Warren Buffett
Ever wonder how successful stock investors pick great companies? Here are a few steps taken from the playbook of investing greats like Warren Buffett, Benjamin Graham, and Peter Lynch.
Steps
- 1Stay within your circle of competence: You are best positioned to identify winning companies within your own field of expertise. If you work in retail, you are more qualified to decide if you should invest in companies like Walmart, Target, Best Buy, etc. than the latest bio-tech company.
- 2Look for Economic Moats: There are some companies that manage to be virtual monopolies in their area. These companies have, over the years, succeeded in building a "moat" around them to keep their competitors away. They have a durable competitive advantage. Some examples of competitive advantage are:
- Brand - Think Harley Davidson, Coke, BMW. These are brand names etched in the public mind as the best in their class. These companies can raise their prices on the strength of their brands resulting in deeper profits.
- High Switching Costs - When was the last time you switched banks? Or cell phone providers? Or cigarette brands, if you are a smoker? You get the picture here? Companies that have high switching costs can hold on to their customers a lot longer than companies that don't.
- Low Cost Producer - Companies that are able to make products and sell them at phenomenally lower prices than their competition automatically attract customers - lots of them. As long as quality is not compromised, of course. Walmart and and Dell have perfected this concept to a science.
- Secret - Large pharmaceutical companies with patents; companies that own copyrights, drilling rights, mining rights, etc. are pretty much the sole producer or service providers in their area. Again, these companies can raise prices without fear of losing customers, resulting in higher profits.
- Scalability - This is a product or service that has the potential to network or add more users with time. Adobe has become the defacto standard for publishing, Microsoft's Excel for spreadsheets. eBay is a great example of a user network. Each additional user to the network costs the company virtually nothing. The additional revenues that come in as the network expands go straight to the bottom-line.
- Brand - Think Harley Davidson, Coke, BMW. These are brand names etched in the public mind as the best in their class. These companies can raise their prices on the strength of their brands resulting in deeper profits.
- 3Check the quality of management: How competent is the management running the company? More importantly, how focused are they toward the company, customers, investors, and employees? In this age of rampant corporate greed, it's always a great idea to research the management of the company. The companies annual reports as well as newspaper/magazine articles are good places to get this information.
- 4Even a great company can be overvalued. Learn to interpret financial statements and fundamental analysis to find one that the market has valued fairly, or undervalued.
- Price to earnings ratios should be below 20. If the P/E ratio is over 20, then the company could be overpriced for it's earnings. Benjamin Graham popularized this indicator after the great depression.
- Buy a Price-to-book below 2. The price-to-book ratio is the price of the company divided by the total value of its assets. A low ratio shows that the company's stock is cheap.
- Price to earnings ratios should be below 20. If the P/E ratio is over 20, then the company could be overpriced for it's earnings. Benjamin Graham popularized this indicator after the great depression.
Tips
- Start thinking about everyday companies you come across with this new framework.
- Visit the company’s website and financial websites online that give you varied insights on the stock like Wikinvest.com and Morningstar
- Learn the basics of reading financial statements. Then, check to see how profitable the companies you're interested in are. Check their debt position. See if they have been growing steadily.
Warnings
- Never jump into buying stocks in a company unless you've sat down and done your research.
- Stay away from stock tips -- they are merely someone's grandiose theory about getting rich quick or a salesman that is paid to inflate a stock so that the company can raise money by dumping stock on unsuspecting investors.
- Warren Buffet says that it amuses him how high IQ CEO's mindlesly immitate one another. Warren says that he NEVER gets good ideas listening to others.
- While you should invest in companies you know, do not limit yourself to just one or two sectors. Try to research about companies in a variety of sectors and diversify your stock portfolio.
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