The most detailed analysis of Buffett’s investing rules is outlined in the book “The New Buffettology” by his daughter Mary Buffett. We combine this study, plus his letters to Berkshire Hathaway shareholders, TV interviews & Buffett’s Own Book “The Snowball.”
Adding to this array of information, we include the two single most important criteria created by his mentor, the great Benjamin Graham, Fair Value (Intrinsic Value), and Margin of Safety.
1. Never Lose Money
One of the most famous Buffett quotes of all time highlights that he is a very cautious investor and will only ever make an investment with a very high probability of profiting. Warren is actually very risk-averse.
2. Never Forget Rule Number 1
To highlight the importance of making low-risk investments, Buffett highlights the importance of rule number 1, “Never lose money.”
The key message is that you should not take unnecessary risks with your investments. In effect, buy companies with great products, in great markets, which make substantial profits.
And most importantly, buy the stocks when they are on sale at bargain prices. We cover all these aspects in the following rules.
3. Always Have A Margin of Safety
If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger the margin of safety you’d need. If you’re driving a truck across a bridge that says it holds 10,000 pounds and you’ve got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay; but if it’s over the Grand Canyon, you may feel you want a little larger margin of safety… Warren Buffett
The margin of safety is all about reducing the risk of an investment. The bigger the discount you can get when buying a share of a company, the less risk you have, because actually, how far further could the stock price fall?
If a stock price is significantly below the company’s actual fair value, that percentage difference is known as the Margin of Safety. Essentially the percentage that the stock market undervalues a company.
In other words, the Margin of Safety is the percentage difference between a company’s Fair Value per share and its actual stock price. If a company has profits and assets that outweigh a company’s stock market valuation, this represents a Margin of Safety for the investor. The higher the margin of safety, the better.
In classic value-investing theory, the margin of safety is the level of risk an investor can live with. The margin of safety is an estimate of the risk a stock buyer takes.
4. Find Companies With Good Financials
From interviews, lectures, and his history of stock purchases, it is no secret that Buffett looks for great companies making robust and growing profits in markets where they have a competitive advantage. Here we will take a look at some of the critical signs of companies with good fundamentals.
If a business does well, the stock eventually follows. Warren Buffett
Businesses that are making regular profits and controlling their costs in an industry they have an advantage in will eventually be discovered by Wall Street analysts, and the stock will rise accordingly.
5. Find Companies With Good Earnings
Solid earnings history and growth rates are vital signs of a good business. It will come as no surprise that profitability is a crucial metric for Buffett and Wall Street. Buffett looks for companies with a consistent track record of earnings growth, particularly over a 5 to 10 year period. But he does not overly concern himself with quarterly earnings results as he believes the investment analyst community and media are so focused on short-term results that it is damaging for business.
6. A Consistently High Return on Equity
This is a profitability measure calculated as net income as a percentage of shareholders’ equity, also called ROE. A high ROE shows an effective use of investor’s money to grow the value of the business.
Focus on return on equity, not earnings per share. Warren Buffett
This refers to focusing on the value of a company, not the speed of their earning increases.
7. Does the Company Earn a High Return on Total Capital?
Return on Invested Capital (ROIC) quantifies how well a company generates cash flow relative to the capital it has invested in its business.
It is defined as Net Operating Profit after Taxes / (Total Equity + Long-term Debt and Capital Lease Obligation + Short-term Debt and Capital Lease Obligation)
8. Is the Company Conservatively Financed?
For a company to pull out of any business difficulties it may encounter, it needs plenty of financial power. Companies with a durable competitive advantage usually create such great wealth for their owners that they are long-term-debt-free or close to it. Standard debt-to-equity ratios give a poor picture of the business’s financial strength in that shareholder’s equity is seldom used to extinguish the debt. The earning power of a business is the only real measure of a company’s ability to service and retire its debt. You need to ask yourself, how many years of current net earnings would be required to pay off all the long-term debt of the business in the current year?. Source The New Buffettology
To achieve this precise calculation, you can use the closest match, the Solvency Ratio.
The solvency ratio is a measure of whether a company generates enough cash to stay solvent. It is calculated by summing net income and depreciation and dividing by current liabilities and long-term debt. A value above 20% is considered good.
9. Does the Company Earn More Money Than Bonds?
The initial rate of return for the stock needs to be higher than the yield on U.S. Treasury bonds?
If a company cannot make a profit per share higher than the return of a safe asset like treasury bonds, you should not invest in it. This is a straightforward calculation, and we will use the Earnings Yield. Earnings Yield is the earnings per share for the most recent 12-month period divided by the current market price per share.
10. Does the Company have an Identifiable Durable Competitive Advantage?
The competitive advantage over others in the industry might be better technology, better products, patents, or even a captive market. Does the company’s industry, for example, have high barriers to entry, e.g., a microchip maker or telecoms company? Also, do not forget, is a durable competitive advantage, meaning it will last for at least ten years.
11. Do You Understand How the Product Works?
Buffett always says that if he does not understand how the product or service works, then he will not invest. The idea is that if you cannot understand the business, you will not accurately assess potential threats or competition.
Never invest in a business you can’t understand
He wants to only invest money in companies he can understand.
12. Avoid Companies That Might Be Obsolete In 20 Years
If the company does have a durable competitive advantage and you understand how it works, then what is the chance that it will become obsolete in the next twenty years?
Time is the friend of the wonderful company, the enemy of the mediocre. Warren Buffett
Mediocre companies will eventually lose out to fitter and stronger companies. The excellent company with a competitive advantage and long-term profitability will win over time.
This one may be tough to manage; it will require you to think forward and use your visionary skills to assess if the company will be replaced by new technology, better services, or simply archived due to consumer preferences.
13. Does the Company Allocate Capital Exclusively in the Realm of its Expertise?
Buffett does not like companies that try to diversify into markets that they do not understand. A term coined by the investing legend Peter Lynch “Diworsification,” refers to precisely the phenomena of a company trying to expand into markets and services that are not central to its expertise. There is plenty of evidence that this type of expansion is usually bad for business and future profits.
Diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing. Warren Buffett
14. Is the Company Free to Raise Prices with Inflation?
If the company has severe competition, which pushes product or service prices downward, this may be a stock to avoid. At least if prices cannot increase with inflation, you may need to factor this into the valuation and Margin of Safety calculations you are using to assess the business.
15. Are Large Capital Expenditures Ahead?
Are large capital expenditures required to update plant and equipment? This question is aimed at companies that have to invest heavily in plant and equipment to remain competitive, for example, carmakers or telecoms companies. These infrastructure upgrades can take a considerable toll on debt and free cash flow.
16. Buy at the Right Time
Is the company’s stock price suffering from a market panic, a business recession, or an individual calamity that is curable?
This is the magic question and the question that leads to Buffett’s famous quote.
BE FEARFUL WHEN OTHERS ARE GREEDY, AND BE GREEDY WHEN OTHERS ARE FEARFUL
If the market is going through panic, a stock with great company fundamentals (financials), low competition, and a substantial competitive advantage could see its stock price fall dramatically. This would be a great time to buy, as you will see a higher Margin of Safety.
17. Is the Company Actively Buying Back its Shares?
One sign Mr. Buffett looks for is companies buying back their own shares. This usually means that the company’s management sees a bright future and also believes the stock market severely undervalues the company. This is often a good omen and seen as a definite positive.
18. Buy Simple Businesses
I try to invest in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will. Warren Buffett
An excellent insight into the fact that many businesses begin to fail when the third generation of family owners take over. So, “a business that is so simple any idiot can run it” is a maxim that reminds us of the risks of nepotism.
The point here is that a really great business can be run by anyone as long as the business fundamentals remain the same.
19. Be a Long-Term Investor
Our favorite holding period is forever. Warren Buffett
Focusing on the long-term is what Warren preaches; this is another example to help people relax about their investments and focus on the long-term future.
In the short term, the market is a popularity contest. In the long term, the market is a weighing machine. Warren Buffett
The media and Wall Street are constantly promoting fashionable stocks; Buffett rebels against this popularity contest. The weighing machine refers to the fact that good companies’ market dominance and profitability will mean eventually they will be valued highly.
Widespread fear is your friend as an investor because it serves up bargain purchases. Warren Buffett
This is a jibe at how wrong most investors are. For example, when everyone around you is talking about investing in Cryptocurrencies, it is probably time to sell. Moreover, when everyone is complaining about the massive crash in the Crypto market, it could be time to buy.
20. The Best Time to Sell is Never
One of my personal favorite quotes from the oracle of Omaha. However, the fact is that Buffett does sell, but the vast majority of the time, he is accumulating stock.
Summary
Did these rules help you get an understanding of Buffett’s intelligent yet straightforward and highly effective investing strategies? Let us know in the comments below.
A perfect example of diworsifcation is Amazon taking over Whole Foods. Whole Foods has never been worse.