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3 Things Warren Buffett Looks for in a Stock

By Matthew Frankel, CFP® - Apr 10, 2016 at 9:22AM

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Learn how you can apply the Oracle of Omaha's wisdom to your own investment decisions.

Many people want to invest like Warren Buffett, and it's easy to see why. Berkshire Hathaway (BRK.A 0.07%) (BRK.B -0.01%) has been one of the great investing success stories of the last half century or so, and a large part of this has been the company's stock portfolio. Fortunately, Warren Buffett doesn't have superhuman stock-picking abilities or any type of magic powers -- he simply looks for great businesses to buy, using principles that anyone can use.

With that in mind, here are three characteristics that are common among Buffett stocks, which you can apply to your own investment strategy.

Good risk management
Many investors perceive banking as a risky business, and after the financial crisis, who could blame them? However, the truth is that banking isn't an inherently risky business; some banks simply do a better job of managing risk than others.

Just look at Berkshire's single largest stock holding, Wells Fargo (WFC -1.50%). The bank has a long history of smart risk management and efficiency, which has allowed it to consistently produce better profitability than the rest of the "big four" banks. Just take a look at the bank's return on assets (ROA) and return on equity (ROE) over the past decade. Notice how the blue lines are always on top, in good times and bad.

WFC Return on Assets (TTM) Chart

Image source: YCharts.

Part of the smart risk management is that Wells Fargo has historically avoided some of the riskier sides of the banking business, such as investment banking. In fact, Wells Fargo's business model is closer to that of a small savings and loan than it is to most other big banks. Plus, Wells Fargo has a history of using tougher lending standards than peers.

It was prudent risk management that not only allowed Wells Fargo to survive the financial crisis, but to come out of it even stronger than it went in by acquiring rival Wachovia at a fire-sale price.

Smart risk management is an important component of every long-term investment. This means management that doesn't take on lots of debt, doesn't make risky investments, and doesn't prioritize profits over stability.

A wide economic moat
One of Buffett's main criteria he looks for when evaluating a stock or business is a wide economic moat. This refers to a sustainable competitive advantage that gives the company a leg up on peers and will preserve its market share and profitability for years to come.

Longtime Buffett stock Coca-Cola (KO 0.20%) is a great example of this. The company's brand name is one of the most recognized in the world, which gives the company pricing power over rivals. In fact, according to Millward Brown, Kantar, and Bloomberg, Coca Cola's brand alone is worth nearly $84 billion.

In addition, Coca Cola has one of the most impressive distribution networks in the world, which gives the company cost advantages and an edge when bringing new products to market. Consumer tastes may change over time, and they are right now -- in fact, sales of the company's Coca-Cola and Diet Coke sodas have been declining for some time now. However, this distribution advantage will help the company adapt better than rivals. 

A "forever" business
One of Buffett's top stock holdings is Kraft Heinz (KHC 0.21%), acquired when Berkshire-owned H.J. Heinz merged with Kraft Foods in 2015. And, a big reason Buffett loves this company so much is that it's a "forever" business.

First of all, Kraft Heinz has a huge economic moat in the form of its brands. Aside from the obvious (Heinz condiments and Kraft-branded products) Kraft Heinz's portfolio contains brands such as:

  • Oscar Mayer
  • Velveeta
  • Capri Sun
  • Kool-Aid
  • Philadelphia cream cheese
  • Planters
  • Lunchables
  • Grey Poupon

Not only do these provide the company with pricing power and global recognition, but these brands are what will ensure the company's success year after year. "These are brands I liked 30-plus years ago, and I like them today. And I think I'll like them 30 years from now," Buffett said in a CNBC interview shortly before the merger.

The lesson here is that Buffett loves companies with durable advantages (like strong brands) in a business that will be around forever. People will always need groceries, just like they will always need the other businesses in Berkshire's portfolio -- banking, insurance, energy, pharmaceuticals, etc.

Just a starting point
Now, this isn't an exhaustive list of the reasons Buffett bought these stocks for Berkshire's portfolio. Clearly, there's a lot more that goes into a billion-dollar stock purchase than looking at three characteristics. However, I mention these three things because they're common factors you'll find in any stocks that make solid long-term investments.

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Stocks Mentioned

The Coca-Cola Company Stock Quote
The Coca-Cola Company
KO
$63.41 (0.20%) $0.13
Wells Fargo & Company Stock Quote
Wells Fargo & Company
WFC
$39.50 (-1.50%) $0.60
Berkshire Hathaway Inc. Stock Quote
Berkshire Hathaway Inc.
BRK.A
$414,148.01 (0.07%) $303.91
Berkshire Hathaway Inc. Stock Quote
Berkshire Hathaway Inc.
BRK.B
$275.65 (-0.01%) $0.04
Kraft Heinz Intermediate Corporation II Stock Quote
Kraft Heinz Intermediate Corporation II
KHC
$38.20 (0.21%) $0.08

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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