Warren Buffett believes that when you’re selecting stocks to put your money in, you shouldn’t be looking at the stock to make that decision. You should be looking at the business. Buying stocks is investing in businesses. When Warren considers buying stocks, he looks at the underlying business. He considers what the business does, if it’s consistently profitable, if it has brand loyalty, if it’s durable. He considers these factors of the business for the past 10 years up to today.
Warren only buys good businesses that are profitable and will continue to be in the future for as long as he can see. He doesn’t even consider buying shares of a business that he does not understand. His reasoning is that if you don’t understand what the business does, how can you make an informed decision as to whether or not it is a good business?
Identify Great Businesses
First of all, Warren Buffett’s stock strategy does not involve following the latest hot stocks and he won’t chase momentum stocks. What he does is identify great, profitable companies that he would consider owning. There are many factors in determining if a business is profitable and these will be explored in later articles.
Buy Stocks at a Bargain Price
Even if a business meets all of Warren’s criteria, he doesn’t jump in and buy shares. He also considers if it is a bargain to buy the shares because you can still lose money if you buy a great business which is overpriced. This is where Warren Buffett does not follow the majority. He does not follow the latest ‘hot stocks’. He doesn’t look for stocks where the crowd looks. When the crowd is buying, he sells and when the crowd is panicking and selling like crazy, he buys like crazy. This is called contrarian investing and it is the underlying foundation of Warren Buffet’s investment strategy.
Warren believes that 95% of investors are short-sighted in the sense that when they buy a stock, they are looking for a return on their investment in the short term. This is what drives the wild fluctuations of the stock market. When a business makes a bad decision and they lose money or there is some negative news about it, the short-sighted crowd will panic and sell like crazy when in fact, the situation will correct itself in the future.
For example, when Coca-Cola changed their Coke formula in 1985, it was disaster and their stock price dropped like a rock because all the short-sighted investors panicked and sold their stock. Shortly after, Coca-Cola reverted back to the old formula and their stock went on to rise to new heights. These kinds of situations create fantastic buying opportunities for long-term investors like Warren because he sees that the business has fallen into some temporary trouble, resulting in a discounted stock price (because of short-sighted investors selling their shares) which will recover and keep rising when the business has corrected its mistakes.
Identifying a True Bargain
However, there are several things to note with these ideas. Just because a stock price has fallen a lot does not mean that it’s a great bargain. Some businesses go from a big drop in their stock price to more dropping and finally bankruptcy. The key is to identify great businesses which have had their stock prices hammered. This creates the first half of what is considered a great bargain because the business has proven itself to be profitable in the past and is now selling for a deep discount. The other half of a great bargain is based on why the business is selling for such a low price. Even a great business can go bankrupt if it can’t get itself out of the bad situation that it’s in. You must be able to determine whether the business can recover from the bad news and how long it will take them to do that. If the business has been profitable in the past and the negativity surrounding it is a temporary problem, then the low stock price is truly a bargain.
Warren Buffett identifies great profitable businesses and waits for a bargain stock price before investing in it. The bargain stock price is created by short-sighted investors over-reacting to negative news about the company.
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