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Rediff.com  » Business » How Warren Buffett picks stocks in a bear market

How Warren Buffett picks stocks in a bear market

April 24, 2009 09:43 IST

In times of economic decline, many investors ask themselves, 'What strategies does the Oracle of Omaha employ to keep Berkshire Hathaway on target?'

The answer is that the esteemed Warren Buffett, the most successful known investor of all time, rarely changes his long-term value investment strategy and regards down markets as an opportunity to buy good companies at reasonable prices.

In this article, we will cover the Buffett investment philosophy and stock-selection criteria with specific emphasis on their application in a down market and a slowing economy.

The Buffett Investment Philosophy

Buffett has a set of definitive assumptions about what constitutes a 'good investment'. These focus on the quality of the business rather than the short-term or near-future share price or market moves. He takes a long-term, large scale, business value-based investment approach that concentrates on good fundamentals and intrinsic business value, rather than the share price.

Buffett looks for businesses with 'a durable competitive advantage.' What he means by this is that the company has a market position, market share, branding or other long-lasting edge over its competitors that either prevents easy access by competitors or controls a scarce raw-material source.

Buffett employs a selective contrarian investment strategy: using his investment criteria to identify and select good companies, he can then make large investments (millions of shares) when the market and the share price are depressed and when other investors may be selling.

In addition, he assumes the following points to be true:

  • The global economy is complex and unpredictable.
  • The economy and the stock market do not move in sync.
  • The market discount mechanism moves instantly to incorporate news into the share price.
  • The returns of long-term equities cannot be matched anywhere else.

Buffett Investment Activity

Berkshire Hathaway investment industries over the years have included:

  • Insurance
  • Soft drinks
  • Private jet aircraft
  • Chocolates
  • Shoes
  • Jewelry
  • Publishing
  • Furniture
  • Steel
  • Energy
  • Home building

The industries listed above vary widely, so what are the common criteria used to separate the good investments from the bad?

Buffett Investment Criteria

Berkshire Hathaway relies on an extensive research-and-analysis team that goes through reams of data to guide their investment decisions.

While all the details of the specific techniques used are not made public, the following 10 requirements are all common among Berkshire Hathaway investments:

1. The candidate company has to be in a good and growing economy or industry.

2. It must enjoy a consumer monopoly or have a loyalty-commanding brand.

3. It cannot be vulnerable to competition from anyone with abundant resources.

4. Its earnings have to be on an upward trend with good and consistent profit margins.

5. The company must enjoy a low debt/equity ratio or a high earnings/debt ratio.

6. It must have high and consistent returns on invested capital.

7. The company must have a history of retaining earnings for growth.

8. It cannot have high maintenance costs of operations, high capital expenditure or investment cash flow.

9. The company must demonstrate a history of reinvesting earnings in good business opportunities, and its management needs a good track record of profiting from these investments.

10. The company must be free to adjust prices for inflation.

The Buffett Investment Strategy

Buffett makes concentrated purchases. In a downturn, he buys millions of shares of solid businesses at reasonable prices.

Buffett does not buy tech shares because he doesn't understand their business or industry; during the dotcom boom, he avoided investing in tech companies because he felt they hadn't been around long enough to provide sufficient performance history for his purposes.

And even in a bear market, although Buffett had billions of dollars in cash to make investments, in his 2009 letter to Berkshire Hathaway shareholders, he declared that cash held beyond the bottom would be eroded by inflation in the recovery.

Buffett deals only with large companies because he needs to make massive investments to garner the returns required to post excellent results for the huge size to which his company, Berkshire Hathaway, has grown.

Buffett's selective contrarian style in a bear market includes making some large investments in blue chip stocks when their stock price is very low.

And Buffett might get an even better deal than the average investor: His ability to supply billions of dollars in cash infusion investments earns him special conditions and opportunities not available to others. His investments often are in a class of secured stock with its dividends assured and future stock warrants available at below-market prices.

Conclusion

Buffett's strategy for coping with a down market is to approach it as an opportunity to buy good companies at reasonable prices.

Buffett has developed an investment model that has worked for him and the Berkshire Hathaway shareholders over a long period of time. His investment strategy is long term and selective, incorporating a stringent set of requirements prior to an investment decision being made.

Buffett also benefits from a huge cash 'war chest' that can be used to buy millions of shares at a time, providing an ever-ready opportunity to earn huge returns.

Dan Barufaldi is an Independent Consultant associated with the management consulting and global business development firm, Globe Lynx Group, located in Lewiston, NY. He has a Bachelors degree in economics from Cornell University. Barufaldi has authored business articles and columns in four newspapers and several Chamber of Commerce publications.

Dan Barufaldi, Investopedia.com
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