Some things just go together. Adele and singing a powerful ballad. Lebron James and playing basketball. Warren Buffett and investing in stocks.
But while Adele and Lebron regularly do their thing, Buffett is content to sometimes avoid investing in stocks. Of course, the Oracle of Omaha bought 19 shares to Berkshire Hathaway‘s portfolio in 2022 (which we know so far, anyway). However, it cannot be ruled out that Buffett may buy few or no stocks in the new year.
The reason is that the legendary investor has a very strict test that he applies before buying even a single share of a company. Take Buffett’s advice: don’t buy any stock in 2023 unless it passes this critical test.
Image source: The Motley Fool.
The two stages of Buffett
Buffett wrote to Berkshire Hathaway shareholders in 2013 that he and his longtime business partner, Charlie Munger, used essentially the same approach to buying stock as they do to acquiring entire companies. There are two steps to this process:
- Estimate the company’s profit range five or more years into the future.
- Buy the stock if it is available at a reasonable price, relative to the lower end of the estimated earnings range.
There is an important word that Buffett used with the first step in this process. He wrote that he and Munger needed to determine if they could sensitive estimate the profits of a business.
Anyone could pull off profit projections out of the blue. Buffett, however, would insist that detailed research and careful analysis be done to estimate profits.
Note that it specifies that a range of earnings is estimated. The multi-billionaire knows that it is impossible to accurately predict the future profits of a company. The best anyone can do is determine a realistic range.
The period of five years or more in the future is also essential. Companies might be able to generate strong profits in the short term, but unable to do so in the long term.
dig deeper
An obvious question about Buffett’s two-step process is: how can an investor estimate a company’s earnings range? The most important prerequisite is that you understand the business well enough to make an informed estimate.
Buffett emphasized this in his 2013 letter, stating, “However, it is essential that we recognize the perimeter of our ‘circle of competence’ and stay well within it.”
The best place to start estimating future profits is to look at the financial state. Look at current and past earnings to get a baseline. Check the balance sheet to make sure debt service isn’t hampering earnings growth.
Examine industry trends and the competitive landscape. A company that dominates a rapidly growing market will have a better chance of increasing its profits than a company with a lot of competition in a stagnant market.
Also, don’t hesitate to look at the earnings forecasts of Wall Street analysts. Remember that the goal is to estimate earnings for at least five years into the future and not just for the next few quarters.
There is also another question that needs to be addressed: what is a reasonable price, relative to the lower end of the estimated revenue range? This will vary as the business grows. However, the average estimate of the price/earnings ratio of the S&P500 dating back to 1950 is 19.6. A stock that is trading well below this level, relative to the low of its projected earnings, should be reasonably priced safety margin.
Two stocks that pass the Buffett test
Are there any stocks that pass this Buffett test in 2023? I think so.
I’ll put western oil (OXY 1.14%) on the list without doing a detailed analysis. Buffett clearly thinks the oil and gas producer is reasonably valued relative to its future earnings potential, as it recently bought a large chunk of Berkshire stock.
If we only look at the stocks that Buffett doesn’t own, I think Medical Properties Trust (MPW -0.80%) (MPT) stands out. The Healthcare Real Estate Investment Trust (REIT) leases properties to hospital operators.
Analysts believe it can increase earnings by an average of 6.5% per year over the next five years. I think that’s a feasible estimate, given that MPT has grown its revenue by more than double that rate over the past five years.
But let’s be more pessimistic and assume that MPT only increases its profits by 3% per year over the next five years. The stock is trading at around 4.6 times that lower projected earnings. It’s an attractive value that I think makes MPT worthy of serious consideration, especially with its hefty 10.5% dividend yield thrown into the mix.
Maybe Occidental and MPT won’t offer good returns. Buffett himself acknowledged in his 2013 letter that he sometimes makes mistakes. If he does, you and I will too. However, only buying stocks that pass its critical test should prevent disastrous mistakes.
Keith Speights has positions at Berkshire Hathaway. The Motley Fool fills positions and recommends Berkshire Hathaway. The Motley Fool recommends the following options: January 2023 long calls on Berkshire Hathaway $200, January 2023 short calls on Berkshire Hathaway $200 and January 2023 short calls on Berkshire Hathaway $265. The Motley Fool has a disclosure policy.
0 Comments