“Stock God” Warren Buffett: ROE should be higher than 20%

Warren Buffett's investment experience and philosophy

When it comes to investment gurus, how can Warren Buffett (Warren Buffett) fall behind?! Born in 1930 in Omaha, Nebraska, Warren Buffett is known as the “Prophet of Omaha” and also known as the “stock god”. He is a highly respected and loved investment master, entrepreneur, billionaire, and philanthropist. Every year, a large number of fans travel the long distance to Omaha to listen to him speak at the Berkshire Company annual conference.

Buffett's father is a stock broker and a former member of the US Congress. Buffett was interested in investing and making money when he was very young, and people around him said he was a math prodigy. He made his first stock investment at age 11 and made a small profit from it. At age 13, he started his own business as a newsboy. In high school, he and his friend invested in a used pinball machine at an initial cost of $25 and eventually sold it for $1,200.

In terms of studies, he studied business at the University of Pennsylvania and the University of Nebraska, then studied with Benjamin Graham at Columbia University, obtained a master's degree in economics, and then continued his studies at the New York School of Finance.

After graduation, he worked as an analyst at Graham's Graham Newman Company, and founded Buffett Partners Ltd. in Omaha in 1956, gradually accumulating a fortune of one million.

He later fell in love with a textile company called Berkshire Hathaway, began teaming up with Charlie Munger and took control of the company in 1965, then gradually developed the company into a company that diversified investments in assets such as insurance, energy, utilities, transportation, manufacturing, and retail. This company is a bit like an investment tool for Buffett to realize his investment philosophy. Through this company, he buys mature but underrated companies and maintains a large share in leading companies.

What did he do when he had accumulated a great deal of wealth? In 2006, Buffett shocked the world by announcing that he would invest his wealth in philanthropy. 85% of the funds will be donated to the Bill and Melinda Gates Foundation (focusing on issues such as world health issues, American libraries, and global schools). Until then, he had also been doing charity work.

Other than acts of charity, there are too many famous quotes about Buffett that have been widely celebrated! For example, “You should invest in a business that even a fool can run, because one day an idiot will run it.” “Life is like a snowball; the important thing is to find very wet snow and long slopes.” “The first rule of investing is not to lose money; the second rule is to never forget the first one.” “If you're uncomfortable with owning a stock for 10 years, you shouldn't own it for 10 minutes.” “Be wary when others are greedy, and be greedy when others are wary.”

It is worth mentioning that he writes a letter to Berkshire's shareholders every year, which is regarded by the industry as a must-read classic. Robert Hagstrong's “Buffett's Way” also summarizes much of Buffett's investment wisdom.

So what exactly is Buffett's investment wisdom? He insists on value investing. He is always looking for risk-controlled investments. He emphasizes the company's intrinsic value (involving competitive advantage, financial situation, management team, etc.), and does not invest in companies he doesn't understand or is outside of his ability circle, emphasizes reasonable prices, safety margins, and focuses on long-term investment.

Warren Buffett's stock selection principles

So what lessons can Buffett's investment philosophy give us in terms of stock selection strategies? Let's take a look at his specific stock selection guidelines.

1. The book “Buffett's Way” summarizes 12 guidelines in 4 areas.

• The enterprise aspect includes a simple model, continuous and stable operation, and good long-term prospects. These guidelines are about “what is a good company.”

• The market aspect includes determining the market value of the enterprise and purchasing it at a discounted price. This comes down to the valuation and margin of safety part.

• Management aspects include management being rational, honest, and able to think independently. As can be seen, Buffett still values the management part very much.

• Let's focus on the 4 financial guidelines:

① Focus on return on net assets rather than earnings per share. Since the company usually keeps the profit from the previous year, then the profit per share will usually increase, so there is little point in looking at this value. Annual performance is measured by the return on net assets ROE (equal to net profit/net assets, that is, net profit/shareholders' equity), which represents how much net profit a unit of net assets can bring.

② Calculate the true “shareholder surplus.” Shareholders' surplus is actually free cash flow. It is obtained on the basis of net profit, plus depreciation, loss, and amortization, and then deducting capital expenditure. Use these metrics to find companies that generate more cash than they consume.

③ Look for businesses with high profit margins. High profit margins reflect both the ability of the company's management and the company's ability to control costs.

④ Every dollar of retained profit creates at least one dollar in market value. For example, if a company's retained surpluses over the past ten years add up to X, the increase in market value over the past ten years is Y, and if Y is less than X, it means that the company has not used retained profits effectively, and the company has regressed.

2. In a 1977 letter to shareholders, Buffett outlined his four principles for stock selection: understandable companies, good long-term prospects, talented managers, and attractive prices. These four basic principles are consistent with the corporate, market, and management standards mentioned above.

3. In a 1987 letter to shareholders, Buffett said that a good investment must meet the following two conditions: one is that the average ROE for the past ten years is higher than 20%, and the other is that the ROE for no one year in the past ten years is less than 15%. Buffett attached great importance to the ROE indicator.

4. Buffett has repeatedly mentioned in public that he values gross margin as an indicator. In Berkshire's long-term stock holdings, the gross profit margin (gross profit/operating income) is basically above 40%.

5. The debt/equity ratio (debt/shareholders' equity) is also an indicator Buffett will consider. A company with too much debt may mean that the company is too aggressive, so investors will have to take higher risks.

How do we apply these principles?

Based on Buffett's stock selection principles, how can we apply it to specific stock selection?

First, we can obtain the following quantitative indicators relatively directly:

1. ROE> 20%

2. Gross margin > 40%

3. Free cash flow>0

Also, with regard to “purchase at a discounted price” and “debt-equity ratio”, at the initial screening stage, we can separately assign them to price-earnings ratio and balance-to-debt ratio, which are easier to screen:

1. Price-earnings ratio: We usually compare this indicator with historical levels and industry averages. Well, here we can first set a valuation fraction of < 70%, and first ensure that it is not within the 30% range, which is the highest in history. Of course, you can also set this specific value according to your own judgment.

2. Balance ratio: The market generally believes that if the balance ratio is < 60%, the financial risk is more manageable.

What else can be done in specific practical terms?

Next, let's take US stocks as an example and conduct preliminary screening through the Bulls and Futubull Stock Selector.

Of the above 5 indicators, in addition to free cash flow, we can directly filter the other 4 indicators.

We selected 143 stocks through these quantitative indicators (based on November 7, 2023 data). Next, in Buffett's stock selection principles mentioned earlier, the qualitative part should come into play, including content related to corporate guidelines and management guidelines.

For example, of these 143 companies, Google is included. We have broken down this company in detail in the “Financial Report Season Guide for Star Companies” course. We can give you some information about its model, operation, prospects, etc., to help answer the question “is it a good company?” For other companies, you can also refer to some of the ideas in that course and disassemble them in detail.

Well, in the management section, we can see each company's specific management team under the individual stock profile tab to gather more information from managers to understand and analyze.

*Note: The images displayed on the screen are for illustrative purposes only and do not constitute any investment offer or guarantee.

I hope this content and extension about Buffett will be helpful to you.