Warren Buffett’s advice for serious stock-pickers

In May we published the first of a series of three articles on some of Warren Buffett’s most memorable quotes, gleaned from the annual letters he wrote for many years to shareholders of his company, Berkshire Hathaway. That first article focused on advice for savers who wanted to invest in the stock market without all the effort of choosing their own stocks. This second article is for people who do want to pick stocks – and the ‘Sage of Omaha’ had a great deal to say on the subject.

We have not edited the quotes, other than (where shown) to shorten them, so be prepared for American spelling and punctuation.

• Read: The Warren Buffett gems you haven’t heard before

Buffett’s stock selection criteria

In his 1978 letter Buffett laid out with admirable simplicity the qualities he looked for in a stock:

‘We select our … securities in much the same way we would evaluate a business for acquisition in its entirety. We want the business to be (1) one that we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) available at a very attractive price.’

He places great emphasis on the ‘return on capital’ measure, which is in essence the earnings of a business relative to the value of its assets. He is less interested in earnings per share. Here’s how he put it in 1980:

‘The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage [debt], accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.’

Best of all, he said, is a business that can reinvest its earnings at a high rate of return, which will result in very profitable growth that can continue to compound:

‘The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return.’ (1993)

The importance of a ‘moat’

Few businesses can achieve sustained high returns on capital, because competition tends to erode margins and therefore returns relative to assets. The few that can, Buffett says, will have a ‘moat’ – a protective barrier against rivals that allows returns to remain high:

‘A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore, a formidable barrier such as a company’s being the low cost producer (GEICO [Berkshire’s insurance arm], Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success.’ (2008)

Brands support high profit margins, which lead to high returns on capital:

“Buy commodities, sell brands” has long been a formula for business success. It has produced enormous and sustained profits for Coca-Cola since 1886 and Wrigley since 1891.’ (2012)

However, even businesses such as Coca-Cola can go off the rails if they try to diversify beyond their core business. Buffett identifies this as one of the biggest dangers:

‘A … serious problem occurs when the management of a great company gets sidetracked and neglects its wonderful base business while purchasing other businesses that are so-so or worse. When that happens, the suffering of investors is often prolonged. Unfortunately, that is precisely what transpired years ago at both Coke and Gillette. (Would you believe that a few decades back they were growing shrimp at Coke and exploring for oil at Gillette?) Loss of focus is what most worries Charlie [Munger, Buffett’s late business partner] and me when we contemplate investing in businesses that in general look outstanding.’ (1997)

The stocks to avoid

In Buffett’s view, an enduring moat is hard to keep in areas of the economy that are changing rapidly, although we should acknowledge that he was writing before the era of technology ‘superscalers’ such as Meta (Facebook) and Amazon. Here’s how he put it in 1997:

‘We favor businesses and industries unlikely to experience major change. The reason for that is simple … we are searching for operations that we believe are virtually certain to possess enormous competitive strength ten or twenty years from now … Leadership alone provides no certainties … Though some industries or lines of business exhibit characteristics that endow leaders with virtually insurmountable advantages, and that tend to establish Survival of the Fattest as almost a natural law, most do not.’

And in 2008:

‘[We] rule out companies in industries prone to rapid and continuous change. Though capitalism’s “creative destruction” is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all. Additionally, this criterion eliminates the business whose success depends on having a great manager.’

And 1988:

‘Severe change and exceptional returns usually don't mix. Most investors, of course, behave as if just the opposite were true ... they usually confer the highest price-earnings ratios on exotic-sounding businesses that hold out the promise of feverish change. That prospect lets investors fantasize about future profitability rather than face today’s business realities. For such investor-dreamers, any blind date is preferable to one with the girl next door, no matter how desirable she may be.’

Instead, he looks for businesses that have already proved their worth:

‘Making the most of an already strong business franchise, or concentrating on a single winning business theme, is what usually produces exceptional economics.’ (1988)

He steers clear of companies that are seeking to recover, even if their share price is depressed:

‘Our … experience cause[s] us to conclude that “turnarounds” seldom turn, and that the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price.’ (1980)

Some parts of the market, he says, should simply be avoided:

‘For certain companies, and even for some industries, there simply is no good long-term strategy.’ (1993)

But however good a business, investors must always pay attention to valuation:

‘You can, of course, pay too much for even the best of businesses.’ (1997)

Buffett identifies some of the warning signs that can lurk in companies’ announcements:

‘References to EBITDA make us shudder – does management think the tooth fairy pays for capital expenditures? [EBITDA stands for earnings before interest, tax, depreciation and amortisation; the latter two aim to measure the gradual loss of value of a company’s assets, which will need to be made up for by capital expenditure sooner or later]. We’re very suspicious of accounting methodology that is vague or unclear, since too often that means management wishes to hide something. And we don’t want to read messages that a public relations department or consultant has turned out. Instead, we expect a company’s CEO to explain in his or her own words what’s happening.’ (2001)

‘No matter how financially sophisticated you are, you can’t possibly learn from reading the disclosure documents of a derivatives-intensive company what risks lurk in its positions.’ (2004)

He is sceptical of the merits of most takeovers:

‘Most major acquisitions display an egregious imbalance: They are a bonanza for the shareholders of the acquiree; they increase the income and status of the acquirer’s management; and they are a honey pot for the investment bankers and other professionals on both sides. But, alas, they usually reduce the wealth of the acquirer’s shareholders, often to a substantial extent.’ (1995)

‘I have long scorned the boasts of corporate executives about synergy, deriding such claims as the last refuge of scoundrels defending foolish acquisitions.’ (1991)

The Buffett portfolio

Once a business that meets his criteria is identified, Buffett believes in committing serious sums of money:

‘Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards – so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren't willing to own a stock for ten years, don't even think about owning it for ten minutes.’ (1997)

Investors should not, he says, try to understand every business but should instead remain within their ‘circle of competence’:

‘What an investor needs is the ability to correctly evaluate selected businesses. Note that word ‘selected’: You don't have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.’ (1997)

Consequently, he believes in ‘concentrated’ portfolios:

‘We try to avoid small commitments – “If something’s not worth doing at all, it’s not worth doing well”.’ (1982)

Buffett has little time for investment styles such as ‘value’ investing, even though he has often been called a value investor. Here’s what he said in 1989:

‘An investor cannot obtain superior profits from stocks by simply committing to a specific investment category or style. He can earn them only by carefully evaluating facts and continuously exercising discipline.’

And in 1993:

‘Growth is always a component in the calculation of value … we think the very term “value investing” is redundant. What is “investing” if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value – in the hope that it can soon be sold for a still-higher price – should be labelled speculation.’

He believes in giving investments five years – but not much more – to prove themselves:

‘We never take the one-year figure very seriously. After all, why should the time required for a planet to circle the sun synchronize precisely with the time required for business actions to pay off? Instead, we recommend not less than a five-year test as a rough yardstick of economic performance. Red lights should start flashing if the five-year average annual gain falls much below the return on equity earned over the period by American industry in aggregate.’ (1984)

He believes in ‘buy and hold’:

‘We do not sell holdings just because they have appreciated or because we have held them for a long time … We are quite content to hold any security indefinitely, so long as the prospective return on equity capital of the underlying business is satisfactory, management is competent and honest, and the market does not overvalue the business.’ (1988)

The Buffett approach to ‘timing the market’:

‘We … ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen ... Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak.’ (1995)

‘We try to price, rather than time, purchases. In our view, it is folly to forego buying shares in an outstanding business whose long-term future is predictable, because of short-term worries about an economy or a stock market that we know to be unpredictable. Why scrap an informed decision because of an uninformed guess?’ (1995)

Often, he says, the market values businesses correctly – they are ‘efficient’. But not always …

‘Amazingly, EMT [efficient market theory] was embraced not only by academics, but by many investment professionals and corporate managers as well. Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day.’ (1989)

‘What we do know … is that occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics will be unpredictable. And the market aberrations produced by them will be equally unpredictable, both as to duration and degree. Therefore, we never try to anticipate the arrival or departure of either disease. Our goal is more modest: we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.’ (1987)

But he has little time for ‘contrarian’ investing for its own sake:

‘A contrarian approach is just as foolish as a follow-the-crowd strategy. What’s required is thinking rather than polling.’ (1991)

He seeks to avoid risk and believes in the paramount importance of a margin of safety:

‘Charlie and I detest taking even small risks unless we feel we are being adequately compensated for doing so.’ (2004)

‘In the final chapter of The Intelligent Investor Ben Graham [said]: “Confronted with a challenge to distil the secret of sound investment into three words, we venture the motto, Margin of Safety.” Forty-two years after reading that, I still think those are the right three words.’ (1991)

This is the second in a three-part series of summaries of Buffett’s most useful quotes. The next will focus on his views on tariffs, taxes, inflation and other aspects of the business world.

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• Read: The Warren Buffett gems you haven’t heard before
• Read: Generate your retirement income the Warren Buffett way 
• Read: Warren Buffett’s greatest lessons for ordinary investors

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Direct shareholdings should generally form part of a well diversified portfolio of other investments. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.