Warren Buffett hasn't been investing much lately. The multibillionaire has been a net seller of stocks for 10 consecutive quarters. He's built a massive cash stockpile of nearly $348 billion for Berkshire Hathaway.
This huge cash position prompted a question from a shareholder at Berkshire's annual shareholder meeting in May. Buffett was asked if he thought some good investment opportunities would come along soon for Berkshire to use some of its cash. He replied that Berkshire was ready to spend $100 billion on a stock -- but only if it met the following three criteria.
Image source: The Motley Fool.
1. He has to understand it
Buffett's first (and, arguably, most important) criterion for buying a stock was that it "makes sense to us" and "that we understand" it. Anyone who has followed the "Oracle of Omaha" for a while won't be surprised by his response.
In Buffett's 1996 letter to Berkshire Hathaway shareholders, he wrote:
You don't have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.
If you've ever wondered why Buffett doesn't buy tech stocks often, even though they're popular with many other investors, this explains a key part of his thinking. He only invests in businesses he understands.
Just look at the largest holdings in Berkshire's portfolio, such as Apple, American Express, and Coca-Cola. I know I'm mixing up some geometrical shapes here, but their business models are squarely in Buffett's circle of competence.
2. It must offer "good value"
No one will be shocked by Buffett's second criterion for investing $100 billion in a stock, either. He said that it must offer "good value." There's a lot packed into that statement, though.
Buffett won't buy a stock only because it has a low price-to-earnings ratio. A low valuation metric doesn't necessarily mean a stock is a good value. Instead, the legendary investor demands that the stock's valuation is reasonable compared to its likely earnings growth over the next five or more years.
One big hurdle with this requirement is that Buffett can't always estimate a company's earnings growth. This ties into his insistence on only buying stocks with businesses he understands. However, it goes beyond that. Sometimes, Buffett might be comfortable with his knowledge of a company's business but still feels uneasy about projecting its earnings growth because there are too many variables.
3. It can't have a significant risk of losing money
Last, but not least, Buffett said that he'd be willing to spend $100 billion on a stock if it's one "where we don't worry about losing money." Again, this wasn't anything new. He famously has two rules for investing: "Rule No. 1 is to never lose money. Rule No. 2 is never forget Rule No. 1."
Of course, Buffett has often made investments that ended up being losers. For example, he has referred to the 1993 investment in Dexter Shoe as a "gruesome" mistake. He wrote to Berkshire Hathaway shareholders in 2007 that it was "to date, the worst deal that I've ever made." Buffett used 25,203 of Berkshire's Class A shares to buy Dexter. It cost $433 million at the time. However, Dexter's competitive advantage soon evaporated. Those 25,203 Class A shares would be worth more than $19 billion today.
Note, though, that Buffett didn't claim that he would never lose money on a stock. But he doesn't want to invest in any stock where he would worry about losing money. That's a subtle but important difference.
A question of when, not if
Buffett emphasized that he doesn't know how long it will take for Berkshire to find an opportunity that meets these three criteria. However, it's a question of when, not if. He said at the shareholder meeting, "Occasionally, very occasionally -- but it'll happen again. I don't know when. It could be next week. It could be five years off, but it won't be 50 years off."
Perhaps the opportunity won't come while Buffett is still CEO of Berkshire Hathaway. He plans to pass the baton to Greg Abel next year, while continuing to serve as chairman. But Abel shares the same mindset as Buffett. He told shareholders last month, "We know that when the opportunity presents itself, whether it be equities or private companies, we're ready to act, and that's a large part of being patient -- using the time to be prepared."
