I was at a group dinner with Warren Buffett about fifteen years ago and I asked him: what do you look for when you evaluate a stock?
His answer: First he thinks about the business and decides whether he can roughly estimate its key economic characteristics five to ten years out. If he can't then he eliminates them from consideration right there.
Here is a favorite example of Buffett's: How would you go about buying a farm?
Would you try to figure out what someone else would pay you for it later?
Or would you focus on how many acres it has, what kind of revenue you can get each acre to produce, what your costs will be and what the resulting stream of free cash flow will be to you as the owner?
Buffett does the latter, whether the business be a farm or any other.
Now, just because it's simple (and it is), doesn't mean it's easy. There are many businesses for which you just won't know enough to make a reasonable assessment of what the key variables look like in five to ten years.
Buffett and Munger put these in what they call their "too tough" pile.
So Buffett's investment process looks something like this:
- Reduce the universe of companies to those whose economics are predictable enough for him to roughly estimate ten plus years out.
- Eliminate those not run by competent and aligned managers.
- For the remaining (small) group of companies, estimate a conservative intrinsic value.
- Buy them when he can do so with a big margin of safety between the price and their estimate of value.
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