As we come to the end of the first month of the year, uncertainty about market direction is at a peak. Will we see a continuation of the bear market and increased volatility, or will there be a rebound to former highs? If the market continues to struggle, is it a good idea to keep buying stocks on the dip?
According to Warren Buffett, CEO of Berkshire Hathaway, the answer depends on whether the stocks pass his multi-step process. While the process may seem simple, it requires thorough research and market understanding. It is important to consider these steps before making any stock purchases in the coming year.
Buffett’s Advice In a Bear Market
In 2022, the Sage of Omaha made significant investments in a variety of stocks, including Occidental Petroleum (the best performer of the year), Chevron, HP, Paramount Global, and Apple.
Now, many are wondering what the future holds for the Oracle of Omaha. Despite the unknowns, Buffett’s approach remains consistent: he focuses on two key characteristics:
- Analyzing the company’s earnings range for the next five or more years, and
- Purchasing shares at a reasonable price based on the lower end of the estimated earnings range.
But that’s not all…
5 Key Attributes Buffett Looks For
- A company with a durable competitive advantage: Warren Buffett looks for businesses that have a unique selling point or advantage over their competitors, which allows them to consistently generate profits over the long term.
- A management team he trusts: Buffett values honesty, integrity, and competence in a management team. He wants to see a track record of good decision-making and responsible handling of shareholder capital.
- Good return on investment: Buffett looks for companies that can generate a high return on invested capital. He believes that a business that consistently generates a good return on investment will ultimately lead to strong shareholder value.
- Fair price: Buffett is known for his value investing approach, which means he looks for stocks that are trading at a discount to their intrinsic value. He wants to make sure he is getting a good deal on his investments.
- Clear understanding of the business: Buffett emphasizes the importance of staying within one’s “circle of competence” and only investing in businesses that can be thoroughly understood. He wants to be confident in his ability to evaluate the long-term prospects of a company before making an investment.
Why This Process Isn’t Black and White
Estimating a company’s future earnings is a crucial step in the investment process, but it can also be challenging. While a quick online search may provide a range of figures and estimates, it is important to conduct a thorough analysis.
Even for experienced investors like Buffett, it is nearly impossible to determine a precise figure for a company’s future earnings. Instead, the focus should be on coming up with a realistic range.
The timeframe of at least five years is also important to consider, as a company may have strong short-term earnings but may not be able to sustain them over the long term.
To determine a plausible earnings range, it is important to have a thorough understanding of the business and stay within one’s “circle of competence,” as Buffett noted in previous shareholder letters.
Begin With Financials
Buffett has a consistent investment strategy that is not swayed by macroeconomic or political factors. While some may attribute his success to his years of experience, it is possible for non-professionals to make good business investments as well.
Rather than trying to identify potential winners, it is important to invest in a diverse portfolio of businesses with a proven track record of success.
Examine financial statements and consider factors such as current and past earnings, debt, industry trends, and the company’s competition. Companies that are leaders in fast-growing markets may be more likely to deliver strong returns compared to those in stagnant markets with many competitors.
So, what’s a reasonable price, and how do you determine it?
Valuation is based generally on discounted cash flow analysis but proxies like P/E and P/S ratios can be used. Depending on your investing strategy, dividend yield may be another critical deciding factor.
Here are some resources to assist you:
- Is a Higher Price To Earnings Ratio Better?
- High PE-Growth Stocks
- Low PE-Growth Stocks
- What Is A Good Dividend Yield Percentage?
When evaluating the intrinsic value of a stock, take into account the company’s projected growth and relevant internal and industry-specific variables (eg. FDA approvals for biotech firms).
The aim is to invest with a margin of safety, which is the difference between the intrinsic value of a stock and its current price. A higher margin represents a lower risk.
This is a particularly important consideration for value investors. It is important to note that the margin of safety is only as reliable as the calculation of intrinsic value.