30 Stocks That Fit Warren Buffett’s Investing Strategy

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While some critics believe that Warren Buffett’s strategy cannot be replicated, Robert Hagstrom disagrees. He has authored several popular books that highlight Buffett’s core investing principles. In The Essential Buffett: Timeless Principles for the New Economy, Hagstrom argues that it is possible to imitate Buffett’s approach in your personal area of ​​expertise. He presents the approach through an accessible series of questions that should be explored as with any potential investment. The approach demands that you:

  • Analyze a Stock as a Business
  • Demand a margin of safety for each purchase
  • Manage a Concentrated Portfolio
  • Protect yourself from the speculative and emotional forces of the market

development of perspective

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Buffett believes speculators are primarily concerned with a company’s stock price, while investors tend to focus first on how the business is doing. Buffett firmly believes that knowledge helps increase investment returns and reduce risk.

It is also important to keep your emotions under control. We should not let our emotions rule our good judgment. Each person should take into account his psychology. Some losses are inevitable when it comes to investing, so if you can’t handle the volatility emotionally you should consider a more conservative investing style.

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Buy Great Companies, Not Great Stocks

Hagstrom identifies 12 basic Buffett principles that should be considered when buying a company. Not all of Buffett’s buys demonstrate all of these principles, but the principles as a group help establish a fair approach to the selection of stocks. The principles cover both qualitative and quantitative business elements. These are used to make the Buffett Hagstrom screen.

Buffett’s business principles

1. Is the business simple and understandable?

Knowledge helps in increasing investment returns and reducing risk. Buffett cautions that if you buy a company for superficial reasons, there is a tendency to dump the stock at the first sign of weakness. Investors should be able to understand company factors such as cash flow, labor issues, pricing flexibility, capital needs, revenue growth and cost control.

2. Does the business have a consistent operating history?

Buffett avoids companies that are either solving difficult business problems or radically changing their direction because previous plans were unsuccessful. Turnarounds are rarely successful in their turn. Buffett thinks the best returns come from companies that have been producing the same product or service for years.

While this principle is primarily a qualitative element, the screen consistently seeks positive operating profit over the past seven years as a basic test for performance.

3. Are the business’s long-term prospects favorable?

Buffett thinks the economic world is divided into a smaller group of “franchise” companies and a larger group of commodity businesses. Franchised companies produce a good or service that is needed or desired, has no close substitutes and is not strongly regulated. Companies must have a strong, lasting business advantage that protects sales and profits from competitors. Franchisees have the pricing flexibility to raise prices without the fear of losing market share or unit volume. A strong franchisee has the power to avoid a big mistake.

It is important for the company to have a sustainable corporate advantage that acts as a barrier to make it difficult for others to compete. Although this is a qualitative screen, several financial principles help identify franchise companies, in particular, measures of return on equity.

management principles

4. Is the management rational?

When considering a company, Buffett evaluates managers for their rationality, candor and independent thinking, among other characteristics.

Buffett seeks companies whose managers behave like business owners and act rationally, particularly in investing retained earnings and company profits. Hagstrom believes that the most important action of management is the allocation of capital of a firm. Effective use and reinvestment of a company’s cash flows ultimately determines a firm’s growth and its long-term value. This issue becomes important as a company matures and begins to generate additional cash flow that cannot be reinvested at a higher rate in the primary business line.

A company with excess cash flow and an average investment rate of return may overlook the problem, try to buy growth, or return cash to its shareholders. While Buffett uses these cash flows to acquire strong companies, he favors companies that use the extra cash to repurchase shares. Share repurchases help raise the stock price through increased demand and increase the proportionate claim of income for the remaining shares. Growth is difficult to buy, as many companies pay too much for their acquisitions and face difficulty in integrating and managing new business.

5. Is management clear with its shareholders?

Buffett holds in high esteem managers who fully disclose company performance, reporting mistakes and successes alike. Buffett respects managers who report more information than is necessary with generally accepted accounting principles (GAAP). Buffett seeks financial reports that enable the financially literate investor to determine the estimated value of the business, determine the likelihood that a firm can meet its financial obligations, and gain an understanding How well the managers are running the business.

6. Does the management oppose the institutional imperative?

Buffett seeks out companies run by managers willing to think independently. Most managers follow an “institutional imperative” to imitate the behavior of other managers because they are afraid of standing out and looking stupid. Hagstrom distinguishes three factors that strongly influence management’s behavior:

Most managers cannot control their desire for activity, leading to harmful decisions such as corporate takeovers.

Managers compare their firm’s sales, earnings and compensation not only to true competitors, but also with companies beyond their industry. These comparisons help invoke “corporate hyperactivity.”

Most managers have an exaggerated sense of their abilities.

financial theory

7. Focus on return on equity, not earnings per share.

Buffett doesn’t take quarterly or annual results too seriously when studying a company’s financials. They feel it would be better to look at three to five-year averages to get an idea of ​​the financial strength of a company.

While Wall Street typically measures a company’s performance by studying earnings per share, Buffett looks for strong and consistent returns on equity that are achieved without added leverage or accounting gimmicks.

The AAII Buffett Hagstrom screen looks for returns on equity above 15% for each of the last four quarters and the last three fiscal years.

Companies can increase return on equity by increasing asset turnover, increasing profit margin or increasing financial leverage. Buffett is not against the use of debt—financial leverage—but cautions against excessive use of debt. Acceptable levels of debt vary from industry to industry, so a filter was added that requires the debt-to-equity ratio to be below the relevant industry norm.

8. Calculate “owner’s earnings”.

Buffett looks beyond earnings and even cash flow to measure a company’s performance. Buffett judges performance using “owner’s earnings,” which Hagstrom defines as net income plus non-cash charges of depreciation and amortization less capital expenditures and any additional working capital required. This is similar to calculating free cash flow, which also subtracts dividend payments.

9. Look for companies with consistent and high profit margins.

Buffett seeks out franchise companies that sell goods or services that have no dominant competitor, either because of a patent or brand name or similar intangibles that make the product unique. These companies usually have high profit margins due to their specific location; However, simple screens for high margins can only highlight firms within traditionally high margin industries. The Buffett Hagstrom screen looks for companies whose operating margins and net profit margins are above their industry benchmarks. Operating margin itself relates to costs directly associated with the production of goods and services, while net margin takes into account all of the company’s activities and operations. Follow-up examinations should include a detailed study of the firm’s position in the industry and how it may change over time.

10. For every dollar made, make sure the company has made at least one dollar of market value.

The market recognizes companies that use retained earnings unproductively through weak price performance. Buffett thinks that companies with good long-term prospects run by shareholder-oriented managers will attract market attention, resulting in higher market value. The AAII Buffett Hagstrom screen requires at least a dollar-per-dollar share price increase for every dollar added to retained earnings over the past five years.

stock valuation

11. What is the value of business?

Even if you have identified a good company, it does not necessarily represent a good investment unless it can be purchased at a fair price.

12. Buy the stock if it can be obtained at a significant discount to its valuation.

Many investors turn to simple multiples such as the price-earnings ratio to help establish an initial hurdle before undertaking a deeper analysis. Since Buffett prefers to focus on free cash flow, the price-to-free-cash-flow (P/FCF) ratio is used to screen.

The lower the price-to-free-cash-flow ratio, the better. However, a company with high growth is eligible to trade on…


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