How Warren Buffett chooses a great stock, in 4 steps
In an episode of their podcast "We Study Billionaires: The Investors Podcast," hosts Preston Pysh and Stig Brodersen delve into the four rules Buffett follows before making a stock pick, citing "The Snowball: Warren Buffett and the Business of Life," by Alice Schroeder and Buffett's foreword of "Security Analysis," by Benjamin Graham.
While Buffet doesn't recommend that the typical investor cherry-pick stocks - he prefers conservative bonds and low-fee index funds for that purpose - Pysh and Brodersen emphasize that he makes sure to follow each of these four rules before investing in any company:
1. Invest in companies with vigilant leadership.
"The first rule is that the company has to have vigilant leadership," explains Pysh, founder of BuffettsBooks.com. "Everything within the company starts from the top and reflects the lowest position of the company. Finding the right leader of a company and organization is vitally important to Buffett."
The renowned investor will look at the top of the company - at the CEO and the chairman of the board of directors. He looks at their salaries, whether or not they've kept company debt in check, and their past decisions, which give him a good idea of how prone to risk the company is.
2. Invest in companies with long term prospects.
The next crucial thing to look at is whether or not the company will be able to sell their product in 30 years.
A good question Buffett likes to ask is, "Will the internet change the way we use the product?" If the answer is yes, that means the product could soon become irrelevant and you might not want to invest. This is one of the reasons he chose to invest in Wrigley's gum, because chewing gum will be around for a very long time.
3. Invest in stable stocks.
"The third rule is that the stock should be stable and understandable," explains Brodersen. To figure this out, he looks at the company's metrics over the past 10 years to make sure its earnings have been consistent and trending in the right direction.
To help you see a company's stability for yourself, Pysh and Brodersen built a stability calculator.
4. Invest in stocks with an attractive intrinsic value.
Finally, Buffett predicts the intrinsic value of the company - what it will be worth in the future. If he can buy the stock for much lower than the intrinsic value, he'll consider investing.
"A dollar tomorrow is not the same as a dollar today," emphasize the podcast hosts. If you're interested in the intrinsic value of your investments, Pysh and Brodersen also built an intrinsic value calculator.