4 Rules Warren Buffett Uses to Find Great Investments
[Note: Buffet will not select a stock if each of these four rules are not met. Just to make as we’re going through this process, you can’t pick and choose the first two rules and disregard the others.]
First Rule — The company must have vigilant leadership.
The very first Buffett rule is the company must have vigilant leadership. Buffett is looking to see who the CEO of the company is. He also researches who is the chairman of the board of directors that’s representing the shareholders. We must remember everything within the company trickles down to the lowest level employee of the leader. That’s why finding the right leader of a company is vitally important to Buffett.
Vigilant leadership is a very qualitative rule. There are a couple of different ways that you can find and research this leader. You may want to look at:
- How much does this CEO make?
- What is his annual salary?
- Do you like their decision-making?
- Have they made good decisions in the past?
There are also several quantitative measures to look for in leadership. A vigilant leader is not going to allow a company to have a lot of debt. If a company has a high debt to equity ratio, you can generally assume either this is a leader who is trying to make the business survive because it’s getting ready to die or this person just makes very risky decisions. Other signs of good leadership are stable, predictable results and consistently making wise decisions to not jeopardize the future of the business. What we are looking for is a company that has a leader who is not prone to a lot of risks.
When a company doesn’t have much debt, it creates a lot of flexibility to make the right decisions. When a company does not have a lot of debt, that company can go left and right a whole lot easier. The analogy I like to think of is a speedboat. The speedboat is a representative of a company that doesn’t have a lot of debt. Then, think of a company that has a lot of debt as a cruise liner. It would be difficult for a company with a lot of debt to change direction if a competitor comes into the water. A speedboat, on the other hand, can turn on a dime because they’re not highly leveraged and not reliant on borrowed dollars. This all wraps into this larger rule of having a vigilant leader that would not put the company in that position.
Second Rule — The company must have long-term prospects.
Warren Buffett’s second rule is the company must have long-term prospects. If you think about it, it’s quite simple. You want a company that can deliver you a nice return year after year. Most people are trying to find the next Microsoft or companies that are emerging and experiencing a lot of growth. A good example is best explained in a speech Warren gave at the Sun Valley Convention in the early 2000s. He told the audience investing in new technology was often counterproductive to the investor because in the end there will be one or two companies that will survive this competitive nature.
The whole point of me saying this story is Buffett looks for companies with long-term prospects. He didn’t want to invest in a company that will be a flash in the pan; that only lasted for a couple of years. It’s interesting to see how he took something that the common person looks at as, “I’ve got to find the next Microsoft, or I got to find the next Apple.” He flips that on its head and says, “Actually, you need to find something that’s going to be around in 30 years from now or 40 years; that you can really rely on.”
Why does Buffett have a long-term prospects rule? It comes down to one thing: he wants to avoid the friction of tax. Whenever you buy a stock and sell it one year later, you’ll be taxed at an extremely high rate within a one-year time frame. For instance, day traders pay extremely high tax on the short-term gains they make (if they even make gains or owning that stock). But if you continue to own something and profits continue to mature and grow within the company, he’s not taxed at all on that growth until he would eventually sell the stock.
Buffett is quoted for saying “Ownership is forever.” If he continues to hold for 30, 40, 50 years, he never pays the effective tax on that growth from his initial purchase price. There are some statistics out there that show if a person would sell their stock every single year and pay a short-term gain tax; compared to the person who would just buy one time and hold for 30 years and both picks were growing at 10% annually, the difference at the end is enormous. One person might make $150,000 in capital gains, while the other person makes almost double because they were able to hold their pick and not have to pay taxes every year.
I’m basically saying two things. I’m saying that if you sell your stocks within a year you will be in another tax bracket. But what I really want people to understand is that even if the tax bracket was the same, no matter if you held the stock for one year or for five years, your capital gains will not be the same. It might sound like the same, but I’m really going to stress, it is not the same.
Third Rule — The company must be stable and understandable.
The third rule is the stock is stable and understandable. When I read Benjamin Graham’s books, The Intelligent Investor and Security Analysis, a common theme throughout both of those books is stability. Without stability, you can’t determine what the trend line is and you can’t determine the future cash flows of the business are.
The fourth and last rule Warren Buffett uses to find stock picks is calculating the intrinsic value of a company to find if it is undervalued. Without finding a business that has stable results, stable earnings, stable levels of debt (all these factors that are very crucial to properly defining and properly determining what a company is worth) you won’t be able to say with a high level of confidence that your projections for the future are attainable or probable.
When you’re looking through the key factors in finding a stable business, earnings or profit is extremely important. You don’t want a company with high earnings one year and low in the following year. You want to find a company that can produce stable and consistent earnings and grows earnings over time. If you were to graph the earnings, it should look nice and clean. Another factor you should investigate is if the company has a stable dividend. If you’re receiving dividend payments and plot it on a graph for the past 10 years, you want to see something that’s consistent and trending in the right direction.
Fourth Rule — The company must be undervalued.
Warren Buffett’s fourth and final rule is calculating the value of the business. He begins his research with this rule because he can quickly filter out companies that are not worthy of his purchase. The only change that Buffett and Charlie Munger had to their investment process is this final rule. When they originally wrote this rule, it was by the business at an attractive price. What they did is they changed the rule to purchasing a business at a very attractive price. This is a trickier rule because what you’re doing is you’re actually calculating the intrinsic value of the company using a discount cash flow calculation to determine the value of a company today. What I think a lot of people don’t understand is that a dollar tomorrow is not the same as a dollar today. And that’s where you need to start when you’re trying to understand, “How do I calculate the intrinsic value of a business?”
Buffett is trying to calculate all the future cash flows. He thinks this year, the company might earn $10 a share. Next year, he might think it earns $11 a share. The year after that, 12, 13. Once he figures out what all the future cash flows are, he will then discount those cash flows back to today, so he knows what the value of all those future dollars are today. When you figure out the intrinsic value of the company, then you can put the price on the company. You might say, “Hey, this company’s worth $100 a share.”