Warren Buffett: how the world’s best investor chooses stocks

Warren Buffett is one of the most highly regarded investors alive today and he has a few simple methods for choosing which stocks to buy. James Reynolds details the three best lessons he’s learned from studying Buffett’s methods.

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

Buffett at the BRK AGM

Image source: The Motley Fool

Warren Buffett is without a doubt one of the best investors alive today. He is so well known that even people who aren’t interested in investing know his name. But how does he know which companies he should invest in and how is he right so much of the time? Luckily for us, he has imparted much of that wisdom into books, interview, and letters, all of which we can study today.

Circle of competence

A circle of competence is the subjects and industries in which an investor has a keen interest or understanding. We can’t all be experts in everything, but if I have an interest in a topic, I’m more likely to have an advantage when choosing which companies to invest in. Conversely, if I don’t have at least a reasonable understanding of a given sector, how will I know which businesses are likely to succeed?

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Warren Buffett has been criticised in recent years for not investing in the tech boom. But he has always stated that he doesn’t understand how tech companies work or, more importantly, how they make money. He instead focuses on business that produce products, like Coca-Cola or on banking, like with Bank of America. I for my part don’t understand anything about banking but have been very interested in renewable energy for years, so that’s where I focus my attention.

Another famous investor, Peter Lynch, echoed this sentiment in an interview he gave to CNN. “I know restaurant managers who invest in IBM, but I always ask why they don’t invest in restaurants. They know how the business works. They know if a restaurant is profitable and what sorts of challenges they face”.

Fundamentals

Another important part of Warren Buffett’s strategy is to focus on the fundamentals of a business. How does it make money? How much money does it make? Does it have a lot of cash on-hand or is it in a lot of debt?

All of this information is readily available to investors with a quick online search. Reading financial statements can be a little overwhelming at first (and sometimes quite dry) but the details of the business are there for anyone to see.

Buffett has always advised to stay away from companies with a lot of debt, and to aim towards ones with good cash flow.

If a company has a lot of debt, paying it down will cut into its profits. But if it has good cash flow and money in the bank, it can weather unexpected storms (like pandemics).

Warren Buffett is a patient man

Finally, Buffett is always happy to wait. This can be waiting years and years for an investment to become profitable. Or it can be waiting to even make an investment.

The man once compared investing to baseball, with one key difference. “In investing, there’s no-one telling you to swing.” Buffett is the first to admit he’s missed out on some good investments. But, when we’re using our hard-earned cash, it’s always better to be cautious; to wait for the perfect moment and the perfect company before making an investment.

There is no way to be absolutely sure of any investment, but understanding the business and knowing the sector can give investors a serious advantage. Patience can help us to wait for the perfect moment.

If it’s good enough for Buffett, it’s good enough for me.

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James Reynolds has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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