Like most investors, one of your top goals has been to enjoy financial freedom at whatever age you choose. So, it stands to reason that your money should ideally generate above-market returns with below market risk.
One of the best ways to do that is to follow the Warren Buffett model.
In fact, if you want to invest in companies attractive to the billionaire, make sure they are:
- Simple companies that are easy to understand
- Companies with predictable and proven earnings
- Companies that can be bought at a reasonable price
- Companies with “economic moat,” or a unique advantage over its competition.
“I look for companies that have a business we understand; favorable long-term economics; able and trustworthy management; and a sensible price tag. We like to buy the whole business or, if management is our partner, at least 80%,” says Warren Buffett.
“When control-type purchases of quality aren’t available, though, we are also happy to simply buy small portions of great businesses by way of stock market purchases. It’s better to have a part interest in the Hope Diamond than to own all of a rhinestone,” he added.
One company that fit Buffett’s model was Coca-Cola (NYSE:KO)
Using fundamental arguments, Buffett bought more than $1 billion worth of Coke (KO) in 1988.
All after seeing consistent performance and good long-term prospects based on the nuts and bolts of the company. He also saw bargain in the stock price after years of disaster.
And, at the time, the stock, said Buffett, wasn’t reflective of the growth set to occur in the company’s international business. So, he bought in 1988.
Eleven years later, that $1 billion investment in Coke exploded to $12 billion.
To spot opportunities, Buffett looks for five key criteria
Before Buffett invests, the company must include five key criteria.
No. 1 – The company must be easily understood
An investor must fully understand a business before investing in it. If you have a problem explaining it to yourself in simple terms that even a child can understand, or if it’s just too complex, you may want to avoid the investment.
Buffett makes sure he can understand the business inside and out. If not, that company may not be worthy of his investment. That may help explain why his portfolio is full of financial and consumer-goods companies instead of tech stocks and health companies.
No. 2 – The company must have predictable and proven earnings
“If the company has operated with consistent earnings power and if the business is simple and understandable, Buffett believes he can determine its future earnings with a high degree of certainty. If he is unable to project with confidence what the future cash flows of a business will be, he will not attempt to value the company. He’ll simply pass,” notes The Warren Buffett Way.
No. 3 – Can the stock be bought at a reasonable price?
When Warren Buffett refers to “price,” he’s referring to the valuation of the stock.
If the price is not satisfactory, the billionaire will pass.
His goal has always been to identify stocks that can earn above-average returns, and then buy the stock at prices below current value. In fact, as Buffett noted in 1988, “Great investment opportunities come around when excellent companies are surrounded by unusual circumstances that cause the stock to be misappraised...”
No. 4 – Does the company have a strong economic moat?
If the company has a strong economic moat, it allows it to set itself apart from its peers, and protect itself. In determining a strong moat, we want to know if the company has a strong brand. Are switching costs too high for consumers to change what they currently use? Is there a network effect? For example, Apple has a network effect with its Mac computer.
Buffett also wants to know if the stock he’s investing in offers product at a cheaper cost.
If you offer high quality products at lower costs than your competition, much like Wal-Mart, you have an economic moat.