How to Pick a Stock Like Warren Buffett

Michael Jordan is to basketball as Warren Buffett is to investing. The Nebraska native is closer to celebrity status than anyone else in the investing world and for good reason. When Buffett buys a stock, he considers it the same as buying a business: There is an extensive checklist he churns through before even considering making a purchase. Within that list are several key lessons for all investors. Here are a few:

Find reliable and candid leaders

Buffett must have full faith in the trustworthiness of a company's leadership team. While not all of us have the luxury of sitting down with company executives to gauge their reliability, we can all do our homework. How?

a black and white photograph of Warren Buffett

Image source: Getty Images.

Buffett listens to several past earnings reports of a company in question before considering an investment. This sounds tedious, but it is a fantastic way to learn if a CEO is exaggerating expectations.

Take note on the predictions offered on calls while the executives are giving their unscripted remarks and answering analysts' questions. If multiple quarters pass and their expectations have not come to fruition, perhaps the executives are unreliable.

Whenever a prediction of Buffett's does not come true, he is the first to bluntly acknowledge it; many other leaders avoid such candidness. In the most recent Berkshire Hathaway shareholder meeting, Buffett admitted his purchase of Occidental Petroleum credit was, in hindsight, ill-advised. Quite refreshing.

Buffett further warns investors to steer clear of CFOs making aggressive adjustments to meet previous guidance and openly criticizes those who do so. "Adjusted EBITDA" is an increasingly popular term on Wall Street that Buffett's partner, Charlie Munger, openly despises.

Trustworthiness and reliability are absolutely vital to Buffet. Regardless of promising profitability or ingenious product design, misleading the public is a deal breaker for this empathetic billionaire.

Find good stewards of capital

Beyond stressing absolute honesty and candidness with shareholders, Buffett looks for leaders who use capital efficiently. If a company is retaining earnings and producing less in profit as a result, that is an immediate red flag. Capital expenditures are vital to expansion, but shareholders would be better off with a dollar than $0.90 in growth, especially if the expansion prospects resulting from an investment are muted. 

As an investor with a longer time horizon, Buffett makes an exception to this rule. If the long-term growth prospects of an investment are promising enough, then he may approve. An example is Amazon. The incredible growth opportunities before the trillion-dollar company even enticed Buffett amida triple-digit earnings multiple and no dividend.

Ignore day-to-day market moves

Perhaps most importantly, Buffett makes no effort to trade the day-to-day movement in stock prices. He calls the stock market "Mr. Market." Sometimes Mr. Market is happy while other days he is mad. Buffett avoids the noise by making no attempt to predict that schedule. Would you sell a business you extensively researched and excitedly picked a day later because you could make .8%? Hopefully not.

Buffett wants to own companies not for a few days or months, but for several years. And he usually does. Only this year did Warren authorize his firm Berkshire Hathaway to sell shares of Goldman Sachs that it bought during the 2008-2009 financial crisis, and they still own shares of Coca-Cola from the late 1980s.

Buffett is not perfect: He sold off Berkshire's airline assets this past quarter at what looks to be a generational low even as markets clawed 40% off their lows, siting a fundamental change in the industry. Still, he is right far more often than he is wrong and it's no coincidence why. Perhaps he has incredible luck, but it is far more likely his impeccable approach to investing.

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Bradley Freeman owns shares of Goldman Sachs. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares) and recommends the following options: long January 2021 $200 calls on Berkshire Hathaway (B shares), short January 2021 $200 puts on Berkshire Hathaway (B shares), and short September 2020 $200 calls on Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


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