Want To Invest Like Buffett? Here's How...

The internet is filled with articles (some better than others) that encapsulate Warren Buffett's guiding investment principles. In fact, entire books have been written on the subject.

Let's be honest. Reading them probably won't turn you into a stock market wizard overnight. Knowing Buffett's methodology is one thing – utilizing it successfully is a different matter.

But even professional ballplayers still spend time perfecting their mechanics in a batting cage. Being a great investor requires similar dedication. You might not become the next Warren Buffett, but you can still learn (and apply) his accumulated wisdom. After all, if you want to outslug the market, I can think of no better investor to emulate.

In fact, I spent some time recently discussing Buffett's rise with my Daily Paycheck readers. I've studied Buffett for years – and documenting his rise for my premium subscribers was like a trip down memory lane.

And fascinating though Buffett's biography may be, there are bigger questions that need to be answered. Most importantly: What type of companies does he invest in, and how can mere mortals profit from his approach?

Unfortunately, there is no simple answer to that question. Looking back over the past five decades, Buffett has made money on small companies and large companies, stocks and bonds, domestic and foreign firms, preferred shares – and even wagers on foreign currency and commodities futures contracts.

Yet, while it is difficult to draw up a formulaic investing approach based on Buffett's past stock selections alone, his comments and actions have yielded some very valuable insights. And by further analyzing the commonalities within Berkshire's portfolio, we can reverse engineer to determine the prized traits that Buffett searches for in a prospective investment.

So strap in as we do just that. Take some time to read this, re-read it, print it out and tape it on the wall in your office next to your computer (or wherever you trade).

I can't think of a better way to start off a new year...

6 Characteristics Of A Buffett Stock Pick

Most of Buffett's biggest winners share some (if not all) of these characteristics.

Warren Buffett meeting with President Obama in the White House.

1. Straightforward Business Models – Buffett has always gravitated to easily understood companies with recognizable brands and shied away from those that he feels are beyond his depth. If you can't define a business and explain how it generates revenue in a few words, then it might be difficult to estimate its intrinsic value or spot emerging threats.

Berkshire owns companies that make everyday products such as candy, soft drinks, and razors – not satellite missile defense systems. This guideline may limit potential opportunities, but it can also keep you from straying beyond your circle of competence and getting into trouble.

2. Proven Managerial Expertise – A business is only as good as the executives calling all the shots. Some are far more astute than others and can be trusted to maximize long-term shareholder value, while candidly admitting to mistakes.
Take a few minutes to ask important questions. Does the stock have relatively high insider ownership? Are management's incentives aligned with the interests of rank and file shareholders? Has the company made rational decisions with retained earnings or is it more interested in meeting arbitrary short-term earnings targets to appease Wall Street analysts?

Buffett places a great deal of importance on trustworthy management teams and usually keeps them intact after an acquisition.

3. Healthy Balance Sheets and Strong Returns-on-Equity – The best managers squeeze more profit out of every dollar at their disposal, which makes this tenant a direct reflection of the previous one. Buffett is a well-known advocate of return-on-equity (ROE), which gauges how efficiently a company is using the equity capital on hand to generate profit. Generally speaking, look for businesses with ROE north of 15%.

A close companion metric is return on invested capital (RoIC), which takes borrowing into account. On that note, Buffett typically avoids companies that rely too heavily on debt to expand. Over-leveraged businesses carry more risk, particularly in economic downturns.

4. Sustainable Economic Moats – This is perhaps the most important requirement. Buffett won't invest a penny in a business that lacks a defensible economic moat. In medieval days, wide moats encircling a castle would help protect the inhabitants from marauding invaders. Today, the same concept applies to businesses with defensive fortifications to help prevent encroachment.

Any profitable business making boatloads of cash is bound to attract hordes of imitators. That's particularly true of trendsetters with novel new ideas and disruptive products. Innovators may prosper for a while. But success always invites competition, which inevitably erodes profits and drives down industry returns toward the cost of capital.

Only businesses encircled by defensive moats can fend off competition, generate sustainable excess returns and create real lasting value for shareholders.

These moats are formed by competitive advantages such as protective patents and intellectual property rights. The wider and deeper the moat, the better protected the company. Buffett prefers them to be nearly "unbreachable." You'll find economic moats surrounding all of the world's greatest, most profitable businesses... Facebook, Visa, Coca-Cola, Wal-Mart, and more.

5. Consistent Free Cash Flow and Owner Earnings – As you probably know, I pay close attention to free cash flow (FCF). This is the pool of cash left over after deducting capital expenditures. Buffett relies heavily on a similar metric that he dubs "owner earnings."

As the name implies, owner earnings are what's left over for stockholders after all the bills have been paid in full. This pool (which can be substantially more or less than standard GAAP earnings) can be tapped for dividends and stock buybacks or retained for future acquisitions and expansion projects.

While capital requirements vary from industry to industry, look for companies that can convert more of their revenues to FCF than their peers.

As a corollary, it's often wise to steer clear of companies with cloudy or unpredictable cash flow forecasts. Not surprisingly, Buffett shuns hot IPOs, risky technology companies, rapidly changing industries, and nascent businesses that haven't yet proven they can successfully navigate a challenging operating cycle.

6. Attractive Valuation and Measurable Margin of Safety – Perhaps more than anything else, Buffett's remarkable success can be traced back to one core tenet: finding undervalued stocks trading for less than their intrinsic value.

Heavily influenced by Ben Graham, Buffett scrutinizes balance sheet assets and liabilities and has a keen eye for pricing disconnects. The wider the discount between market price and a stock's true value, the larger the margin of safety.

Keep in mind, a $50 stock might only be trading at $30 because the company is facing some short-term operating challenges or macro headwinds. So value investing usually requires patience and a long-term perspective – and a willingness to go against the crowd.

But you can't argue with the results.

Action To Take

Stocks like that meet these criteria don't exactly grow on trees – which is why Buffett has a very concentrated portfolio. Historically, about three-fourths of Berkshire's assets are in less than 10 holdings. And he isn't distracted by market-driven selloffs, paying more attention to the firm's operating fundamentals.

Also, keep in mind, the things I discuss above are just a brief overview. The list is by no means all-inclusive. There are other criteria that Buffett will weigh. Are the industry economics compelling? Has the company differentiated its products, or does it sell commodity-like items with little pricing power?

But if a prospective investment checks off all these boxes, then you might have a Buffett-worthy portfolio candidate. If nothing else, you'll be investing in a mature, well-run, undervalued business with competitive advantages that yield lofty returns and excess cash.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.