by Jeff Desjardins | posted with permission of Visual Capitalist | January 26, 2018
What springs to mind when you think of legendary investor Warren Buffett?
For some, it’s his humble Omaha origins or his long-lasting obsession with Coca-Cola. For other people, it’s Buffett’s impeccable investing track record and extraordinary wealth that make a lasting impression.
While these are all legitimate connections to make with the Buffett name, perhaps he is most synonymous with the discipline of value investing—the style and mindset Buffett has made famous over the decades.
This infographic provides a deep dive into Warren Buffett’s brain and it explains everything about his investing philosophy, along with the framework he uses to evaluate potential opportunities.
It’s the second part of the Warren Buffett Series, which Visual Capitalist has done in partnership with finder.com, a personal finance site that helps people make better decisions—whether they want to jump on the cryptocurrency craze or follow Buffett’s more traditional path to financial success.
See Part 1: The remarkable early years of Warren Buffett.
Note: New series parts will be released each month. Stay tuned for future parts with Visual Capitalist’s free mailing list.
Warren Buffett’s investment philosophy is well known. He famously focuses on the intrinsic value of companies and he buys stocks when they are “on sale.” Buffett’s not afraid to accumulate big positions in companies he likes—and his favourite holding period is “forever.”
While this formula may seem simple on paper, it’s extremely nuanced and complex in practice.
How does Buffett’s brain work?
Buffett has said that he borrows 85% of his investing style from Benjamin Graham and 15% from Phil Fisher.
The godfather of value investing gave Buffett a framework for finding undervalued assets and companies.
The famous growth investor showed Buffett the importance of investing with good management teams. According to writer Robert Hagstrom, Buffett applies these ideas by focusing on four key principles of investing:
1. Analyze a stock as a business
Have the priorities of a business owner and look at the company from a long-term perspective. Is it increasing its intrinsic value? Would you want to own the entire company?
2. Ensure a “margin of safety”
Buffett considers “margin of safety” the three most important words in investing. In other words, does a company have more intrinsic value than book value?
3. Manage a focused portfolio
Concentrate on a few stocks that will provide above-average returns over time. Buffett suggests investors think of this as owning a “punch card” with just 20 investment choices that can be made over a lifetime.
4. Protect yourself from Mr. Market
Mr. Market can be speculative and emotional, and he should not be relied upon as a predictor of future prices. Instead, take advantage of Mr. Market periodically, whenever there is a fire sale.
Buffett’s investment criteria
Here are 12 key factors Buffett considers when looking at potential opportunities:
Is the business easy to understand?
2. Operating history
Has the business been around for a long time, with a consistent operating history?
3. Long-term prospects
Is there reason to believe that the business will be able to sustain success in the long term?
4. Rational decisions
Is management wise when it comes to reinvesting earnings or returning profits to shareholders as dividends?
Does the management team admit mistakes? Are they honest with shareholders?
6. Resisting the “institutional imperative”
Can the company resist temptations created by institutional dynamics, such as imitating peer companies, or resist changes in direction?
7. Profit margins
Does the company have high profit margins?
8. Return on equity
What is the return on equity (ROE) of the business?
9. Owners’ earnings
What is the company’s ability to generate cash for shareholders, who are the residual owners? This is technically defined as free cash flow to equity (FCFE).
10. One-dollar premise
For every dollar retained from net income, does the company create at least one dollar of market value?
11. Intrinsic value
What is the value of the future owners’ earnings, discounted back to the present?
12. Margin of safety
What’s the chance you’ll lose money on the stock, in the long run, if you buy it at today’s price?
Or to sum all of these ideas up succinctly, here’s a quote from the man himself.
My strategy is to find a good business—and one that I can understand why it’s good—with a durable, competitive advantage, run by able and honest people, and available at a price that makes sense.
Part 3 of the Warren Buffett Series will be released in late February. See Part 1: The remarkable early years of Warren Buffett.
Credits: This infographic would not be possible without the great biographies done by Roger Lowenstein (Buffett: The Making of an American Capitalist) and Alice Schroeder (The Snowball), as well as numerous other sources cataloguing Buffett’s life online.
Posted with permission of Visual Capitalist.