To become the best, you need to do what the best are doing. So to become a great stock picker you need to learn how to invest like Warren Buffet.
If you are just starting out investing in the stock market, you need a simple investment strategy that will help you steer clear of the bad companies and pick the good ones.
We need look no further than the Oracle of Omaha himself, Warren Buffett who is a legend in the world of investing. And has been called one of the greatest investors of all time.
Warren Buffett has 4 simple rules he follows when he is choosing a company to invest in. These rules will help guide you in determining whether a company is worth your coin.
Keep in mind though all 4 rules must be met before it is considered a good buy.
Check out Warren Buffett's 4 rules below. Learn them, understand them, then get out there and give it a go. After all, the best way to learn is to do.
Invest like Warren Buffett: His 4 Rules for Stock Picking
If you want to learn how to invest like Warren Buffet, you are going to need to learn about the 4 rules he lives by when picking stock.
By following his 4 rules, you will be able to minimize your risk when it comes to investing in the stock market. Which, as a beginner who doesn't want to lose all his/her hard earned money, is probably pretty high on your list.
1. The Company Must Be Managed By Vigilant Leaders
The first rule to learning how to invest like Warren Buffet is to choose a company with vigilant leaders. Not just any old leader but a vigilant one.
When you purchase stocks, you are buying shares of a company. In a way, you are becoming a part-owner in that company, and, as such, you would definitely want to make sure it has excellent leadership.
This leader must have visions for the future of the company and concrete plans for how to achieve them. The companies that become great tend to have, what Jim Collins calls in Good to Great, level 5 leadership.
Now while that may something hard to assess (or at least a little time consuming), there are other ways to determine if the company has vigilant leadership.
One of those ways is by looking at how they are handling their debt.
Companies who do not handle their debt well are typically the ones who do not last very long. And if they do last, it may be a long, long time before you see any profit from your investment.
Warren Buffet has two key indicators that he likes to check to determine how well the company is managing their debt: the debt to equity ratio and the current ratio.
Debt to Equity Ratio
The debt to equity ratio (D/E ratio) is simply the amount of debt a company has divided by its equity. As a rule of thumb, Warren Buffet wants the D/E ratio to be less than 0.5. This means that the equity should be at least 2x the debt.
You can determine a companies debt to equity ratio simply by going to Yahoo Finance, searching for the company, and clicking on "Statistics" as seen here for Johnson & Johnson. (Scroll down until you get to the Debt to Equity Ratio statistic.)
One thing to note about this rule is that it doesn't apply to certain industries such as the financial industry as their business is debt and the D/E may not be below 0.5.
Current Ratio
The current ratio is used to determine if the company will be able to handle their debt in the coming year. From it, you can determine whether the company will have to go into more debt.
The current ratio can be calculated by dividing a companies total current assets by its total current liabilities.
Total current assets are the company's assets that will be converted into cash that year. While total current liabilities are the bills that will be coming due that year.
So you will want to make sure that the company's cash will be able to cover the company's bills. Otherwise, it is likely the company will have to go into more debt just to cover it.
What Buffet likes to see here is a ratio that is greater than 1.5. This means the company should be able to cover their debt in the current year.
When looking at a company's Balance Sheet, choose the quarterly view instead of annual. You always want to know what's the latest info when it comes to debt.
2. The Stock Must Have Long Term Prospects
If you're going to invest in a company, there's no point investing in one that isn't going to be around for very long. So when you are looking at companies, pick the ones that you know are going to be around for a while.
One that is going to be around for the next 30 years at least. So look at the company's main product and determine whether you think it will be here for the long haul.
If not, ditch it and move on to the next.
Now, there are two reasons to hold a company for the long term. One being, the longer you hold a company the more dividends you can receive and the greater your capital gains (assuming its a good company).
All of which means more money for you. And who doesn't want that?
The second reason for wanting to hold onto your investment long term is because of capital gains tax.
Capital Gains Tax
Imagine if you bought a stock at $10, then later sold that stock for $20, you would have made a $10 profit. This profit is called capital gains and it is taxed by the IRS.
The thing is there are two types of capital gains tax: short-term and long-term. Short-term is considered any asset held for less than a year while long-term is anything held for more than a year.
Short term capital gains are taxed at your current income tax rate while long-term gains are given a special rate.
Check out the tables below of the capital gains tax rate for 2021 and see for yourself why it is more beneficial for you to hold onto your investments for longer than a year.
Long Term Capital Gains Tax Rate (2021)
Tax Rate | 0% | 10% | 20% |
|---|---|---|---|
Single | < $40,400 | $40,401- -$445,850 | > $445,850 |
Head of Household | < $54,100 | $54,101 - $473,750 | > $473,750 |
Married Filing Jointly | < $80,800 | $80,801 - $501,600 | > $501,600 |
Married Filing Separately | < $40,400 | $40,401 - $250,500 | > $250,800 |
Short-Term Capital Gains Tax Rate (2021)
Tax Rate | 10% | 12% | 22% | 24% | 32% | 35% | 37% |
|---|---|---|---|---|---|---|---|
Single | $0 - $9950 | $9951 - $40,525 | $40,526 - 86,375 | $86,376 -$164,925 | $164,926 -$209,465 | $209,466 -$523,600 | >$523,600 |
Head of Household | $0 - $14,100 | $14,101 - $53,700 | $53,701 -$85,500 | $85,501 -$163, 300 | $163,301 -$207,350 | $207,351 -$518,400 | >$518,400 |
Married Filing Jointly | $0 - $19,900 | $19,901 - $81,050 | $81,051 -$172, 750 | $172, 751 -$329,850 | $329,851 -$418,850 | $418,511 -$628,300 | >$628,300 |
Married Filing Separately | $0 - $9950 | $9956 - $40,525 | $40,526 -86,375 | $86,376 -$164,925 | $164,926 -$209,425 | $209,426 -$314,150 | >$314,150 |
As you can see, long term capital gains taxes are much more beneficial to you and your wallet.
For instance, if you are single, making over $41,000 a year, you would be taxed 22% for short-term capital gains.
However, if you were to hold on to that invest for at least a year and a day, you would only pay 10% in taxes. That's a 12% savings in taxes!
3. The Stock Must Be Stable and Understandable
One of the things that Warren Buffett always says is that you shouldn't invest in things you do not know. Why?
Because if you don't understand the business, there's no way you'd understand if a new product will be profitable or a disaster. Or if a new marketing strategy, will sink or swim.
So picking a company you understand and know is the first step to investing like warren buffet. Then you'll want to make sure that company is stable.
And a stable company is predictable. A company needs to be predictable if you want to be able to accurately assess whether you want to invest in the company or not.
With a predictable company you can look at past earnings and make a pretty accurate estimate of future earnings. The same cannot be said for company with sporadic earnings that are up one year than down the next.
What you want to see in a stable company is its earnings and growth trending up over time and its debt, ideally, trending down.
What to Do
To look at a company's predictability go to key ratios and look at the past 10 years. I like to use market watch if I am looking for trends as they have a nice graph that you can see of the key stats. (here)
They only show 5 year trends though and you may want to go back as far as 10 years. So if necessary look for a 10 year summary or go through the charts they have available on Market Watch.
MSN also shows graphs of the Debt to Equity ratio and Book Value per share trends. You can see that here.
Just because a company isn't stable doesn't mean the company won't be profitable in the future. It simply means that it is higher risk. But when you are starting out, you will want to reduce your risk as much as possible.
4. The Stock Must Be Undervalued
This is the final and most important rule if you want to invest like Warren Buffet. Like any good bargain shopper, you want to buy a stock in a company at a discount. So look for companies that are undervalued.
To determine whether the company's current stock price is undervalued or not, you first have to figure out what the company is actually worth, or its intrinsic value.
And in order to do this you would need the company to be stable with predictable future earnings (from dividends) and growth (from an increase in book value, a company's valuation).
Hence the importance of Rule 3.
Doing the Calculations
With a stable and predictable company, you can take the company's past dividend pay outs and book value growth, and graph it. From there, you can take the slope of the graph and it extend it out into the future to determine a rough estimate for future earnings.
Then once you predict how much an investment in this company will earn you in the future, you must figure out what that future value is worth now. This is referred to as discounting cash flow.
These calculations won't be exact figures but actually estimates as you will have to make assumptions about what will happen in the future.
Furthermore, all of your calculations for book value and dividend earnings would depend on the company's EPS, or earnings per share.
So check your calculations by looking at the analysts projected EPS values. These projected EPS earnings should look similar to its past EPS values. This will determine whether your calculations are realistic estimates or not.
To do these calculations yourself can be pretty long and drawn out so I would suggest finding a calculator that could help do most of it, if not all, for you.
Intrinsic Value Calculators
Alpha Spread has an intrinsic value calculator that literally does everything for you. Simply put in the name of the company or its ticker symbol and it will tell you its intrinsic value.
Trade Brains also has a couple of calculators you could use for your estimates. You may need to know key metrics such as growth rate, past EPS values, etc., for the various calculators.
*Note: I am not an affiliate of either of these companies.
The intrinsic value of a company is based on what you think is reasonable to get as a return on your investment. Some will use these calculations to determine whether to invest in stocks are bonds.
All in All
Investing in the stock market comes with risk. Especially if you are a newbie. But those risk can be managed with knowledge and a good understanding of the company you'd like to invest in.
That's why it is important to learn how to invest like Warren Buffet, one of the greats.
Remember his 4 rules, and they will go a long way in helping you to understand a company. As well as, determine whether it is the right investment for you.
Want to save for college by investing in the market? You need a 529 plan.
*DISCLAIMER: The Information provided in this post is simply the opinions of the blogger and is given in the spirit of educational fun. It is not investment advice. Please do your own research and decide what is right for you before investing in any asset. If necessary, seek the help of a certified professional in discussing your options.