Buffett became a billionaire by investing in stocks, and his method is simple. It’s about buying stocks that are cheap.
Yes, thanks, that sounds easy… But stocks in which kinds of companies? What are the criteria for selecting them? What are the rules?
Here are the investing principles boiled down to five simple rules.
Rule number 1: The Company Must Be Stable
Both revenue and profit should be steadily rising.
This sounds obvious – but a lot of private investors already err here.
They buy stocks in the latest fad, maybe an IPO or a biotech company, without checking whether the company makes a profit. Or they might buy shares in something that they really like or even fall head-over-heels in love with, like Tesla (“what a nice car, and it’s good for the environment!”) without realizing that it’s running on a deficit (Yes, Tesla is losing money).
If there’s no profit, there’s no stability. It’s hard to predict the future, and that makes it hard to assess the value of the company.
Rule Number 2: The Company Must Sell Something You Understand
Buffett says you must invest within your field of competence. This means you need to understand whatever service or product the firm sells.
Lets use the biotech example again. Very few investors really understand what a biotech company is trying to develop. It’s too complicated even for the specialists; if you’re a scientist, you have no real knowledge of the trials within the company.
This means you have no idea what a future product would look like or whether it might be better than a competitors, because it doesn’t even exist yet.
Rule Number 3: The Company Must Have a Future
You should be very sure that the company will be bigger in 10 years. How can you be sure of that?
You can be fairly certain that the company will grow if it’s protected by competitive advantages like economies of scale, switching costs, toll bridge, patents or secrets. If you want to know more about competitive advantages, you can read my free e-book here.
Is that the case in a biotech company? Can you be sure that they will be bigger in 10 years? If they haven’t developed any products yet, you have no idea whether they’ll even exist in 10 years.
Rule Number 4: The CEO Must Be Trustworthy and Competent
How do you know if the management is trustworthy and competent?
When it comes to trust, you have to use your social skills – just like you would use them when meeting people in real life. Watch videos, read interviews and, if you can, meet them in person. Trust your gut feeling.
When it comes to competence, look at the numbers. By numbers I don’t mean the stock price. I mean the company’s annual and quarterly reports and its track record. If the manager is new to the job, go back to his previous job and look at the numbers. What numbers, you might ask:
Apart from growing revenues and profits, here are some specific things you should notice:
- Are they buying back shares when the stock is cheap or expensive?
- What’s the level of compensation? Is it at a fair level?
- How high is long-term debt? Can they pay it back within a few years with free cash flow?
Rule Number 5: The Company Must Be on Sale
You must buy shares when the company is on sale. Even the most wonderful company can be a lousy investment if you buy the shares too expensive.
Buffett says that it’s like buying 1 dollar for 50 cents and that only some people get it. If someone doesn’t get it right away, you’ll never be able to explain it to them.
Do you get the concept that because the stock market is not efficient, you can buy stocks for less than they are worth?
It’s really worth exploring, because knowing how to spot cheap stocks can make you super rich.
Don’t forget the e-book Free Yourself. It’ll teach you how to calculate how much a company is worth. You cane get it for free here.