To many, Warren Buffett is the greatest investor of all time. Indeed, since he took control of Berkshire Hathaway in 1965, its stock has delivered an incredible return of around 155 times the total return of the S&P 500 index.
So what does Buffett do differently that gives him an edge over the rest of the market? Here's a look at some of the key aspects of his investment strategy.
Durable competitive advantage
One of the first things he looks for in a potential investment is a durable competitive advantage. Also coined by Buffett as an 'economic moat', a durable competitive advantage is a condition or circumstance that put a company in a favourable position in relation to its competitors. Think of Coca-Cola and Diageo as great examples of such companies. The strong brand power of their unique products allows them to generate consistent profits year after year, with little chance of competitors stealing market share.
By focusing on companies like this, Buffett invests in businesses that earn high returns on capital over a long period of time, rewarding shareholders well in the process.
In order to identify companies with durable competitive advantages, Buffett spends a significant amount of time analysing companies' financial statements.
One thing he looks for is a high gross margin, as this indicates that the company has the freedom to price the products or services it sells well in excess of its cost of goods sold. A lower gross margin indicates that the company exists in a competitive industry, where no one firm has a sustainable competitive advantage.
Buffett also keeps a close eye on a company's expenses, preferring thosr that have consistently low selling, general & administrative (SGA) expenses. Thosr that don't have durable competitive advantages suffer from strong competition and can show wild fluctuations in SGA costs as a percentage of gross profit.
Another expense that he pays attention to is research and development (R&D) costs. Often, what seems like a competitive advantage is the direct result of a patent or technological advancement and if that patent expires, or the technology becomes obsolete, the company may lose its competitive edge. As a result, the company may need to spend a significant amount on R&D to invent new products and this can affect profitability negatively. Buffett believes that firms that have to spend heavily on R&D have an inherent flaw in their competitive advantage, and therefore he generally steers clear of them.
Obviously, he pays close attention to a company's earnings, and he looks for those that have generated an upward trend in earnings over many years. He also pays particular attention to the 'net earnings' or 'net income' figure, as opposed to the earnings per share (EPS) figure, as the EPS figure can be boosted upwards artificially if a company participates in a share buyback.
Lastly, when Buffett is confident that he has unearthed a business with compelling prospects, he's willing to hold it for the long term. He understands that in the short term, sentiment can affect share prices, however, over a longer period, a quality company with a durable competitive advantage should outperform the market and generate superior returns for its investors.
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Edward Sheldon owns shares in Diageo. The Motley Fool UK has recommended Diageo. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.