Warren Buffett's Investing Strategy: An Inside Look

A staunch believer in the value-based investing model, investment guru Warren Buffett has long held the belief that people should only buy stocks in companies that exhibit solid fundamentals, strong earnings power, and the potential for continued growth. Although these seem like simple concepts, detecting them is not always easy. Fortunately, Buffet has developed a list of tenets that help him employ his investment philosophy to maximum effect.

Buffett's Investing Style

Buffett’s tenets fall into the following four categories:

1. Business
2. Management
3. Financial measures
4. Value

This article explores the different concepts housed within each silo.

Business Tenets

Buffett restricts his investments to businesses he can easily analyze. After all, if a company's operational philosophy is ambiguous, it's difficult to reliably project its performance. For this reason, Buffett did not suffer significant losses during the dot-com bubble burst of the early 2000s due to the fact that most technology plays were new and unproven, causing Buffett to avoid these stocks.

Management Tenets

Buffett's management tenets help him evaluate the track records of a company’s higher-ups, to determine if they've historically reinvested profits back into the company, or if they've redistributed funds to back shareholders in the form of dividends. Buffett favors the latter scenario, which suggests a company is eager to maximize shareholder value, as opposed to greedily pocketing all profits.

Buffett also places high importance on transparency. After all, every company makes mistakes, but only those that disclose their errors are worthy of a shareholder’s trust.

Lastly, Buffett seeks out companies who make innovative strategic decisions, rather than copycatting another company’s tactics.

Tenets in Financial Measures

In the financial measures silo, Buffett focuses on low-levered companies with high profit margins. But above all, he prizes the importance of the economic value added (EVA) calculation, which estimates a company’s profits, after the shareholders’ stake is removed from the equation. In other words, EVA is the net profit, minus the expenditures involved with raising the initial capital.

On first glance, calculating the EVA metric is complex, because it potentially factors in more than 160 adjustments. But in practice, only a few adjustments are typically made, depending on the individual company and the sector in which it operates.

$\begin{aligned} &\text{Economic Value Added}= NOPAT-(CI \times WACC)\\ &\textbf{where:}\\ &NOPAT = \text{net operating profit after taxes} \\ &CI = \text{capital invested} \\ &WACC=\text{weighted average cost of capital}\\ \end{aligned}$​Economic Value Added=NOPAT−(CI×WACC)where:NOPAT=net operating profit after taxesCI=capital investedWACC=weighted average cost of capital​

Buffett's final two financial tenets are theoretically similar to the EVA. First, he studies what he refers to as "owner's earnings." This is essentially the cash flow available to shareholders, technically known as free cash flow-to-equity (FCFE). Buffett defines this metric as net income plus depreciation, minus any capital expenditures (CAPX) and working capital (W/C) costs. The owners' earnings help Buffett evaluate a company’s ability to generate cash for shareholders.

Value Tenets

In this category, Buffett seeks to establish a company's intrinsic value. He accomplishes this by projecting the future owner's earnings, then discounting them back to present-day levels. Furthermore, Buffett generally ignores short-term market moves, focusing instead on long-term returns. But on rare occasions, Buffett will act on short-term fluctuations, if a tantalizing deal presents itself. For example, if a company with strong fundamentals suddenly drops in price from $50 per share to $40 per share, Buffett might acquire a few extra shares at a discount.

Finally, Buffett famously coined the term "moat," which he describes as "something that gives a company a clear advantage over others and protects it against incursions from the competition."

The Bottom Line

Buffett's tenets provide a foundation on which he rests his value investing philosophy. But applying these tenets can be difficult, given the data that must be cultivated and the metrics that must be calculated. But those who can successfully employ these analytical tools can invest like Buffett and watch their portfolios thrive.