You have most probably heard of Warren Buffett, one of the world’s richest man, and his incredible story of investment success. The secret to his approach has been a subject of many books, films and publications and continues to appear in news papers headlines till this very day.
Warren Buffett’s unique long-term outlook focuses on company fundamentals, including earnings and growth potential in his analysis as the basis for investment choice, focusing on companies that have value and are expected to continue to generate and deliver that value to its investors in the future. The challenge here is actually identifying such companies for you to invest in. There is no universal recipe for that, however below you can find a list of things you might consider to help you to create such a portfolio on eToro.
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Value Investment and the Long-term outlook
Warren Buffett’s strategy focuses on investing into companies that demonstrate fundamental worth, a promising result and provide value rather than trading rapidly and focusing on making a profit on short-term fluctuations of the market. This type of investing includes purchasing securities which are valued too low according to how much they are actually worth intrinsically and are therefore traded at discount. That may appear controversial to those who believe in market efficiency and the fact that markets already incorporate all the available information in their valuation. Warren Buffett considered companies and their potential, rather than focusing on temporary market movements that affect stock prices; in many ways he regards his investments as investments into the actual business and not simply its stock. He therefore focuses on the long-term company performance, its anticipated returns and assumes that any market and economic movements only matter in the short-term. The challenge here is to detemine how much actually the stock is worth as there is no universal approach to determening that. For that reason the first aspect Warren Buffett focuses on is whether the company is actually easy to analyze. These are usually public companies with transparency in terms of operations, financial performance, goals, strategy and products/services provided. He then moves onto looking at their financial performance, company’s strategy and business approach in order to estimate its ‘actual’ value. The strategy then compares the estimated or intrinsic value of a share to its current price on the market and a decision on whether it should be added to a portfolio is made. Let’s look at this step by step.
Let’s start with assessing a company’s value.
Company’s Financial Performance
A good starting point of evaluating a company is through its financial performance and associated metrics. Some of the key company performance indicators are available on eToro under the ‘Stats’ section.
Warren Buffet closely considers ROE (return on equity) which is a direct indication of shareholder’s return on investment. ROE is calculated by dividing a company’s net income by its shareholder equity. It indicates company’s ability to make a return using the capital provided and preferrably a company should be able to generate good returns without embarking on too much debt. Return on investment (ROI) is obtained by dividing net income by investment and is a pretty good demonstration of investment’s efficiency or profitability as compared to alternatives. It is perhaps a good idea to consider these statistics in comparison to the industry level as a whole as each industry has its own benchmark for a good level of ROE and ROI. Although good past performance of the company is not an indication of its continuation, an analysis of historical return on equity from the past 10 years should be a good indication of consistency on average. Buffett overall tends to favor companies that demonstrate a strong trend of increase in earnings. That is perhaps the most obvious indication of a company’s growth potential and its ability to continue to generate returns for its shareholders.
ROE and ROI are not the only things you should look at. Warren Buffett also sees dividends as a way for the company to thank its investors for providing capital and favors stocks which are able to pay this kind of income. Dividends many times are viewed as positive signal of company’s health and also provide investors with a cash flow which they can choose to re-invest, compound on or use for any other purposes.
2. Debt Levels. Debt levels are important indication of company’s health and its ability to survive in the long-term. A company that has too much debt may face additional risks of not being able to meet its interest payments or have sufficient cash on hands needed for operations after doing so. Debt is not necessarily a bad thing as they could potentially be a chaper and more effective way to finance the company, as long as the company is able to maintain its operations in changing market conditions. Debt-to-equity ratio (D/E) is quite a common ratio used for such purposes; a low D/E is an indication that the company is generating earnings from the equity provided by shareholders rather than from debt it borrowed from external parties, which is something Warren Buffett considers important. You can also have a look at a company’s debt quantities in comparison to the total assets it owns on its balance sheet. eToro provides these values on the 4 latest quarters or 4 ultimate years, depending on your analysis.
3. Profit. Profit margin is another important statistic Warren Buffett pays attention to and it shows the extent to which business operation can actually make money, the ability to turn revenues into profits. It is not only an indication of company’s ability to sell and generate revenue but also ability to control its cost and avoid unecessary expenses. Like with other financial metrics, it is a good idea to consider a company’s net profit margin in comparison to its peers in the same industry or perhaps an industry index.
4. Company as a whole
One of the most important, if not the most, important factors in company’s ability to generate shareholder value is the type of product or service it provides, as well as the overall strategy and ability to outperform its competitors. Warren Buffett tends to avoid companies whose products are very similar to its competitors and are unable to maintain customer interest by offering innovative desirable solutions. In other words, he believes that companies with competitive advantage are more likely to be successful in the future. Companies with a clear strategy and pricing power that manage to attract and retain customers through the creation of a powerful brand providing quality output might be considered; it is important that the company is able to stay afloat and profitable despite the possible negative economic conditions. In fact Warren Buffett’s outlook focuses on identifying whether the company was and will continue to generate shareholder value and therefore pays closes to historical performance, observing how it managed to operate in different economic conditions.
You might also consider the economic value added metric. EVA measures financial performance by taking operating profit and subtracting costs of capital, as well as adjusting for any taxes; it is considered to be the ‘true’ profit of a company. Warren Buffett considers something called the ‘owner earnings‘ as a way to realistically portray the cash position of a company. It is calculated by taking earnings, adding depreciation and amortization and subtracting annual capital expenditures for plant and equipment.
Company’s management is of course one of the key determinants of its success. An investor may ask, does the management act rationally in the best interest of its owners? Does it waste resources or does it thoughtfully re-invest its earnings into successful projects and investment opportunities? All of these factors determine how effectively capital is allocated within a firm in the long-term. You can find a quick introduction to the company in its ‘Feed’ and also in the company profile under the ‘Stats’ section.
5. Future value of a company
There are many ways to estimate the future value of a company. Projecting earnings which are expected in future and determening their present value is one of the most common ways to do so; discounted cash flow model (DCF) is a very common one, which estimates future cash flow values of a company and discounts them back to the present value of a company, taking inflation into consideration. Data on cash flow from the latest 4 accounting quarters or 4 ultimate years is available on eToro, however you might consider looking at company’s financial reports over a longer time period to evaluate consistency.
Earnings multiplier is another common metric, taking profits as the main indicator of a company’s financial success, adjusting price to earnings ratio to interest rates currently available on the market. Trading multiples approach compares the current value of a business to its peers in the industry through common ratios like P/E and EBITDA. Book value and liquidation value could also be considered, however they do not really account for the future profit generating potential of a company and focus mainly on the current value of assets it holds, so they are a less informative indication of future value of a company.
Is the company undervalued?
Now that we have considered all of the above criteria we can form an idea of what the company’s value is according to them and whether the market is currently undervaluing it.
Estimating company value
Determening the intrinsic value of the company and deciding whether it is undervalued is the perhaps the most difficult task in this process. Fundamental analysis and consideration of things like revenues, profits, assets held and all other factors mentioned above could be a focus point.
Once you determine the intrinsic value from the criteria above it can be compared to the market capitalization of this firm (product of current share price and the total number of shares outstanding), which is an indication of what the market thinks the company is currently worth. Any investor is looking for a return and this gap between the estimated value of a company and its current price on the market constitutes the margin of safety for an investor. The level of safety margin depends on your own degree of risk aversion; accounting for it allows for a ‘cushion’ in case of any mistakes made in your analysis, but is of course not a guarantee of future success. Because the company’s stock is purchased at discount, another source of return is the realized growth in share price an investor anticipates over time. Once you have identified of several companies that provide this opportunity, it is possible to combine a portfolio consisting of several of them and allow them to deliver returns over a long time period.
Although it many ways similar, Warren Buffett’s strategy is not exactly a buy-and-hold one. Buffet chooses companies and holds their stocks as long as they satisfy his selection criteria and maintain the value he believes the company has. However, this strategy is not about reacting to every short-term market volatility either. Financial markets are constantly operating and changing asset prices, so prices of these assets tend to be much more volatile than the actual fundamental value of the business in most cases. What matters to Warren Buffett is the long-term vision and expected performance and not temporary changes caused by investor behavior. A strictly long-term outlook is of course a very inflexible approach which might lead to you to miss on short-term opportunities on the market. Of course you can always adjust the strategy to your own needs and that is also what Warren Buffett advocates. For example, if the company demonstrates a promising fundamental value yet market volatilities cause the price to drop temporarily while you anticipate it returning to the correct higher level, an investor might consider using the opportunity to purchase additional shares of this company at a cheaper price. That is given that their valuation is correct and they are ready to undertake risks associated with entering such trades.
Of course hand-picking stocks and rebalancing your portfolio is a lengthy process, so an alternative could be investing into index funds with low costs and there are plenty of these as well as other ETFs available on eToro for you to choose from. Indices combine different instruments that track the performance of an industry or a market sector, replicating performance of a particular benchmark; some of the most famous ones include the US S&P 500 and NASDAQ 100 or the European EUSTX50.
Apart from saving on time and effort in case you lack the necessary skills and knowledge, such funds also offer diversification and a broader market exposure, but their comparative returns do tend to be quite low.
An important aspect which Warren Buffett’s approach considers is the psychology of trading. Making decisions based on emotions such as panic or greed may lead to irrational behavior and make you change the original criteria and values of your investment process. This also involves the attempts at timing the markets or engaging in too much risks and focusing excessively on the surrounding economic conditions. Buffett also notes the importance of investing into companies which he actually understands, being able to determine how they derive value, what kind of products they provide, associated expenses, pricing process, capital structure and so on. This can also help you control your emotions and make the analysis process smoother. It also makes it easier for you to stay on top of news and trends in the industry, making research and rebalancing processes easier.
Of course even such a successful investor as Warren Buffett made mistakes in his journey as any investment bears risks. Buffett, in his adherence to the strategy of focusing only on the companies he understands, widely avoids the technology sector, preferring more traditional types of businesses. Many times that is because the products or services they offer are innovative and therefore hard to compare or predict their future performance, as well as these companies tend to lack physical collateral basing their value on intangible assets mostly. That may be quite an outdated outlook as in the future these companies are likely to provide investors with returns due to the fact that the technology sector is growing at an exponential rate. Another potential opportunity such approach may ignore are the overseas companies, which are not very easy to analyze. The number of successful companies from emerging economies such as China is rapidly increasing, yet obtaining information on them is not very easy for international investors.
At the end one big risk to understand here is that despite the accuracy of your metrics analysis, estimation of a company’s true worth is still a very subjective and imprecise matter. Every investor uses a different set of parameters and methods for calculating firm’s value and many times this leads to imprecision and errors. It is also very hard to anticipate company’s future revenues which are so important in valuation; there is always a risk of extreme unexpected events happening which one cannot possibly account for.
As you might have realized, Warren Buffet’s investment strategy focuses on ignoring short-term volatitlies on the market and focusing on the long-term value a company can generate and it is definetely not for every investor. The success of this strategy ultimately depends on your ability to choose the correct analytical tools and interpreting metrics you are considering in your analysis, determining the worth of a firm and identifying whether it is currently undervalued by the market. Holding a portfolio in the long-term is also a challenge to those in need of quick profits but could be an idea to consider for a long-term investment. Remember that any trading and investing involves capital loss risks and enjoy using the eToro platform! Good luck.
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