Warren Buffett, the billionaire CEO of conglomerate Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B), is one of the most successful stock-pickers and value investors of all time, and many investors aspire to replicate his success. The good news is, you can learn the principles Buffett uses to choose stocks and apply them to your own investment strategy.
Here are seven steps you can use to create your own portfolio of "Buffett stocks":
- Invest in what you know.
- Learn the basics of value investing.
- Identify cheap stocks.
- Find businesses that will stand the test of time.
- Invest in good management.
- Be aggressive during tough times.
- Keep a long-term mindset.
Invest in what you know
Before you invest in any stock, you should be able to understand what the business does and how it makes money. That's the reason Buffett has historically avoided most tech stocks -- he says he simply doesn't get their business models, so he sticks to what he knows best. While Berkshire's stock portfolio and subsidiaries represent a diverse mix of companies, you'll notice a high concentration in certain industries, such as insurance, banking, utilities, and consumer products. These are all businesses Buffett understands very well, so it makes sense that he's willing to put a great deal of capital into them.
Learn the basics of value investing
Buffett believes that most Americans are better off buying low-cost index funds as opposed to individual stocks. It's not that there isn't money to be made in evaluating and selecting stocks, but most people don't have the time, desire, or knowledge to do it right.
If you're reading this, I'm assuming you have the desire to invest, as well as the time to do some homework. But before you can invest like Buffett, you need a strong knowledge of value investing. Watching financial news and reading articles like this one is a good start, but I highly recommend a couple of books to any aspiring value investor:
- The Intelligent Investor, by Benjamin Graham
- One Up on Wall Street, by Peter Lynch
Between the two, you'll have an excellent foundation for evaluating stocks and finding overlooked value in the market.
Buffett has said that "what is smart at one price is stupid at another." With a strong knowledge of value investing concepts, you'll be well positioned to make that distinction.
Identify cheap stocks
Once you've established your value-investing criteria, it's time to make a list of stocks that fit your wish list. For example, let's say you want stocks that trade for less than 15 times earnings and have a strong history of generating 20% returns on assets year after year. Most brokerage accounts offer screeners and other tools to make this process easier and will generate a list of stocks based on your criteria.
Find businesses that will stand the test of time
Once you have a list of stocks whose metrics look attractive, narrow it down by choosing businesses that will hold up well during recessions. This is why Buffett loves to invest in utilities. Eliminate businesses that are highly dependent on a strong economy, such as retailers that sell discretionary or luxury products.
You also want to look for businesses that have a durable competitive advantage, or a wide moat, as Buffett says. There are several things that can give a business an advantage, such as efficiency, scale, or a proprietary technology. To give one example, Buffett favorite Coca-Cola has an amazing distribution network, as well as an extremely valuable brand name that gives it pricing power.
Invest in good management
It's hard to put enough emphasis on the value Buffett places on good management. Buffett will invest in a stock only if he trusts management and thinks it will continuously act in shareholders' best interest. Positive signs include a history of dividend growth and buybacks (both ways of returning capital to investors), and excellent reputations. Buffett often spends a considerable portion of his shareholder letter praising the leaders of Berkshire's subsidiaries, and he has bought and sold investments based on management actions.
Be aggressive during tough times
It's generally a bad idea to time the market. Long-term investors will probably do fine no matter when they buy.
Yet it's still important to look for opportunities during tough economic times. I often tell people that one of the secrets of successful long-term investors is that they love market corrections, as they offer the best opportunities.
Buffett invests money in good times and bad, but he did a great job of capitalizing on opportunities during and shortly after the Great Recession, with such savvy deals as his Bank of America investment. "Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold," Buffett told shareholders in his latest annual letter.
Keep a long-term mindset
In regard to Berkshire Hathaway's stock portfolio, Buffett has said that "our favorite holding period is forever." However, that doesn't necessarily mean Berkshire will hold any of its stocks forever. In fact, Buffett and his team sell stocks regularly, and there are a variety of good reasons for selling your holdings.
What Buffett is trying to say is that he goes into his investments with a long-term mentality. In other words, if he can't see himself owning the stock for years, he won't buy it at all. "If you aren't willing to own a stock for 10 years, don't even think about owning it for 10 minutes," Buffett has said. Buying stocks because you think they're going to have a good quarter, or because a hot new product is being released next year, is simply not Buffett's way.