How to invest like Warren Buffett?
Investing in the stock market can be a roller-coaster ride.
This is especially true if you don’t have a sound investment strategy in place.
One tried and tested investment technique popular among investors is value investing.
Benjamin Graham founded the value investing technique.
It was later refined and popularized by Warren Buffett.
Value investing like Warren Buffett involves identifying undervalued good quality stocks.
These undervalued stocks trade at a discount to their intrinsic value.
By buying these stocks, the investor creates a margin of safety for themselves.
This margin of safety help can reduce the downside risks of the investment.
Here are 5 steps to successful value investing like Warren Buffett:
(1) Research good companies
Research is the crucial first step to successful value investing. It is vital to research on the company, industry, and macroeconomic factors.
Research companies by reading their annual reports, financial statements, and press releases. This helps understand the company's financial health, future prospects, and any potential issues.
Understanding the industry and macroeconomic factors is important. These can impact the company's performance. Healthy companies operating in declining industries can find it challenging to remain profitable.
Now, create a list of say 10 companies that you think have good potential.
(2) Calculate valuation
We now need to determine the intrinsic value of each company in the good potential list.
We can use several calculation methods to determine the intrinsic value of a company. For example:
Discounted cash flow analysis
Price-to-earnings ratio
Dividend discount model
Historical financial statements required for intrinsic value calculations. These include:
Balance sheet
Income statement
Cashflow statement
(3) Assess management capabilities
We want to invest in companies with a strong management team.
They need to have proven good track records of running the business.
Ability to make sound business decisions and implementing successful strategies are important.
Assessing the management team's track record is a key step in value investing. This help us to determine the company's future prospects and growth potential.
There are a few ways to assess the management capabilities:
Read management comments in financial reports
Listen to management's quarterly result presentations and Q&A
From the good potential list of 10 companies, let's assume we removed 2 because management team did not make the cut.
These can include not delivering on business guidance or wrong decisions recently. So, we are now down to 8 companies.
(4) Check margin of safety
The margin of safety concept is central to value investing.
Margin of safety refers to the difference between the intrinsic value and price.
The margin of safety provides a cushion against unforeseen events and market turbulence.
Value investors look for stocks with margins of safety of at least 30%. This means that the stock price is at least 30% below its intrinsic value.
From the filtered down list of 8 companies, we now check each of their Intrinsic Value vs. Latest Price.
If Latest Price / Intrinsic Value < 70%, then these are good candidates for value investors to BUY.
Let's assume we are lucky and found 2 out of 8 companies in our list of good companies from Step (3).
Next step will be to:
BUY the 2 companies with price at least 30% below its intrinsic value, then check-up on them once a month
Put the remaining 6 in the Monitoring list, setup price triggers, and check-up on them once a month
Best practice is not to use more than 10% of your investment capital in a single stock.
(5) Invest long term
Successful value investing is a long-term game.
It’s essential to focus on the long-term outlook of the company.
We should avoid getting distracted by short-term fluctuations or market noise.
Value investors believe in the idea of “buying and holding.” Buy companies that you believe will grow over decades and hold on to their shares for the long-term. This investment strategy allows for the power of compounding to work over time.
Recalculate the Latest Price / Intrinsic Value of each stock during monthly portfolio check-up.
When Latest Price goes much higher than Intrinsic Value, value investors can Sell.
This allows value investors to capture the profit and reap rewards from investing.
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