Did you know that a $10,000 investment in Berkshire Hathaway in 1965, the year Warren Buffett took control of it, would be worth over $40 million today? Berkshire Hathaway has sustained an average return of over 20% for the past 45 years. How does Buffett do it?
Buffett believes in value investing. Value investors look for securities that are unjustifiably low based on their intrinsic worth. Buffett holds stocks for decades, not for months. Here is the basic methodology used by value investors. For more detailed information, I highly recommend the book, The Intelligent Investor by Benjamin Graham.
- Has the company performed well? Look at return on investment (ROE) for the last five to ten years. ROE = net income/shareholder’s equity.
- Has the company avoided excess debt? Large debt can result in volatile earnings and interest expenses.
- Are profit margins high? Are they increasing? A high profit margin indicates the company is executing its business well.
- How long has the company been public? Buffett usually considers companies that have been around for at least 10 years.
- Economic moat? Does the company have a sustainable competitive advantage by having a well known brand name, pricing power, or a large portion of market demand?
- Is the stock undervalued? Is the stock selling for at least 25% less than its intrinsic value?
Value investors are concerned with fundamentals such as earnings growth, dividends, cash flow, etc and this requires research and hard work. Value investors buy and hold for the long term, often for decades. Unless you are willing to do the research and understand business fundamentals, value investing is probably not for you. Buffett recommends buying low-cost index funds instead. “A very low cost-index fund is going to beat a majority of professionally managed funds,” says Buffett.
Watch the short video on Warren Buffett’s advice on investing and index funds.