How Warren Buffett picks stocks

“Excellent business results by corporations will translate over
the long term into correspondingly excellent market value and
dividend results for owners, minority as well as majority,” Warren Buffett once said.

How true this is even today although Mr Buffett said this as far back as 1978 in a letter to Berkshire Hathaway shareholders for FY1977.

When it comes to marketable equity securities, the Berkshire Hathaway chairman selects them in much the same way as he would evaluate a business for full acquisition.

Mr Buffett lists four criteria for selecting securities:
(1) the business of the company must be one that he can understand;
(2) it must have favorable long-term prospects;
(3) it must be operated by honest and competent people; and
(4) the securities must be available at a very attractive price.

Notice the emphasis on long term?

In the words of the Berkshire Hathaway chairman: “We ordinarily make no attempt to buy equities for anticipated
favorable stock price behavior in the short term. In fact, if
their business experience continues to satisfy us, we welcome
lower market prices of stocks we own as an opportunity to acquire
even more of a good thing at a better price.”

In a point that underscores value investment, he said: “Our experience has been that pro-rata portions of truly
outstanding businesses sometimes sell in the securities markets
at very large discounts from the prices they would command in
negotiated transactions involving entire companies.
Consequently, bargains in business ownership, which simply are
not available directly through corporate acquisition, can be
obtained indirectly through stock ownership. When prices are
appropriate, we are willing to take very large positions in
selected companies, not with any intention of taking control and
not foreseeing sell-out or merger, but with the expectation that
excellent business results by corporations will translate over
the long term into correspondingly excellent market value and
dividend results for owners, minority as well as majority.”

Misleading ‘record’ earnings

When companies say they achieve record earnings, be wary how they define “record” earnings.

Warren Buffett said in a March 14, 1978, shareholder letter: “Most companies define ‘record’ earnings as a new high in
earnings per share. Since businesses customarily add from year
to year to their equity base, we find nothing particularly
noteworthy in a management performance combining, say, a 10%
increase in equity capital and a 5% increase in earnings per
share. After all, even a totally dormant savings account will
produce steadily rising interest earnings each year because of
compounding.”

How true this statement is even today, some 39 years after Mr Buffett, the chairman of Berkshire Hathaway, said it.

The legendary value investor went on to say: “Except for special cases (for example, companies with
unusual debt-equity ratios or those with important assets carried
at unrealistic balance sheet values), we believe a more
appropriate measure of managerial economic performance to be
return on equity capital. In 1977 our operating earnings on
beginning equity capital amounted to 19%, slightly better than
last year and above both our own long-term average and that of
American industry in aggregate. But, while our operating
earnings per share were up 37% from the year before, our
beginning capital was up 24%, making the gain in earnings per
share considerably less impressive than it might appear at first
glance.”

Bottom line: When a company boasts record earnings using earnings per share as a basis, look at how much it has added to its equity base in the relevant period.