How to buy stocks according to Warren Buffett & Charlie Munger

June 20, 2012


(Photo by valuewalk)

I’ve spent the last year reading & listening to everything Warren Buffett and his business partner Charlie Munger have said. I don’t know why I waited so long to go directly to the source rather than read other people’s interpretations of their ideas!

If you are unfamiliar with their lessons – I highly recommend you search for all of the speeches on youtube by Buffett & Munger. These videos will teach you more than any class or all of the other blogs/articles/books combined.

Here’s what I’ve distilled their ideas down to:

There are 4 rules to buying a stock/business.

1. Deal in businesses we’re capable of understanding with predictable repeatable cash flows. (ie: think coca cola rather than groupon)

2. Business has to have some intrinsic characteristics, should be difficult to replicate (large moat), & have a durable competitive advantage.

Buffett likes to say that even if he had $1B to spend, he couldn’t overtake the market share of coca cola because the coke brand is one of the most valuable brands in the world. Coke’s sugar water might be easy to replicate but their manufacturing/distribution system is not. It would be impossible to get your soda company to replace coke in all of the mcdonald’s restaurants in the world. Coke has a huge moat and is why it’s Buffett & Munger’s favorite stock.

3. The business must have a management with honesty, integrity and talent.

Buffett likes to joke that the business should be so simple that any dummy should be able to run it because one day – a dummy might have to run it. (ie: companies like coke, mcdonald’s, gilette, etc may be able to be run by anyone without specific technical expertise. Can apple be run in the long term without the unique genius of steve jobs? That answer is still to be seen – but is one of the reasons why their stock is trading at a low valuation.)

4. Regardless of how good the business matches the above 3 filters, we will not buy unless it’s for the right price.

Buffett & Munger have their own (secret) formulas to figure out future cash flows and the intrinsic value of a company. (A recent example of an overpriced company is the facebook ipo. There was so much hype around it that the stock is priced at ridiculous valuations. I also don’t think facebook qualifies for rules #1 & 2.)

Other lessons from Buffett:

1. We don’t have to understand every business – just the ones we buy. Wait patiently for the right pitch then swing for the fences. Buffett doesn’t believe in diversification – he believes in putting all his eggs into one basket and then watching that basket carefully.

2. The basic theory in buying a private business or a stock (or any type of investment) is to buy a dollar’s worth of value for less than a dollar. Give yourself a good margin of safety. ie: Buy a dollar’s worth of value for 70 cents or less. If you keep doing that, you will be well off.


3. Mentally prepare yourself for 2-3 years out of every 10 to be bad. Historically, that’s how it has been and how it will be in the future.

4. Never buy a stock when it goes up a lot or sell when it goes down a lot. Don’t make emotional decisions.

5. Buy stocks for the long term. Buffett’s time span for owning is forever.

Jeff Bezos, founder & ceo of amazon.com, likes to run his business by looking at a 10 year window. A lot of businesses, he says, are run looking at 5 – 7 year window – and if he did the same, he would face a lot of competition. By doing things that would take 10 years to accomplish, he has little to no competition and thus amazon has done very well for itself. Longer your window of time in investment = the better off you will do. I personally am looking at a 10 year window when I buy stocks now.

6. Don’t think you are buying just a stock. Imagine you are buying the whole company rather than just a stock ticker.

7. Imagine you have a card with only 20 slots in it – and think that in your whole life span, you can only buy 20 stocks. Once the card is full – you can never buy another stock again. Think of how much thought you would then put into each one of your purchases – and Buffett believes if you operated that way – you will be very well off.

8. Buffett basically has two rules.
a. Never lose money.
b. Never forget rule #1

The 6 stocks I own:

As soon as I learned techniques used by Buffett & Munger – I sold all of my stocks (nflx, cost, fds, dis, pm, mo, etc). Most of the stocks were doing well but I felt they didn’t pass the above filters.

So now I own just 6 stocks. I’m not saying you should buy these stocks – I’m just saying they work for me. You should only make investment decisions based on your own research and be very careful as to not lose money.

All of the companies, except amazon, offer dividends and also drip investing. Drip investing is where you buy the stock directly from the company on a regular basis and reinvest the dividends. The benefit of this is that you can keep buying the stocks without paying the large trading fees that brokers charge. With drip investing, my fees might be $3 per purchase or less while an online broker will charge $9.99. Read more here.

My goal is to keep putting as much money I can into the drip investing stocks on a regular basis. I will also keep some money aside in case amazon becomes cheap for any reason and will make additional purchases there as well.

1. Amazon (my largest holding, around 54% of portfolio)

Reason: More and more, I make almost all of my purchases from amazon. This is my go to place to do research for prices, look at customer reviews and to buy. They have one of the best distribution/warehouse systems, their prime service gets products to me within 2 days (sometimes 1 day). Easy returns. They also sell digital music, movies, etc. They have one of the first and largest affiliate systems – with probably millions of people linking to their site. Their cloud services are the largest and most reliable. They have amazon payments system where you can pay a company or another person using your amazon account (similar to paypal). They own zappos, audible, woot and a bunch of other companies. Their market value today is around 100B – while walmart is around 232B. Amazon can be easily scaled up while walmart has more restrictions in expanding globally. All amazon needs is a warehouse while walmart needs retail stores, employees, etc. All being said, amazon is going to be the biggest retailer in the world – definitely bigger than walmart in the future. And amazon is much more diversified and makes customers more happy than walmart does.

2. Intel (drip)

This is a buffett copycat pick. Berkshire recently bought a large chunk of intel stock – which made me analyze intel and saw that it was undervalued. Intel makes chips for electronics and is the largest chipmaker in the world with the largest research and development funding. They are well run and as our society becomes more digital (computers, laptops, smartphones, smart tvs, smart fridges, etc) – intel will play a part in that.

3. Yum Brands (drip)

I wanted a food pick. I didn’t pick mcdonald’s, even though it’s one of the best run companies in the world, because I just don’t like their food. I picked yum because they have the most restaurant units in the world and are growing aggressively in china and india. Yum operates taco bell, pizza hut & kfc. They have a bigger head start in china than mcdonald’s and the chinese love fried chicken and pizza more than hamburgers. Same deal with india where pizza hut is very popular. In the next 10 years, I believe yum is going to grow into a phenomenal food company that will surpass mcdonald’s as the king of fast food.

4. UPS (drip)

This is a pick based on amazon.com doing so well. I make purchases on amazon on a daily basis and see the ups guy regularly. UPS is the largest shipping company in the world – they have a large moat that is not going to be easily replicated. They have airports, planes, trucks and warehouses that can ship items super fast – across the world. No other startup is going to be able to invest billions into planes and airports = large moat. As online shopping becomes more and more popular, shipping companies like UPS will do very well.

5. Fed Ex (drip)

Fed Ex is smaller in market cap than UPS – but is the leader in express shipping in the world.
UPS is the global leader in ground shipping. And there are no other companies that really compete with these two. So instead of just picking one shipping company – I decided to purchase both – since fedex is also a well run company. It’s kind of like buying coke and pepsi – and I feel confident with both picks. They are both well run, have large moats and have predictable returns – as the world becomes more globalized and internet shopping grows (which it will) – fedex and ups will do very well.

6. Starbucks (drip)

I read that coffee is the 2nd largest traded commodity in the world – behind tobacco. People love coffee, it’s addictive and there is no stigma to drinking coffee like there is with smoking cigarettes. And probably lesser health risks. Starbucks is the largest coffeehouse in the world, is run by their inspiring/smart leader Howard Schultz, has a large brand value (moat) and is seen as a premium lifestyle product (pricing power). As countries become more industrialized, their population also drink more and more coffee. They also started selling their coffee thru grocery stores – which already is a $1B product for them. They sell starbucks k cups and is also creating their own home coffee brewer. Starbucks recently bought evolution fresh – a juice company. They own seattles best coffee – which is a lower priced chain aimed at a working class demographic. They own tazo tea – a popular premium tea brand. I see starbucks not as a coffeechain – but rather a large beverage company with brand recognition. While soft drinks have a negative stigma for calories/sugar/obesity – people will flock towards drinks like coffee/tea/fresh juices. And starbucks will become one of the largest beverage companies in the world.

Sidenote: How I value stocks

A note about amazon’s valuation: Most of the blogs out there will say that amazon is highly overvalued because its p/e ratio is around 184. P/E ratio is basically the price of the stock (market cap) divided by it’s earnings (net income).

I think p/e ratio, while useful at times, is a poor way to value a company – especially one that’s growing like amazon. Earnings are also a number that can be manipulated thru depreciation, amortization and other non-cash items.

All you need to know is that net income is pointless – what matters is how much cash the company takes in and how much cash goes out. This number is much harder to manipulate and shows the true strength of a business.

Also, amazon is heavily reinvesting cash into more warehouses all over the world, buying other companies, and putting money back into research and development. Earnings number will reflect what is left over after reinvestment – which is not fair valuation method in amazon’s case because not every company is reinvesting at the scale as amazon. So comparing pe ratios of amazon vs another company is not comparing apples to apples.

Here are the formulas I use to evaluate a stock. I’m not a math expert and did very poorly in statistics classes – otherwise I would have sophisticated present value of future cash flows formulas! : )

Anyways – instead of p/e ratio – I use ev/ocf.
p stands for market cap – which is fine but doesn’t take into account how much debt or cash a company has.

ev = entreprise value = market cap plus/minus cash/debt. Enterprise value is the amount of money you would have to bring if you were to buy the whole company. This is a better way to value how much a company is worth in the marketplace than market cap.

instead of earnings – i use operating cash flow (ocf). operating cash flow is how much cash is left over after operating expenses (expenses required to run the business).

you don’t have to calculate these numbers – they are already available in yahoo finance under “key statistics” – see here.

So by my calculation:
amazon’s
p/e = 184.16
vs
ev/ocf = 95.22B/3.05B = 31.22

By comparison
walmart’s
p/e = 14.76
ev/ocf = 276.13B/27.72B = 9.96

31.22 is still pretty high but not astronomical like the p/e. Amazon is a high growth global tech/retailer with a massive moat and brand value. There is no other company like amazon with which we can do comparisons.

Walmart’s valuations are much lower because of the company’s lower growth prospects.

I also think (educated guess) that amazon will be much larger than walmart. Amazon’s ev is 95B while walmart is at 276B. Just by that number alone, amazon is set to triple in the next 10-20 yrs in my opinion.

Just for reference, some of the other formulas i use are:

instead of p/s (price/sales): entreprise value/revenue (lower the better)

instead of profit margin (net income/sales): operating cash flow/sales (higher the better)

ROIC: return on invested capital (see here) – (higher the better)

ROE: return on equity (higher the better)

Debt/Equity (lower the better)

Dividend yield: if applicable (higher the better). dividends are great since you you can reinvest this back into the stock and grow your portfolio.

Payout ratio: if applicable (super high can mean danger. usually, lower the better). see here

Sources:

Berkshire’s stock holdings (updated daily)

Buffett & Munger’s letters to shareholders (good FREE! read)

Poor Charlie’s Almanack

The Essays of Warren Buffett

jeremiah August 8, 2014 at 8:31 pm

Im pretty sure P/E ratio is EPS (earnings per share) divided by the current share price.