Tough Times? Try Investing the “Buffett Way”

Does Warren Buffett have a bulletproof formula for making money on Wall Street?

It sure seems that way. Buffett, chairman of Berkshire Hathaway (Stock Quote: BRKB), is estimated to have $47 billion in assets – making him among the top three wealthiest individuals in the world.

Wall Street certainly thinks so. Berkshire stock is one of the most sought after investments on Wall Street, and its yearly shareholder meetings are a rite of passage for company shareholders, many of whom share a Dairy Queen ice cream cone with the Sage of Omaha after the meeting. Of course, Buffett owns Dairy Queen, too, and the ice cream is usually on him.

Buffett sums up his investment philosophy quite simply: “If a business does well, the stock eventually follows.”

Origins of The “Buffett Way”

Does Buffet really live by that code – and should everyday investors emulate it? Put it his way – you could do a lot worse.

Let’s take a look and see how –and why.

Warren Buffett built his investment creed on the back of legendary stock market guru Benjamin Graham. The father of value investing, Graham firmly believed in what he called “cigar butt” companies, i.e., stocks that most investors avoided and that were undervalued, but stocks that also had a few “puffs of life” in them.

That’s exactly what Buffett likes – value-oriented companies with stable revenues and that are managed by experienced CEO’s. He also favors firms with a strong record of ample earnings growth. Buffet often points to investments in Geico and Wal-mart as a “blueprint” for the Buffett investment philosophy.

That blueprint also includes the following qualities in a stock before it makes it into a Buffett portfolio:

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Keys to a Buffett Buy

– Big companies (at least $50 million of before-tax earnings).

– Reliable earning power (future projections don’t matter to Buffett, and neither are “turnaround” companies).

– Management in place (Buffet wants a good team in place – he won’t provide one)

– An offering price (he doesn’t want to waste time or the seller’s by talking, even preliminarily, about a transaction when the price is unknown).

Source: Berkshire Hathaway annual report

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But those investment tenets are just for starters. Buffett also likes the following characteristics in the stocks he own:

Easily-understood business concepts  — Buffett has taken the “keep it simple, stupid” concept and ran with it. Buffett does not like to make his investment picks so complex he doesn’t truly understand why he’s make the investment in the first place. Buffet’s disregard for high-technology stocks companies  – even during the “go-go” 1990’s  – is a good example of that. The Oracle of Omaha prefers takes the long-term view – he wants to know what a company looks like now – and what it will look like a dozen years from now. In Buffett’s view, high technology firms don’t usually pass that analysis, and their dearth of a long-term track record and weak earnings history almost always make him pass on such stocks.

Regular returns – A big issue for Buffett is a company’s return on equity (ROE).  He usually demands a good outlook on earnings, where he can predict ROE five to 10 years out. Stocks that can’t survive that outward-looking analysis won’t wind up in the Berkshire stable. In addition, Buffet doesn’t like Big spenders” and thus takes a dim view of companies that require great outlays of capital. Those firms usually fail to provide higher returns on equity.

Plenty of cash – Buffett also likes companies that have lots of cash on hand – better, he thinks, to survive the tough economic times we’re seeing now.  In the Sage’s mind, deep cash flow enables businesses to not only pay their own way as they go, but allows them an outlet for growth, as well.

No debt – The Buffett credo is one of no, or low debt. Insurance companies often fit the bill here (he owns both Geico and General Re). The Buffett philosophy keeps it simple one more time here – no debt is the onramp to a superhighway of growth.

Those “cigar butt” plays – Buffett loves to plow cash into undervalued stocks with great growth potential. Picking such stocks isn’t for the faint of heart, but Buffett makes it look easy. By and large, Buffett favors stocks that are significantly cheap, as measured by the company’s intrinsic value, and by evaluating its financial fundamentals. From there, Buffett and his investment team extrapolate that data and calculates what kind of revenue managers can squeeze out of the firm. In a word, Buffet picks stocks primarily on the basis of their long-term potential. Once he buys the stock, Buffett will cling to that stock like a barnacle to the hull of an old fishing boar – not even selling it for decades. Buffett is also actually indifferent if other investors follow his trading patterns. Job one is to pick stocks in businesses that will make money – today, tomorrow, and years from now.

Emphasis on Business

Warren Buffett abhors gut feelings and word of mouth when choosing stocks. For him, it’s all about doing the due diligence, kicking some tires, and always, always focusing on what a company does, how much money it has (and spends), and what kind of management it has.

If a publicly-traded company can pass those high hurdles, it can find a good home on a Buffett portfolio.

Any maybe in yours, too. 

Here’s a snapshot of Berkshire Hathaway’s portfolio holdings, as of March 31, 2011. The company holds $61.8 billion in assets – up from $59.8 billion as of December 31, 2010. 

Stock                                                               Shares

American Express Co. (NYSE: AXP)             151.6 million shares

Bank of New York Mellon Corp. (NYSE: BK) 1.8 million shares as last quarter

Coca Cola Co. (NYSE: KO)                          200 million shares

Comdisco Holdings (NASDAQ: CDCO)      1.5 million shares

ConocoPhillips (NYSE: COP)                        29.1 million shares

Costco Wholesale (NASDAQ: COST)          4.3 million shares

Exxon Mobil Corp. (NYSE: XOM)               421,800 shares

Gannett Co. (NYSE: GCI)                             1.74 million shares

General Electric Corp. (NYSE: GE)               7.7 million shares

GlaxoSmithKline (NYSE: GSK)                    1.51 million shares

Ingersoll-Rand (NYSE: IR)                            636,600 shares

Johnson & Johnson (NYSE: JNJ)                   42.6 million shares

Kraft Foods (NYSE: KFT)                             105.2 million shares

Mastercard Inc. (NYSE: MA)                        216,000 shares

M&T Bank Corp. (NYSE: MTB)                   5.3 million shares

Moody’s Corp. (NYSE: MCO)                      28.4 million shares

Procter & Gamble (NYSE: PG)                      76.7 million shares

Sanofi-Aventis (NYSE: SNY)                       4.06 million shares

Torchmark Corp. (NYSE: TMK)                    2.82 million shares

US Bancorp (NYSE: USB)                            69 million shares

USG Corp. (NYSE: USG)                             17.0 million shares

United Parcel Service (NYSE: UPS)              1.43 million shares

Wal-Mart Stores Inc. (NYSE: WMT)             39 million shares

Washington Post (NYSE: WPO)                    1.72 million shares

Wells Fargo & Co. (NYSE: WFC)                 358.9 million shares

Wesco Financial Corp. (NYSE: WSC)           5.7 million shares

By Brian O’Connell

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Trading involves substantial risk of loss and is not suitable for all individuals. Past Performance is not indicative of future results.