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Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) Chairman and CEO Warren Buffett is perhaps the greatest investing mind of our time. The Oracle of Omaha beats the market whether the weather is fair or foul. Mere mortals can only hope to copy some small sliver of his fantastically successful investment philosophy.
That means looking for great companies trading at a fair price. Stand ready to buy when others sell in a panic. Avoid dangerous debt, prefer simple business models over risky ones, and never forget that owning a stock means owning a little bit of the actual business as well. If the first two rules of Fight Club are never to talk about Fight Club, then the first two rules of Buffett-style investing are "never lose money."
If that seems like a rigid framework, rest assured that Buffett loses out on many of the market's greatest growth stories along the way. But the same rules also keep his feet off of value-destroying landmines.
We asked five Motley Fool contributors to discuss why some of today's most popular and successful stocks aren't Buffett's top picks. Read on to learn why Buffett avoids innovators such as Netflix (NASDAQ:NFLX) and Amazon.com (NASDAQ:AMZN), social media titans like Facebook (NASDAQ:FB) and Twitter (NYSE:TWTR), and tech giant Microsoft (NASDAQ:MSFT).
Dan Caplinger (Microsoft): At first glance, Microsoft seems like the type of tech stock Warren Buffett might gravitate toward. Its Windows operating system software and Office business software both generate huge amounts of cash, and other areas of Microsoft's business offer growth opportunities that could carry the tech giant into the future. Microsoft's 3% dividend yield is also an attractive element for an investor such as Buffett, who often turns to income-producing investments in order to provide more cash for deals that might come up in the future.
Yet Buffett is on record saying he would never buy Microsoft stock, and the reason is largely due to his friendship with Microsoft co-founder Bill Gates.
As Buffett said in an interview a few years ago, if he invested in Microsoft and the tech company then made some sort of positive announcement that caused the share price to climb, there would inevitably be allegations that Gates shared some sort of inside information. Given that Buffett has committed billions in charitable gifts to the Gates Foundation, the relationship between the two CEOs isn't going to end anytime soon.
Therefore, even as Buffett has considered other tech stocks with similar characteristics, he is unlikely to add Microsoft to his portfolio.
Andres Cardenal (Amazon): Warren Buffett loves companies with big and sustainable competitive advantages, or "business moats" as he likes to call them. Amazon is the undisputed leader in online retail. It has consolidated rock-solid competitive strengths on the back of scale advantages, a growing distribution network, and a strong brand. Amazon is also the global leader in cloud computing infrastructure, another business with promising potential for growth.
Still, I don't think Buffett would ever invest in Amazon. The company is all about change, disruption, and innovation. These can be powerful growth drivers for investors, but that's not the kind of business that Buffett likes to invest in. The Oracle of Omaha goes with companies with enough strength to survive changing conditions over the years, not the ones trying to change the world.
Besides, Amazon is allocating tons of capital to various growth initiatives, and this is a major drag on cash flow and profitability. Management has been quite explicit that the company remains in heavy reinvestment mode, so there is no reason to expect improving profitability from Amazon anytime soon.
Buffett gravitates toward companies with stable and predictable cash flow, and Amazon is almost the exact opposite of that.
Bob Ciura (Facebook): I highly doubt Warren Buffett would buy into Facebook. He is known for insisting that investors buy stock in companies they understand, and I would surmise that Buffett doesn't know a whole lot about social media -- at least not enough to compel him to buy the stock.
This is nothing against Facebook, which has proven itself the king of social media. It has grown at an astonishing rate, holding more than 1.3 billion global monthly active users, or MAUs, as of the end of 2014. Facebook is also more effectively monetizing all these users than ever before: revenue and earnings per share soared 58% and 83%, respectively, last year.
But Buffett is a student of famed value investor Benjamin Graham. Buffett seeks a wide margin of safety and a strong economic moat from his investments, and unfortunately Facebook appears to have neither. The stock trades for a whopping 70 times earnings. That leaves very little room for error. In addition, Facebook doesn't enjoy much of a "moat," which refers to its ability to fend off competitors.
Facebook is the dominant player now, but how long that lasts is far from certain. The social media landscape is a graveyard, littered with the remains of once-dominant platforms: MySpace, Friendster, and many more. What is popular with one generation might not remain so for future generations. Ultimately, which social media site is on top amounts to a popularity contest, and Internet popularity can be very fickle.
Anders Bylund (Netflix): In some ways, you could argue that Netflix would work brilliantly in Buffett's portfolio. The digital video veteran is a leader in its chosen field and is darn near a monopoly when it comes to subscription-based consumer video services. And it's kind of hard to look at a stock that has gained 400% over the last three years and not try to match it with the world's finest investors, like Buffett or Peter Lynch. Surely they must have seen this surge coming, right?
But then you're ignoring several of Buffett's most important investment criteria.
For one, Buffett isn't terribly fond of extremely volatile stocks. He prefers simple business models under great management. Large value discounts are good, but he's happy to pay reasonable prices for an objectively great business. And the type of simple business model he favors doesn't really lend itself to highly variable stock charts.
Buffett likes insurance companies, food services, railroads, and heavy-construction specialists. These business models tend to have centuries of history, are well understood, and could be run by a ham sandwich in a pinch.
By contrast, Netflix is breaking new ground in an industry that didn't exist five years ago. The rules for digital video streamers are still being written, and Buffett's famous ham sandwich would absolutely destroy this company.
It takes vision and imagination to do what Netflix CEO Reed Hastings is doing. These are fine management qualities, but not at all what Buffett is looking for. The stock has fallen at least 10% on five different occasions over the last year, and even Hastings would admit Netflix shares might be overpriced today.
So, no. Netflix might be a huge winner in the long term, and a great stock for a certain type of investor (yours truly included), but cash-burning innovators like these simply don't belong in Buffett's portfolio.
Tim Brugger (Twitter): While Warren Buffett doesn't avoid tech stocks altogether -- IBM was his fourth-largest holding at the end of last year -- many don't meet his criteria of investing based on "discrepancies between the value of a business and the price of small pieces of that business in that market." His unwavering adherence to that investment philosophy means Twitter will likely remain on the outside of Buffett's offices in Omaha looking in.
Twitter's "pieces" don't warrant its current $33 billion valuation, for several reasons. Key metrics including monthly average user growth and, just as importantly, current user engagement are both remarkably poor. Yes, the fourth quarter's paltry 4 million increase in MAUs was based on changes in Twitter's reporting method to more accurately reflect real users, but the softness remains a significant concern.
Perhaps the answer to Twitter's stagnant MAU growth is that, per CEO Dick Costolo, a whopping 500 million nonusers visit the site monthly and remain nonusers. That's a wake-up call for investors, and one Buffett isn't likely to answer. Another piece of the business unlikely to fit is that last year's stock-based compensation expense of $631.6 million will jump to a mean estimate of $725 million this year -- significantly more than Twitter intends to spend on capital expenditures to support its "growth" plans.
But what about revenue? Based on Twitter's projections for 2015, even its vaunted revenue performance -- which more than doubled in 2014 from the prior year -- will slow to 60%. Revenue has been one of the few positives for Twitter bulls, and any slowing there during what should be a hyper-growth period is of concern.
No, Twitter isn't likely to land on Buffett's "hot list" anytime soon.