How Warren Buffett Picks Stocks
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Warren Buffett has two rules. The first is "never lose money." The second is "Don't forget Rule Number one." Read how to make your own "Buffett - Lindstrom Portfolio."
Warren Buffett Discussion Forum
12/5/06
In the Motley Fool article, "Dreadful Stocks to Avoid," Richard Gibbons wrote some great bullet points for what Buffett avoids. These are:
- Businesses that bet the farm
- Businesses dependent on research.
- Debt-burdened companies.
- Companies with questionable management
- Companies that require continued capital investment
This is a decent summary but it has some shortcomings. Below are my comments on each point.
- Businesses that bet the farm. I've had great success doing the opposite but you have to be willing to accept failure in some of your stocks as well as great volatility in share price. You need to have some advantage that the typical stock analyst doesn't have. In my case, I have 20 years experience designing successful new products for HP where I was trained to look for the long term. Likewise, Buffett has this uncanny knack to know what the consumer wants from their sweet teeth with Sees Candy and Coke to their need for insurance to counter the fear of the unknown.
- Businesses dependent on research. Companies like HWP, Lam Research and Cisco have to keep inventing new products that are better than what the competition invent or they lose their growth premium. Again, I've made great money by taking profits on companies like these as their share prices soar with the knowledge that they will eventually correct and lose their growth premium. Buffett likes to own stocks forever and doesn't have a technical background to evaluate what technologies are just getting started and are thus cheap despite what the balance sheet says.
- Debt-burdened companies. This is something I try to avoid also. Servicing debt is expensive. There are some exceptions to this rule, such as GE and Banks, where they make their money from this debt. For example, your bank may pay you 4.5% on a CD then lend your money to a small business at 8% for a nice profit. GE will sell bonds at perhaps 6% then lend consumers money to buy their products. They get the income from an immediate sale then they get additional income as the debt is paid off.
- Companies with questionable management. This is a good rule. A good starting point is look at how much shareholder value a company builds compared to what it pays its executives with stock options. I like to see shareholder equity go up over time. Some companies use all their cash flow to reward insiders via stock options then buy back the shares to keep dilution flat. It appears the company is making money and buying back shares, but all the money that comes in is going out the back door via stock options. I've made great money on companies that don't build value, but only as a trade, not as a long term investment.Think about it: If the company was a good value, insiders would cash in their stock options for stock and collect a dividend or hold for appreciation to sell later with a better capital gains tax rate. Instead, many insiders simply sell every option that comes due while maintaining token shares in the company.
- Companies that require continued capital investment. I also like this rule. I don't like to buy any company that sells a commodity be it memory, corn or bandwidth for phone calls. I've made my best money buying companies that sell products to the commodity suppliers. Think about it. If a company has to keep investing to remain competitive, you want to be on the selling side of that trade. I've made a lot of money owning companies that make the tools to build semiconductors. I don't care if Apple, Dell or HP has the latest gizmo that drives their stock to incredible PE ratios since I'll make money on building the chips inside the laptops and iPods.
By following Warren Buffett's strategy there is no guarantee you will do as well as Warren Buffett. If you want to get Buffet's returns going forward, then buy a share of Berkshire Hathaway Class A or Class B stock, which have done very well for investors.
Buffett - Lindstrom Portfolio
Suppose you have $100,000 to invest and you want to follow both Warren Buffett's and my strategies. I advise a "core and explore" approach to investing. Core means place 80 to 99% of your money into a CORE portfolio of well diversified, buy-and-hold, no load mutual funds, ETFs and or blue chip stocks then Explore with the remainder as you learn. Read more about my investment strategy here.
Warren Buffett's Berkshire Hathaway is diverse enough I consider it a core investment. Even so, I would not go overboard. Here is one suggestion:
- Buy six shares of BRKb, now at $3,584 each, for about 20%.
- Put 20% into my explore portfolio.
- Put the other 60% into VTSMX or the more diversified, seven Vanguard index fund portfolio I recommend in my newsletter.
If you keep the "three strategy buckets" in separate accounts, you can compare how they do. With spreadsheets, this is easy to accomplish. The above portfolio give you a nice diversification between active and passive management that is easy to track.
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Kirk Lindstrom:
DISCLAIMER: Answers & my words are general in nature, are not meant as specific investment advice, and do not necessarily represent the opinion of anyone but Kirk. Individuals should consult with their own advisors for specific investment advice.
Warren Buffett Discussion Forum
