Warren Buffett is known as the “Oracle of Omaha” and, for those of you who don’t know him, Buffett is widely considered one of the most successful investors of the 20th century.
If you wanted to invest like Warren Buffett, the miraculous owner and CEO of Berkshire Hataway, what are the criterias you would have to use to choose the right stock to invest in? In this short series of videos called “How to invest like Warren Buffett” I’m going to explain to you exactly that. After reading these posts or watching these videos, even if you don’t have any background in finance or if numbers so far are a nightmare to you, you will be able to easily analyze stocks following the basic principles of value investing and you will learn how to understand financial statements of all the companies in the stock market. So stay tuned, subscribe to the channel if you find any value in my videos, and get ready for a deep dive into the art of stock picking.
Of course none of us knows exactly every step inside Buffett’s mind when he picks a stock that he is going to invest in, but we do know the fundamentals of his “Decision making” thanks to his millions interviews, thanks to dozens of books on the matter and thanks to his shareholder letters and this is exactly what we are going to explore in these videos.
And a second disclaimer here: there are certain things that people like me and you can learn and apply as private investors, and this is going to be the content of these videos, but we need to make things clear about the fact that the reason why Warren Buffett is so rich is not simply because he can find cheap stocks to buy. Warren Buffett doesn’t buy stocks like you and me. He doesn’t look at a trading app and say, “Oh! Amazon dropped 7% yesterday, I better buy some shares.”
No, Warren Buffett always gets a special treatment over everyone else because of his status and because of ways that we as private investors aren’t able to leverage. As a powerful person running a powerful company you are not subjected to the standard framework under which people like me and you buy stocks at the market price. No, you make private deals, you buy preferred stocks, you make special arrangements with the companies you buy.
Nevertheless, as a private individual with the interest to buy stocks you need to be able to evaluate if a company is worth investing in and there is no better way than the principles of value investing that Buffett preaches and that we are going to describe in these videos.
Now, to give you an overview, the four main topics we’ll cover are:
- DCA, aka Durable Competitive Advantage, which is the most important concept behind Buffett’s investment style
- How to read Income Statements
- How to read Balance Sheets
- How to read Cash flow Statements
We are going to find out why this Durable Competitive Advantage is so relevant for successfully picking stocks and what we have to look for, in order to find a company that has one. In the upcoming videos of this series we’ll go more in detail on how to read financial statements to pick stocks and how to find a durable competitive advantage based on these statements.
Buffett’s background and philosophy
As you may know, Buffett follows the Benjamin Graham school of value investing, which looks for companies that at the moment sell at a price which is lower than their intrinsic value. Said like this it does sound overly simplifying, in fact it is. Although Buffett learned value investing from his professor Graham, Buffett developed his own investment strategy which differs from the one of his teacher.
It’s not just about finding a company that sells under its intrinsic value, it’s about choosing the perfect company which can give you or Buffett, with a high grade of certainty, the best long term yield. To explain this in other terms: you may be able to find a company that sells at a price that is lower than its real value, but if the company doesn’t have the potential to grow in the long term as much as you want it to grow, it’s still not going to be a good investment.
An Introduction to Durable Competitive Advantage
Now, Investors like Buffett trust that the market will eventually favour quality stocks that were undervalued for a certain time. He manages to find great companies that, for some reason, are undervalued, and at the same time present an overall potential, as a company, to grow strongly in the future. How does he do that? He looks for companies that have a so-called Durable Competitive Advantage.
I don’t know about you but In the last 1 or 2 years youtube has been storming my phone with ads of Trading Apps, with which you can trade stocks in a matter of seconds and you are brought to believe that day trading is more profitable than long term investment. Well, needless to say that I really don’t agree with this and neither does Warren Buffett. The biggest investors of the world are long term investors and therefore are much more focused on the company as a whole than on the fluctuation of the stock market, which are always emotional fluctuations.
I’ll make another video about advantages and disadvantages of day trading VS long term investing, right now let’s assume that we all agree that long term investing is the right way to go.
So if I need to invest long-term, one of my goals is to avoid having to sell and rebuy many times in the future. Right? My wish is to buy stocks of a company and keep them possibly for my entire life. This way, you never pay taxes and the compound growth applies on a non taxed sum. If this is my goal, then I need to have a way to be as confident as possible not only that the company sells cheap, but will also give me a great return for a long period of time, in the best case for life.
So how do I find this? One of the most established methods is to find companies with a so-called Durable Competitive Advantage, or “MOAT” as Buffet calls it, and this is exactly what Warren Buffet does.
What is a Durable Competitive Advantage?
Durable competitive advantage is any advantage a business may have over its competition which is sustainable and protects the business from being taken over by competitors. It is basically a guarantee that the company will do very well in the long term.
Buffett calls this advantage a moat, a term he coined, which comes from the medieval moat.
The moat of a castle, in the medieval times, was a wide water body that surrounded the castle and protected it from being invaded. This analogy explains how a company can have a particular advantage that protects it from the threat of competitors.
Companies with durable competitive advantage consistently deliver strong growth, profits and returns to their shareholders, and this is exactly what Warren Buffett wants when he invests in a company.
As Warren Buffett says: “The key to successful investing is to determine if a company has durable competitive advantage. Companies with durable competitive advantage consistently deliver outstanding results for investors.”.
Now, to be more practical, let me give you some example of durable competitive advantage that a company might have over its competitors:
1. Selling a unique product
Whenever a Company creates something that is unique, it generates the so-called brand effect. An example of this is Coca Cola, which by the way is one of Buffett’s favourites, or Nike. These companies create something that becomes so famous and part of our daily lives that it’s like these companies own a piece of the consumer’s mind. And don’t tell me that Coca Cola isn’t unique because there’s Pepsi! It’s true, Pepsi is really similar but the way in which Coca Cola found a place in everybody’s mind and became basically as common as water is unbeatable.
2. Selling a unique service
Netflix, Moody’s, American Express. All these companies sell services that people need or desperately want. For selling services of course you don’t need any production plants, so the operational costs are lower and the company has better margin.
3. Low cost businesses
Low cost businesses, namely businesses that manage to sell non unique products at unique prices: Examples are Amazon, WMT, Ikea, Costco. These companies work with small margins and large volumes for ongoing needs.
So, as you can see there are different ways to be “better than the competition” and have a competitive advantage which is sustainable and durable. Warren Buffett believes there are just 2 types of companies:
Companies with a DCA, which will flourish over time, and companies which struggle year after year because they need to compete with many others similar, until one day they collapse or in best case scenario they don’t grow enough.
What factors affect the Durable Competitive Advantage (DCA)?
So, let’s explore this concept further because the more we know how DCA works, the easier we are going to recognize it while looking for investment opportunities. So one important question is “What kinds of DCA are there?”. Companies with durable competitive advantage have one or more of these factors in their business:
Behind every famous brand there is a veil of trust from the consumer. You want to buy that product because it’s a famous brand, and you know that it’s a famous brand because there is a certain grade of quality that makes it better than the competition.
As a result, Companies that manage to create a strong brand compared to the competition are more likely to flourish in the future because the customers are going to be intrinsically more attracted to them.
For Example: Most people like McDonalds over other fast food chains because they acknowledge the brand name, and the brand name means in this case that no matter where they order their burger, the taste and the overall experience is going to be consistent. Because of this consistency, people prefer visiting McDonalds over any other brand.
Moverover, because of this trust in the brand’s quality, these companies can command a premium pricing on their products, thereby increasing their profit margins.
2. Distribution Network:
Another way companies can create durable competitive advantage is by creating a strong distribution network, and this is the case of Amazon for example.
Amazon has such a strong distribution network that it can penetrate deeper in the market and reach a larger customer base, adding more sales and profit. The same is valid for example for McDonalds and any company that manages to create a distribution channel.
3. Intellectual property (copyright, patent, trademarks):
Another, and probably the strongest way companies can create durable competitive advantage is by creating intellectual property.
Intellectual property is whenever a person or a company generates and owns an idea, a concept, a project or a plan in the form of copyright, patents or trademarks. An example are pharmaceutical companies that have produced the Anti-Covid vaccine since 2020, like Pfizer BioNTech or Moderna, for which they filed a patent.
Generally speaking, being able to be present in the right locations creates a huge durable competitive advantage. Most main brands have their shops at the center of the biggest cities and of course this allows them to be always present where there are consumer’s needs, while smaller companies are forced to settle on the outskirts of the city.
5. Switching cost:
Another interesting concept which may result in a durable competitive advantage is the so-called Switching cost. Switching cost refers to how difficult it is for a customer to switch its preference from product offered by Company A to Company B. The higher the difficulty, the higher the switching cost.
To give you an example, if you are an Apple Iphone user, switching to an android may be difficult as you have to reload or copy all the apps, contacts, and other data from Iphone to android, and some of the files may not be compatible with the new operating system. Same thing with the iOs against Windows.
This gives a company an advantage because if they manage to attract customers then it’s going to be hard for these customers to switch to other competitors, unless they have a strong reason to do so.
Advantages of Investing in a Company with a DCA
So now we know some of the most common types of DCA and this is going to help us recognize, as also Warren Buffett does, if a company is worth investing in or not. In the next videos we will learn how to recognize a durable competitive advantage from the financial statements, but first there is an important question to ask: Ok, we understood that a durable competitive advantage makes a company harder to be beaten and therefore if we invest in it we have a higher chance to have good gains, but in reality what are all the advantages that we have as shareholders? How is it beneficial for us and why should you look for durable competitive advantage in a business? There are 4 possible benefits you can get:
1. High Earning Growth:
Any company that enjoys a high durable competitive advantage usually has high quality products and services. This allows such companies to increase prices and therefore their profitability over time.
Higher earnings growth, in return, leads to better and more sustainable price appreciation in stocks.
2. Constant Earning Growth:
When companies have a durable competitive advantage, their earnings growth becomes more stable and predictable.
Consistent growth of earnings makes it easier for you to make future projections about the earnings growth of the company 5 or 10 years from today.
3. Huge Free cash flow:
Another great benefit shareholders get by investing in companies with durable competitive advantage is that they enjoy huge free cash flows. Free Cash Flow is another really important concept for Buffett and value investors in general, and is basically the cash left with the company after paying for all the expenses incurred.
A lot of free cash means the possibility to invest in the business expansion to generate higher profits.
4. Good dividend pay-out:
Last but not the least, companies with durable competitive advantage sometimes distribute handsome dividends to shareholders. When companies have a lot of free cash, and do not have any foreseeable expansion plans, they usually use this extra cash to pay out dividends to shareholders.
Now, in this video we haven’t explored in detail the financial statements of the companies, which are of great importance when it comes to deciding in which company to invest, but we did have to invest this first video on this concept of the DCA because it’s just extremely important and even if you listen to Warren Buffett from time to time you’ll notice how often he repeats this concept.
So, let’s see, you know now what a DCA looks like, so whenever you come up with a company you’d like to invest in, ask yourself this question first: Has the company got a unique product or unique service that can be identified as a durable competitive advantage? If the answer is a yes, then the company has some economic moat.
The second question is “why does the company have this durable competitive advantage?” The higher the number of factors, the stronger the advantage. The final question is “how strong and durable is the advantage?”
Now if you want to learn in an easy way how to read financial statements of the companies and evaluate, through them, if it’s worth investing in these companies, keep following my videos of this series and don’t forget to subscribe to my channel to support me and to keep watching other videos like this. I hope you enjoyed the content of this video, if you did let’s meet again in the next one next week. Bye bye!