Buffett’s annual letter to Berkshire Hathaway BRK.B shareholders came out a little over a week ago on February 27. It is a must-read for investors as there are plenty of good insights to learn from over the years.



One section from last year’s letter stood out: “Anything can happen to stock prices tomorrow. Occasionally, there will be major drops in the market, perhaps of 50% magnitude or even greater. But the combination of the American Tailwind … and the compounding wonders [from the power of retained earnings], will make equities the much better long-term choice for the individual who does not use borrowed money and who can control his or her emotions.” What Buffett is ultimately saying is “keep calm, and invest for the long term.”

Building on the “American Tailwind” reference from last year, one of Buffett’s enduring themes again this year is to “Never bet against America... In its brief 232 years of existence, however, there has been no incubator for unleashing human potential like America. Despite some severe interruptions, our country’s economic progress has been breathtaking,” wrote Buffett.

One memorable section from this year’s letter included, “Ownership of stocks is very much a ‘positive-sum’ game. Indeed, a patient and level-headed monkey, who constructs a portfolio by throwing 50 darts at a board listing all of the S&P 500, will—over time—enjoy dividends and capital gains, just as long as it never gets tempted to make changes in its original ‘selections.’”

Buffett continued by saying that most owners of productive assets will be rewarded. “All that’s required is the passage of time, an inner calm, ample diversification and a minimization of transactions and fees. Still, investors must never forget that their expenses are Wall Street’s income. And, unlike my monkey, Wall Streeters do not work for peanuts,” wrote Buffett. What Buffett is ultimately saying here is that investors should stick with holdings over the long term.

Buffett attracts attention, and a cottage industry has sprung up to pass on and interpret his fundamental teachings. While some critics feel that Buffett’s strategy cannot be duplicated, Robert Hagstrom disagrees. He has authored a number of popular books that highlight Buffett’s core investment principles. In The Essential Buffett: Timeless Principles for the New Economy , Hagstrom argues that it is possible to duplicate Buffett’s approach within your personal area of expertise. He presents the approach through an accessible series of questions that should be explored 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 focused portfolio
  • Protect yourself from the speculative and emotional forces of the market

Developing the Approach

Buffett feels that speculators are primarily concerned with a company’s stock price, while investors first focus in on how the business is doing. Buffett is a firm believer that knowledge helps to increase investment return and reduce risk.

It is also important to keep one’s emotions in check. We should not let our emotions override our good judgment. Every person must take their own psychology into account. Some losses are inevitable when it comes to investing, so if you cannot emotionally handle the volatility then you should consider a more conservative investing style.

Buy Great Companies, Not Great Stocks

Hagstrom identifies 12 basic Buffett principles that a company should possess to be considered for purchase. Not all of Buffett’s purchases displayed all these tenets, but as a group the principles help to establish a reasonable approach to selecting stocks. The tenets cover both qualitative and quantitative business elements. These are used to create the Buffett Hagstrom screen.

Buffett’s Business Tenets

1. Is the business simple and understandable?

Knowledge helps to increase investment return and decrease risk. Buffett warns that if you buy a company for superficial reasons, then there is a tendency to dump the stock at the first sign of weakness. Investors need to 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 fundamentally changing their direction because previous plans were unsuccessful. Turnarounds rarely succeed in their turn. Buffett feels that the best returns come from companies that have been producing the same product or service for years.

While this tenet is primarily a qualitative element, the screen looks for positive operating profit over each of the last seven years as a basic test for consistent performance.

3. Does the business have favorable long-term prospects?

Buffett feels that the economic world is divided into a small group of “franchise” companies and a large group of commodity businesses. Companies with a franchise produce a good or service that is needed or desired, has no close substitute and is not strongly regulated. Companies should have a strong, sustainable business advantage that protects sales and profits from competitors. Franchises have pricing flexibility to raise prices without the fear of losing market share or unit volume. Strong franchises have the strength to survive a major 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. While this is a qualitative screen, many of the financial tenets help to identify franchise companies, notably, measures of return on equity.

Management Tenets

1. Is management rational?

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

Buffett looks for companies whose managers behave like business owners and act in a rational way, especially in the treatment of retained earnings and the investment of company profits. Hagstrom feels that the most important action of management is the allocation of a firm’s capital. Effective use and reinvestment of a company’s cash flow ultimately determines the growth of a firm and its long-term value. This issue becomes critical as a company matures and starts to generate excess cash flow that cannot be reinvested in the primary business line at a high rate of return.

A company with excess cash flow and below-average investment rates of return can ignore the problem, try to buy growth or return the cash to its shareholders. While Buffett has used these cash flows to acquire strong companies, he favors companies that use excess cash to repurchase shares. The share repurchases help to shore up the stock price through rising demand and increases the proportional claim toward income for the remaining shares. It is difficult to buy growth, as many companies pay too much for their acquisitions and run into difficulty integrating and managing the new business.

2. Is management candid with its shareholders?

Buffett holds in high regard managers who fully disclose company performance, equally reporting mistakes and successes. Buffett respects managers who report information beyond that required with generally accepted accounting principles (GAAP). Buffett looks for financial reports that enable the financially literate investor to determine the approximate value of a business, determine the likelihood that a firm can meet its financial obligations and gain an understanding of how well the managers are running the business.

3. Does management resist the institutional imperative?

Buffett looks for companies run by managers willing to think independently. Most managers follow the “institutional imperative” to imitate the behavior of other managers because they are afraid to stand out and look foolish. Hagstrom isolates three factors that strongly influence management’s behavior:

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

Managers tend to constantly compare the sales, earnings and compensation of their firm not only with true competitors, but also with companies well beyond their industry. These comparisons help to invite “corporate hyperactivity.”

Most managers have an exaggerated sense of their own abilities.

Financial Tenets

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

Buffett does not take quarterly or yearly results too seriously when studying company financials. He finds it better to focus on three- to five-year averages to gain a feel for the financial strengths of a company.

While Wall Street typically measures company performance by studying earnings per share, Buffett looks for strong and consistent return on equity that is achieved without excess leverage or accounting gimmickry.

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

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

2. Calculate “owner earnings.”

Buffett looks beyond earnings and even cash flow to measure company performance. Buffett judges performance using “owner earnings,” which Hagstrom defines as net income plus noncash charges of depreciation and amortization less capital expenditures and any additional working capital that might be needed. This is similar to the calculation of free cash flow, which also subtracts dividend payments.

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

Buffett seeks franchise companies selling goods or services in which there is no effective competitor, either due to a patent or brand name or similar intangible that makes the product unique. These companies typically have high profit margins because of their unique niche; however, simple screens for high margins may only highlight firms within industries with traditionally high margins. The Buffett Hagstrom screen looks for companies with operating margins and net profit margins above their industry norms. The operating margin concerns itself with the costs directly associated with production of the goods and services, while the net margin takes all of the company activities and actions into account. Follow-up examinations should include a detailed study of the firm’s position in the industry and how it might change over time.

4. For every dollar retained, make sure the company has created at least one dollar of market value.

The market recognizes companies that use retained earnings unproductively through weak price performance. Buffett feels that companies with good long-term prospects run by shareholder-oriented managers will gain market attention, which results in a higher market price. The AAII Buffett Hagstrom screen requires at least a dollar-for-dollar share price increase for each dollar added to retained earnings over the last five years.

Valuing a Stock

1. What is the value of the business?

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

2. Purchase stock if it can be acquired at a significant discount to its valuation.

Many investors turn to simple multiples, such as price-earnings ratios, to help establish a preliminary hurdle before an in-depth analysis is performed. Since Buffett likes to focus on free cash flow, the price-to-free-cash-flow (P/FCF) ratio is used in the screen.

The lower the price-to-free-cash-flow ratio, the better. However, a company with higher growth deserves to trade at a higher multiple than a slower-growing firm. To adjust for varying growth rates, the price-to-free-cash-flow ratio was divided by the free cash flow (FCF) growth rate to help equate value to growth. The companies with the lowest ratios of free-cash-flow multiple to growth rate are presented in the passing company table. Like all screens, this represents a starting point for in-depth analysis.

Summing It Up

Warren Buffett’s approach identifies “excellent” businesses based on the prospects for the industry and the ability of management to exploit opportunities for the ultimate benefit of shareholders. He then waits for the share price to reach a level that would provide him with a desired long-term rate of return.

Most investors have little trouble understanding Buffett’s philosophy. The approach encompasses many widely held investment principles. Its successful implementation is dependent upon the dedication of the investor to learn and follow the principles. It requires the ability to stick to the approach during times of market volatility. But for individual investors willing to do the considerable homework involved, the Buffett approach offers a proven path to investment value.

By Charles Rotblut, Contributor

© 2020 Forbes Media LLC. All Rights Reserved

This Forbes article was legally licensed through AdvisorStream.

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