Surprisingly, Warren Buffett uses these 3 indicators to look for buying opportunity in stock market.
Warren buffet said most of the concept he applies today are developed by himself by referring to the book named The Intelligent Investor by Benjamin Graham. In fact, he openly admits Benjamin Graham being his teacher. He is like hey I don’t have any magic formula for investment but I do follow fundamentals that should be considered while picking up stock and investing money in it. Now fundamentals are like basic things that we should know while dealing with particular thing. When you are buying cloths, you should know what is the price of that cloth as well in case you want a particular type of fabric for that you should know about types of fabric first. So, you will feel confident about cloths purchased will not be sitting in closet for long time because after purchase you found out they are not exactly that you wanted. Same applies to stock market. That’s why warren buffet always insist you to get clear on fundamentals. And today we are going to discuss the same thing.
A) Value Investing:
Warren Buffett is a strong proponent of Value Investing. He has often quoted that he is 85% Benjamin Graham who is the godfather and founder of Value-based investing strategy. According to this approach, one should look for the intrinsic or true value of a company rather than worrying about only current numbers or performance metrics. With this It is important to look at a company in its wholeness.
Value investors like Warren Buffett ignore the demand and supply complexity. They look for stocks which are priced as low as compared to their intrinsic value. And what is intrinsic value? So, whenever you look at price of stock in stock market you must know that it is made up of two parts one is intrinsic and other is overpriced part. Intrinsic value is the true value of stock which is determined by analyzing fundamentals of business. While market sentiments and price momentum make stocks overpriced which forms overpriced part.
So, value investors like warren buffet believe that in the long run, the market will discover the true value of these quality stocks and their market value will shoot up.
Then you might be thinking how intrinsic value is calculated. So, for that there are few metrics that need to be considered here.
One of them is Return on Equity which is the rate at which stockholders earn returns or income on their investment. It helps in analyzing the performance of the company in comparison to other players. And It is calculated by dividing the net income by the shareholder’s equity. Warren Buffett looks at the ROE for the last 5-10 years to analyze the true potential of a company.
Debt to Equity Ratio is another critical parameter. Buffett prefers companies with lesser debt as it indicates that earnings are being generated from the shareholder’s equity rather than borrowings. It is calculated by dividing the total liabilities with the shareholder’s equity. Higher is the value, lesser are the chances of Mr. Buffett investing in it. That is because a significant chunk of the earnings will go towards servicing the debt.
Another important thing while talking about intrinsic value is profit margin. Warren buffet always look at profit margin. Warren Buffett’s style of investing is analyzing the profit margin of companies (and growth in it) over a sustained time period. And this margin is derived by dividing the net income with the net sales.
Enough of value investing but Value investing is not for you, if:You are an emotional investor. Warren Buffett once said, “Only when you combine intellect with emotional discipline, you get rational behaviour”. Value Investing follows the same principle. Emotions can adversely impact investment related decisions. Value investors do not get swept away by market sentiments but rather look at the true value of a stock. They also do not fall for the “growth trap” without understanding the history or intrinsic strength of the stocks.
Second value investment is not for you if You like to follow the herd.
The value investing approach is not for those who like to follow the crowd. In his words, “Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well”. In the long run, only inherently solid stocks (with a high intrinsic value) are going to fill the pocket.
B) Competitive Advantage:
Moving forward with the second main factor while investing in stock is to look for Competitive Advantage.
The fundamental basis of above-average performance in the long run is durable competitive advantage. A company which has substantial and sustainable competitive advantage over its competitors has Mr. Buffet’s attention. Classic example being his investment in Coca Cola which had a lion’s share of the market at that time. Such companies are able to grab a larger chunk of the market, enjoy customer loyalty and have pricing power. All these factors in combination help them to widen their profit margin in the long-run.
These companies have established a strong and credible brand name in the industry, reach out to more customers through their extensive distribution network and most importantly have a unique offering (whether product or service). They continuously invest in research and innovation to introduce new and better offerings. As in case of Coca-Cola you will say what’s there to Innovate in that soda-water. But, Coca-Cola invented diet-coke. And in japan you will find Coca-Cola slushy which is fluffy form of coke filled in bottle. So, because of that customers get variety to try new stuff related to brand. And because of that they gets attached with brand and it develops bond and loyalty between customers and company. You can clearly see this with Coca-Cola.
As Warren Buffett puts it, “a good business is like a strong castle with a deep moat round it. I want sharks in the moat to make the business untouchable”. Invest in companies that have something different about them. Something that sets them apart. Any characteristic about the business which makes it hard for peers or competitors to replicate gives it a definite edge or an in other words, an “economic moat”. Wider is the moat, tougher for the competitors to take market share which will translate into higher profits for investors. And you should always remember the golden Words of warren buffet which are –Go for a company which has a unique product that can remain desirable for a long period of time.
Durability of competitive edge is equally important. For instance, technology has completely changed the idea of home entertainment. Gone are the days of renting VCDs. You won’t find any store selling VCD. I even doubt even any one still own CD-player. So, because of that technology you are investing in should have longer scope in period of time.
C) Buy and Hold Skill:
And the third fundamental of warren buffet exposes The “Buy and Hold “Potential.
In addition to being a value investor, Warren Buffett is known for his passion for the “buy and hold” approach. As he says, it is easier to predict what will happen 10 or 20 years down the line, rather than tomorrow or even next week. (because he invests in companies with durable competitive advantage).
But what exactly is Buy and Hold? What it does mean from warren buffet’s perspective.
Buy and Hold Approach refers to an investment strategy wherein investors buy stocks or any other investment instruments and holds them over a long period of time, irrespective of market fluctuations or volatility. It falls under the ambit of passive investing as investors ignore stock price fluctuations or such other technical indicators.
He feels investments in stocks should not be for the purpose of capital gains in the near-term. It should be done with a view to create wealth in the long-run. Hence, investing in solid stocks is extremely important as only they will stand the test of time and multiple market cycles.
Example of investment done by Warren Buffett with this approach is Wrigley’s chewing gum.
His investment in Wrigley’s chewing gum is a classic example. He knew that irrespective of any technological upgradation in the future, the basic product would remain the same. It was not going to adversely influence the consumer’s gum chewing habits or preference. Hence, he was sure that the product would stand the test of time. Warren Buffett held on to Wrigley’s share for a very long period of time and finally sold his stake to the company (Mars) and made multi-fold returns on his investments. The original investment of USD 2.1 billion grew to USD 23 billion at the time of sale. I really don’t have words for this. But, yeah this is why he is the warren buffet. Only minds like warren buffet can make money with Wingley chewing gum.
Only fundamental analysis that we discussed now can able to pick and invest in such a multi-bagger stock. So make sure you are considering the above pints discussed while buying stock. Though, there are lot of things that should be taken care of. But this are some basic factors you can’t ignore.