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The investment track record of billionaire stock-picker Warren Buffett is incredible. But his approach to buying and holding shares in large, proven, well-known companies is in fact a fairly simple one.
Like many private investors, some of what I do myself is inspired by Buffett, albeit on a much smaller scale. Here are three things Buffett considers when looking at shares.
Getting to grips with how a business makes money
Even a good business can have a bad year and swing from a profit to a loss. Over the long run though, Buffett’s interest has mostly been in buying shares in companies that have already proven themselves profitable and look set to keep generating profits consistently.
That means it is important to understand how a business works. It is also important to get to grips with its financial situation. For example, a company can be profitable at the operating level but so laden with debt that it loses money overall.
So it is important to understand what a business does, how that makes money, and whether making money operationally means the company can make money overall.
Buffett sticks to what he knows when investing – he calls this his “circle of competence”. In his opinion, it is unimportant how wide or narrow an investor’s competence circle is. The important thing is that they recognise it and avoid the temptation to stray beyond it.
Assets that keep on paying back
Buffett has invested in plenty of capital-intensive industries that need new equipment on a regular basis, from power stations to train lines. But, by contrast, a lot of the shares he has bought are in companies that are able to “sweat their assets” long after they have been paid for.
Coca-Cola (NYSE: KO) is a good example. The soft drinks maker has spent decades investing heavily in building its brands. Sales today are benefitting from investments the company made decades ago. In fact, even if Coca-Cola never spent another penny on marketing, I think its brands would retain substantial appeal for consumers for decades to come.
The economics of such a business can be appealing, because they are not heavily reliant on large, recurring capital expenditure.
Every share has its price
Buffett sometimes watches a company for decades before investing in it. With others, such as Coca-Cola, he builds a stake then does nothing. Buffett remains a large investor in the business – but he has not bought a single Coca-Cola share since the 1990s.
The master investor still holds a large Apple stake – but has sold a lot of Apple stock over the past couple of years. Why? We do not know for sure. But what is clear is that Buffett does not just want to buy into great businesses – he wants to do so at an attractive share price.
Coca-Cola shares are far costlier now than when Buffett bought his. But the company faces more competition, from niche start-ups to a tidal wave of drinks that emphasise their health benefits compared to sugary sodas.
That is a risk to Coca-Cola’s future profitability. Like Buffett, I think Coca-Cola has a very strong business – but have no plans to invest at its current share price.
