Warren Buffett Stock Buying Strategy

Warren Buffett Stock Buying Strategy: Warren Buffett, the legendary leader of Berkshire Hathaway, has decades of experience selecting the right investments at the right time to generate long-term returns for his shareholders. Over the long term, he has beaten the S&P 500 by a wide margin.

Occasionally, he doesn’t quite keep up. However, when you look at his cumulative results, there is no doubt that he is one of the most successful investors of all time. 

Since 1965, when Buffett began managing the company in earnest, shares of Berkshire Hathaway have returned an average of 20 percent per year. Compare that to the S&P 500, which has realized an average annual gain of just 10.2 percent per year.

That has investors asking the big question: what is Warren Buffett’s stock buying strategy? 

Companies With Moats

For years, Warren Buffett has been talking about moats – and not the sort found around medieval castles. The concept is the same, though. Buffett is particularly interested in companies that have a moat – that is, the sort of sustainable competitive advantage that makes it possible for the business to pursue an effective pricing strategy while simultaneously maintaining higher-than-average profit margins. 

The key to the moat theory is that the competitive advantage must be difficult – if not impossible – for others to duplicate. For example, that could mean an exceptionally strong brand, a unique proprietary product, or unusually impressive economies of scale. Coca Cola (KO) is a prime example of a company with a virtually impenetrable moat (its brand), which is why Buffett is such a big advocate of the company.

High Gross Profit Margins

Another factor that makes a big impression on Warren Buffett is a company’s gross profit margin as compared to its peers or the larger industry. These high gross profit margins signal something more important – that the company is a top performer and therefore likely to continue creating value for shareholders. 

While the definition of “high” can vary between industries, as a general rule, Buffett is believed to look for companies with gross profit margins in excess of 40 percent. Apple (AAPL) is a company with famously large gross margins, which explains why Buffett has invested so heavily in it.

It’s worth noting that, according to Buffett, when gross margins consistently fall below 20 percent, it’s a sign that the company is focused on a particularly price-sensitive product or service. That’s not a situation that can reliably produce earnings for shareholders.

SG&A Low Vs Gross Profit Margin

SG&A – or selling, general and administrative expense – is another income statement figure that Warren Buffett reviews with a critical eye. SG&A covers all of the expenses that come with operating a business outside of actually producing goods and services. Examples of SG&A expenses include payroll, marketing, and facilities. 

According to Buffett, companies that can cover their SG&A with less than 30 percent of their revenue are particularly efficient. They have developed a business that runs with minimal waste – a sign that the company is among the best in its industry. 

Remember, the operating profit is the difference between gross profit and SG&A. That means low SG&A directly contributes to the total earnings before interest and taxes (EBIT).

R&D Low Vs Revenues

Some industries rely on research and development to create their next blockbuster product. Pharmaceutical companies are a prime example of businesses that put big bucks into R&D. Though there are some exceptions, Warren Buffett isn’t a fan of investing in businesses with high R&D expenses. 

Research and development reduces profits, just like SG&A expenses. No matter how high revenues go, profits stay depressed if R&D expenses get out of control.

Consider pharmaceutical maker Merck & Co. (MRK) In 2020, the company devoted approximately $13.6 billion to R&D. Revenues were just shy of $48 billion, and SG&A came in at about $10.5 billion. That means Merck has a lot of ground to make up right out of the gate – and pharmaceutical companies can’t afford to be too lean with R&D, as that work leads to new, more profitable drugs. 

It’s a vicious cycle – one that Buffett tends to avoid – though he doesn’t ignore drugmakers altogether. The top three industries in Berkshire Hathaway’s portfolio are technology, finance, and consumer staples, but as of late 2020, he does have small positions in AbbVie (ABBV), Merck (MRK), and Bristol-Myers Squibb (BMY).

Net Earnings Growing Fast

Keeping a close watch on net earnings growth is not a trick exclusive to Warren Buffett. Companies that boast net earnings growing fast tend to attract lots of investor attention. That means more trading and faster-than-average growth in share prices. In many cases, shareholder profits follow. 

What is special about Buffett’s selections is that he has a good sense of whether a company will continue to grow share prices quickly over time. Any company can have a few good quarters when economic conditions are right. Only a handful can keep that net earnings growth rate up over the long-term, and those are the ones Buffett buys for Berkshire Hathaway. 

Positive EPS Over Long Term

Finally, before making any investment, Warren Buffett takes a hard look at earnings per share – and not just for a quarter or two. He wants to see positive earnings per share over the long-term, because that’s where Berkshire Hathaway actually profits.

It’s impossible to guarantee that earnings per share will remain positive going forward, but companies with a solid history and an industry-leading position are more likely to deliver shareholder value. That’s Warren Buffett’s bottom line. 

Warren Buffett’s Stock Buying Strategy: The Bottom Line 

It’s not an exaggeration to say that Warren Buffett is one of the most successful investors of all time. He achieved his success because he is careful, thoughtful, and methodical in making investment decisions.

He doesn’t jump on the bandwagon every time there is a hot IPO, and he pays no attention to fads. He is on the lookout for companies that have a history of strong performance and all of the signs that success will carry into the coming years. 

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.