are under valued. For some reason, these companies have been missed
by the markets and their stock prices do not reflect their true or intrinsic value. Since no specific formula exists
for calculating the intrinsic value of an organization, some fundamental analysis will have to be performed.
Value investors are always looking for the next good deal and need companies that are of highquality, under valued,
but poised to experience significant growth in the future. In turn, the market will eventually correct its valuationmistake and the price of the stocks should rise significantly. Warren Buffett, on the other hand, does not necessarily
care if the markets ever correct their mistakes because he is not a typical value investor.
Warren Buffett is not looking to make any kind of quick turn around on his investment. In it for the long haul, Buffett
will hold stocks for 5 or 10 years before thinking about selling them - that is, he employs the "buy and hold"
strategy as well. Even then, Buffett is not necessarily looking to profit off of his investments in terms of capitalgains. Rather, the Warren Buffett quality stock strategy includes finding stocks based upon the overall potential
of the companies themselves. He is more concerned with their ability to make money than anything else. Finding these
quality stock investments is the hard part but something in which Warren Buffett seems to have little problem.
Finding 'Quality' Stock Investments
Warren Buffett and those who follow his quality stock investment strategy are looking for quality companies. Past
performance may not determine future performance, but it is a valuable tool to use when trying to determine the
intrinsic value of a company. Consistent performance is critical to the long term viability of a company and a key
indicator of consistency is the rate
of return (ROE) of shareholder's equity. This will indicate what kind of return
investors are getting on their investment and it can be useful in determining the overall health of the company when
compared to the ROE of other companies in the same industry.
The ROE is calculated by dividing netincome by the shareholder's equity. Calculating the ROE for the past 7-10 years
is a good way to see how consistently the company is delivering a satisfactory return on shareholder investment.
Warren Buffett and quality stock investors also investigate the overall profitability of a company when gauging its
intrinsic value. Are the currentprofit margins above market average? Have they been steadily increasing for the past
few years? Sustained profitability is a key factor to a quality stock investment so the profit margins have to be
acceptable and they must be increasing.
When a company is highly profitable, it usually means that it is running its business effectively. Profitable businesses
are efficient and look for ways to stay ahead of market trends rather than react to them. Companies that are able
to increase profit margins tend to be those that continually improve efficiency, increase productivity, and reduce
expenses.
Profitability can be calculated by dividing net income by net sales. It is necessary to look back 5-7 years to see
whether or not the profits are increasing at an acceptable level to be considered a quality stock investment.
Profitability = Net Income / Net Sales
In order for Warren Buffett to consider any company for his portfolio, he
wants it to stand the test of time. Quality
companies are those that can weather market trends and still not only maintain profits, but increase them.
Quality investors like to see a company around for at least a decade before taking a serious look at them.
Remember, the quality stock is one that an investor will want to hold onto for 5-10 years - maybe more.
Companies have a tendency to come and go quickly in these uncertain times. Given the fact that most of the technology
companies have only been around for about a decade, most quality investors have only just begun considering them
for their portfolios. While past performance does not ensure future growth, it is often the best tool an investor can
use when trying to predict how the business will perform in the future. Quality investors like to see a company that
has gone public for at least 7 or more years.
Even established companies that have shown increasing profits over the past 5-7 years, such as natural gasconglomerates, are not necessarily quality stocks in the mind of Warren Buffett. Such businesses rely on commodities
for their sales and producegoods that are virtually the clones of their competitors. Therefore, their products
are not really unique and have no natural competitive advantage in the marketplace. It is therefore very difficult
for such businesses to outperform other companies in the same industry. Warren Buffett would not consider such
companies to be quality investments especially since their earnings are derived from dwindling commodities that
suffer severe fluctuations in both price, and profits. Buffett and quality investors like companies that deliver
consistent increases in profits, not instable ones that can fluctuate greatly according to market forces beyond
their control.
If a company has been performing well in recent years with increasing profits and shows great growth potential
for the future while not relying on commodities for its revenues, Buffett might consider it a quality investment
as long as it also has a low debt burden. But, critical to the quality investment stock strategy is finding companies
that will continue to generate income. Finding under-valued stocks is central to this stock strategy and it is the
part that Buffett does best but which cannot be replicated because he is not about to part with his formula for
determining the overall intrinsic value of a company.
Determining the intrinsic value of a company is not an exact science and therefore requires a lot of fundamental
analysis and a fair bit of intuition. The earnings, revenue, assets, track record, debt burden, and balance sheets
all have to be examined carefully before making a decision.
Once a quality investor has studied the fundamentals and compared the business with others in the industry,
he/she must then compare the intrinsic value with the market capitalization. The market capitalization will equal
the current share price multiplied the total number of outstanding shares. If the intrinsic value is 25% or higher
than the market capitalization, then Buffett and most quality investors would most likely consider this a good
investment - so long as all of the other criterion have been met.
However, Warren Buffett and all quality investors fly in the face of the Efficient Market Hypothesis. This theory
asserts that it is impossible to beat the market because the efficiency built in it will make certain
that all relevantvariables are already taken into account when determining the current share price.
Thus, no stocks are ever purchased below their true value nor sold above their true worth.
Fortunately, there is a successful track record that spans decades in which Warren Buffett has continued to pick
stocks that outperformed the rest of the market while making him one of the richest people in the world.
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