Warren Buffett has earned his reputation as one of the greatest investors ever. He has led his holding company, Berkshire Hathaway, to incredible market-beating returns. As of the end of last year, Berkshire Hathaway's market value per share has increased 5,502,284% since Buffett took over, while the S&P 500 has gained 39,054%.
It isn't surprising that investors watch Buffett's every move and try to glean whatever they can from his advice. He doesn't generally reveal much about his specific trades, and these days, some of those trades are dictated by his lieutenants. He waxed enthusiastic about his confidence in Greg Abel, who's in line to take over as CEO after Buffett.
Buffett has often shared how he chooses stocks and what he looks for in a great business. Many investors know that he loves undervalued stocks, but that's just one piece of the whole, and it's not the one he talks about much. There's something else that he thinks is much more important.
Great businesses first
When Buffett does talk about cheap stocks, he usually emphasizes a different part of the equation. Cheap stocks aren't compelling for Buffett; they're only worthwhile if they're great businesses. And if they are, he's just looking for a fair price. "It's better to have a part interest in the Hope Diamond than to own all of a rhinestone," he once wrote.
So what's a great business to Buffett? He talked about his three favorite stocks in this year's annual shareholder's letter, American Express (AXP 0.74%), Coca-Cola (KO +0.10%), and Apple (AAPL +0.33%), and called them "very large and highly profitable businesses with household names." He also added a fourth, Moody's (MCO 2.26%), that fit the criteria. These were examples of "a dozen or so" great businesses of which Berkshire Hathaway owns a percentage, and he explained further that "many of these companies earn very high returns on the net tangible equity required for their operations."
In other words, all these companies have certain physical assets that they can leverage to keep making more money. Although Buffett is focused on tangible equity, he also mentions that these brands are household names, an intangible asset you won't find on any balance sheet that Buffett loves in a great business.
High return on equity
All these features -- being a large, profitable business with a household name and a high return on equity -- work together. Apple, for example, has created an ecosystem of excellent products that constantly draws new customers and generates loyalty among users. These users consistently upgrade to new product launches despite the high price tags. Apple isn't pouring money into developing a new system; everything is there, but as it keeps adding features and improving what it has, customers are spending more.
NASDAQ: AAPL
Key Data Points
Similarly, Coca-Cola hasn't reinvented its wheel in more than a century of operation. It's still serving beverages, although some of the names and formulas look different. It has a valuable global brand name that generates high sales, and its well-managed business brings in high profits. Buffett typically groups Coca-Cola with American Express, which offers financial products to a growing base of customers who pay annual fees, providing a recurring revenue stream.
Moody's, a credit-rating agency, may not be quite as well known among the average investor, but it's an industry leader in an essential field that has few top players. With its size and reputation, it doesn't have a lot of competition to beat out, and it can generate reliable sales and earnings from its existing business.
These companies operate in four different spheres, but have several important things in common. One is that they're resilient under pressure. Customers need their services, no matter what is happening in the economy. They also all pay dividends. Companies can pay dividends when they're large and have reliable earnings.
Buffett's favorite companies aren't the hyped-up exciting stocks many investors look for, but they have long-term staying power. They're often the proverbial tortoises to the hares of the stock market, and most investors should have a few of these kinds of stocks in their portfolios.