People who want to invest like billionaire investor Warren Buffett often follow in his footsteps and take note of the moves that his company, Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B), makes. And for those who want to be more proactive or want to do their own analysis, Buffett offers lots of useful advice. To start, he says there's one thing all prospective investors should be familiar with, and that's accounting.
Why it's important
Buffett isn't advocating that everyone earn a degree or an accounting designation but that investors become familiar with the language so that they understand how to read financial statements. In an interview with Yahoo! Finance, Buffett said he taught himself accounting and later took courses as well. He cautions against reading too much information into stock prices and patterns; it's fundamentals that investors should focus on.
This is important advice, because while it might be tempting to just rely on earnings releases and see whether a company beat expectations, that doesn't tell the whole story. For instance, one of the dangers new investors might not recognize is that adjusted earnings is not the same as accounting net income. Companies often back out items from their true net income to arrive at an adjusted income number they believe better represents their earnings for the period.
For example, in its most recent quarterly results, released on April 14, healthcare company Johnson & Johnson (NYSE:JNJ) reported net income of $5.796 billion, but its adjusted net earnings came in at $6.154 billion -- this is the number that analysts focus on. One of the items that J&J excluded from its adjusted earnings included intangible asset amortization, which doesn't involve cash. This isn't a terribly big concern, since amortization just involves spreading the cost of capital expenses over a period of useful life. However, J&J also had other adjustments to its earnings that might be a bit more debatable.
For instance, it added back $120 million in litigation expenses during the quarter and $118 million for restructuring-related expenses. For a company with as many legal problems as J&J has related to baby powder and opioid lawsuits, these expenses are relevant, and I would say they shouldn't be adjusted out. And "restructuring costs" can be vague. The danger of adjusted earnings calculations is that they can incentivize a company to find as many things as possible to book to these types of expenses, knowing that they'll get added back to adjusted earnings anyway. That's why investors are better off ignoring adjusted earnings numbers altogether.
Just following the markets and trying to read prices can be dangerous
As a value investor, Buffett warns that spending too much time on technical analysis and price movement can be dangerous. Investors got a perfect example of that in March when stocks fell over a cliff due to fears relating to COVID-19. Shares of J&J would fall from around $150 to a low of just over $109. Nothing changed to alter the company's fundamentals or its long-term outlook.
However, as panic ensued and investors continued to sell shares of J&J, it fell to levels not seen since 2017. For value investors, it could have been a terrific opportunity to buy the stock at a bargain. After all, with the company's business model still intact, there was no reason for investors to value J&J at 27% less than what they did before. At its current price, J&J trades at around 23 times its earnings and is still a good long-term buy at around $150.
That's why Buffett cautions investors to look at the business rather than the share price. Buffett first invested in J&J back in 2006 and still holds shares of the company today.
Takeaway for investors
What's important for investors new and old to note is why value investing, over the long term, yields strong results. Buffett is a great example of that. Value investing might not be exciting or lead to quick returns, but it can keep your investments safe. By focusing on fundamentals, investors can see that J&J recorded a strong profit in each of the last 10 years and that in the majority of those years, its profit margin was well over 15%. And with little to prevent J&J from producing strong results in the future, it remains a good buy today, regardless of what its share price does during the short term.
By investing over the long term, investors can also avoid worrying about short-term volatility in the markets. With a strong business and good fundamentals, J&J is a good stock to hold during the pandemic, even if there is another market crash.