“The criteria for selecting a stock is really the criteria for looking at a business. We are looking for a business we can understand. (...)When we find that business we try to figure out whether the economics of it means the earning power over the next five or 10 or 15 years is likely to be good and getting better or poor and getting worse. (...) What we do is simple but not necessarily easy. (...) The checklist that is going through our mind is not very complicated,” Warren Buffett (Trades, Portfolio) explained at a Berkshire Hathaway Inc (BRK.A, Financial) (BRK.B, Financial) shareholder meeting.
The question is, what does his checklist for picking winning stocks look like? While simple in concept, applying Buffett's time-tested principles takes knowledge and diligence. In this discussion, I will walk through Buffett's step-by-step approach to evaluating stocks in detail.
Buffett's investing philosophy
To understand Buffett's checklist, it helps to grasp his overall investing philosophy. Two men heavily influenced Buffett's approach - Benjamin Graham and Philip Fisher.
From Graham, the author of "The Intelligent Investor," Buffett learned the margin of safety principle. This involves buying stocks well below their intrinsic value to minimize downside risk. Graham emphasized tuning out short-term market fluctuations and taking a long-term perspective focused on underlying business fundamentals.
From Fisher, the author of "Common Stocks and Uncommon Profits," Buffett gained an appreciation for identifying high-quality growth companies with strong economic moats and capable management teams. Fisher demonstrated how diversification into a concentrated portfolio of about 10 to 20 top picks actually reduces risk because it is impossible to closely monitor more eggs in too many baskets.
Buffett blended these philosophies, seeking understandable businesses with solid long-term economics and capable management trading at attractive valuations. He analyzes stocks as if buying the whole company, evaluating their long-term cash-generating ability and potential.
Business tenets - Simple and enduring
The first part of Buffett's checklist focuses on the business itself. He asks: Is this a simple business I can understand?
Buffett invests only in companies within his “circle of competence.” This means he sticks to industries and companies he thoroughly understands, saying, “Never invest in a business you cannot understand.” For Buffett, that means grasping how the company generates revenue, what drives costs and margins, the workings of the industry, competitive dynamics, pricing power, capital expenditure needs and risks the business faces.
For example, Buffett understands consumer brands like Coca-Cola Co. (KO, Financial) because their products are easy to understand, and he can accurately estimate consumer demand. Conversely, he avoids complicated technology companies because their rapid evolution makes future earnings too difficult to predict.
He then wonders if the company has a consistent operating history. Buffett likes companies with decades of steady operational results, selling the same products and services year after year. Erratic swings in sales, margins or profits, frequent strategy shifts or restructuring plans are red flags.
For example, Buffett invested in Coca-Cola and Gillette, which each increased profits reliably for over 100 years. Occasional interruptions due to recessions or disruptions create rare buying opportunities in quality businesses at temporarily low valuations.
Finally, he asks: Does the business have favorable long-term prospects? Buffett distinguishes between low-return commodity businesses and companies with an economic moat- a sustainable competitive advantage that allows it to consistently earn high returns on capital and defend profitability. Examples include valuable brands, proprietary manufacturing know-how, exclusive licenses or patents, economies of scale, network effects and high customer switching costs. These signal an ability to keep returns elevated over decades by maintaining pricing power.
Management tenets - Proven operators
Buffett believes first-rate managers are vital because even great businesses can be ruined by poor oversight and decision-making. He assesses if management is rational in allocating capital. He wants managers who think like owners, logically investing profits where returns on invested capital exceed the cost of capital. Destroying value by overpaying for acquisitions or overinvesting in capacity expansion shows irrationality.
The best test is if management exercises discipline in returning excess capital to shareholders via dividends and buybacks rather than squandering it on questionable projects. For example, Coca-Cola has invested wisely over decades and also paid rising dividends.
The guru then asses if management is candid with shareholders. Buffett seeks transparent executives who admit mistakes, give credit to subordinates, provide insight into operations and strategy and report both positive and negative news. Opaque or overly promotional public disclosures are red flags.
For instance, in 1987, Buffett invested in Capital Cities specifically due to his respect for its forthright management team led by Tom Murphy and Dan Burke. Their candor built credibility.
Finally, he asks if management resist the institutional imperative. Buffett likes managers who think independently and make rational choices best for the business rather than blindly following rivals or Wall Street trends. He cautions against overpaid bureaucrats building empires by retaining cash better returned to shareholders.
The institutional imperative pushes executives to copy peers in pursuing growth via hot acquisitions or diversification while underinvesting in existing operations. Buffett seeks managers who rationally resist this.
Financial tenets - Profitability and efficiency
Rather than focusing on stock prices, Buffett analyzes financial performance fundamentals.
Buffett views earnings per share as facile and misleading. Many managers artificially boost earnings per share using debt. He says return on equity better reflects core operational profitability. Seek companies that sustainably earn a high ROE without excessive leverage.
For example, American Express Co. (AXP, Financial) has compounded earnings at over 15% annually since 1965 by reinvesting profits to grow its business at high ROEs near 20%.
Accounting earnings numbers can mislead. Buffett prefers owner earnings - net income plus non-cash charges like amortization and depreciation, less ongoing capital expenditures needed to maintain and replace assets to sustain the business. This shows true cash generation.
A good example is Coca-Cola, which reinvests little capital, allowing owner earnings to compound. Conversely, railroads require large ongoing capital expenditures subtracted from net income to determine owner earnings.
The guru also seeks high profit margins. Companies retaining a larger share of revenues as profits have advantages if costs rise. Compare margins to competitors and past years - consistently wider margins indicate a moat and pricing power. For example, companies like Apple Inc. (AAPL, Financial) and Nike Inc. (NKE, Financial) earn over 30% net margins because of their competitive positions and brands commanding premium pricing.
Additionally, he ensures retained earnings create shareholder value. If managers generate adequate returns by profitably reinvesting earnings into growth, one dollar of retained earnings should create at least one dollar of increased market value. Excess earnings returned to shareholders through dividends and buybacks also boost value. Coca-Cola has increased shareholder value by profitably reinvesting to grow while also paying rising dividends.
Market tenets - Pay the right price
Buffett asks two final questions to determine if he has acquired shares with a sufficient margin of safety.
First, what is the intrinsic value of the business? Buffett estimates the discounted present value of all future owner earnings he expects the company to generate over its lifetime. Conservative assumptions and reasonable projections are necessary for an accurate valuation. For example, he projected Coca-Cola's owner earnings based on long-term growth at 6% annually, then discounted those cash flows at 10% to estimate intrinsic value.
The second question is, can he buy the stock at a significant discount to intrinsic value? Buffett wants at least a 25% margin of safety between his estimated intrinsic value and purchase price to allow for mistakes in evaluating the company. He also seeks additional upside from the potential for above-average earnings growth. Getting $1 of value for 75 cents or less provides a built-in margin of safety. This, by itself, leads to outperformance if the analysis is accurate.
Why Buffett’s checklist is a timeless investment resource
While simple in concept, rigorously applying Buffett's business, management, financial and valuation principles takes practice and discipline. Carefully adhering to his proven checklist can lead investors to stocks poised to outperform over the long run.
For those with the patience and dedication to master his methods, the long-term rewards can be substantial. As Buffett himself said, "What we do is simple but not easy." With commitment to studying this framework, ordinary investors can start to pick stocks like one of the greatest investors of all time.
