Affluent Savvy
Affluent Savvy
Photo: Alena Darmel
Warren Buffett's 4 Rules for Investing A stock must be managed by vigilant leaders. A stock must have long term prospects. A stock must be stable and understandable. A stock must be undervalued.
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Learn More »Warren Buffett’s 4 Rules for Investing I recently finished the book Warren Buffett’s Three Favorite Books and the course on Buffetts Book.com by Preston Pysh. I want to share some of the concepts and techniques that I found helpful. This post will introduce the 4 rules that Warren Buffett used for investing. Warren Buffett’s 4 Rules A stock must be managed by vigilant leaders. A stock must have long term prospects. A stock must be stable and understandable. A stock must be undervalued. Remember, all 4 rules must be met before a stock can be bought. Rule 1. A stock must be managed by vigilant leaders The biggest threat to a company is not being able to repay its debt, and hence bankruptcy. Companies usually borrow money to invest (e.g. acquiring profits-generating assets). However, debts are dangerous as no one can be certain that those investments will pay off in the future. Also, debts are costly because of their interests. In the good times when the investments pay off, the business will be able to repay the debts with interests. But in bad times (e.g. Covid-19), the company would have to spend the earnings or even liquidate their assets to cover the debts. A vigilant leader needs to make sure that the company is not running on more debt than it can safely afford. There are two ratios that show the company’s debt level — Debt to Equity Ratio and Current Ratio. Debt to Equity Ratio (D/E) D/E = Total Debt / Total Shareholders’ Equity. Let’s say you have a $100k house. To purchase it you paid $60k cash (equity) and borrowed $40k from the bank (debt). Your assets are worth $100k in total, and debt is $40k and equity is $60k. In this example, your D/E = $4000/$6000 = 0.67 If your D/E is high, that means you borrowed a lot of money to pay for your house. During the good times you might be able to pay the mortgages through your earnings. But in the bad times, say you lose your jobs, you might not be able to afford the mortgages and have to sell the property. The same logic applies to businesses and we do not want a business with too much debt. Warren Buffetts likes to see that the company has a D/E < 0.5. D/E can be calculated from a company’s balance sheet. Let’s see how this works using WOW.ASX. Calculating D/E for WOW.ASX As we can see Woolworths’ current D/E is about 0.3, which is acceptable. Current Ratio Current Ratio = Current assets / current liabilities Current assets = assets that are cash or will be turned into cash in less than 1 year. This might be your cash in hand, incoming rental payments this year, as opposed to the property, which you are unlikely to sell within a year. Current liabilities = what needs to be paid in less than 1 year. This might be your mortgage payment to the bank this year. The current ratio tells us if a company is able to cover its short term debt with its current assets. Warren Buffett likes a current ratio > 1.50. To find it, go to Morningstar > Key Measures Finding Current Ratio on Morningstar It seems that WOW might not be able to cover its liabilities due in 12 months with its current asset. That means it will be relying on its earning to pay off its current liabilities. This is a risk that we as investors should consider. Rule 2. A stock must have long term prospects Holding a stock for long term reduces the taxes we have to pay. As investors, we are taxed on our capital gains. Capital gains are the profit we made from selling the stock at a higher price. How capital gains are taxed might be different depending on which country you are in, but generally the longer you hold your stock, the less tax you pay. Here in Australia for example, if you hold your shares for more than 12 months, you can reduce 50% of the tax on your capital gain. Warren Buffett would ask himself whether the product or service that the business offers would be used 30 years from now. Goods like chocolates were around 30 years ago, and it’s easy to believe that people will still be eating them for another 30 years. On the other hand, we wouldn’t be so confident about emerging tech companies.
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Learn More »Rule 3. A stock must be stable and understandable If you are the bank lending money to people, you want to lend to someone with financial stability. You want to look at his/her asset value history, debt history, and earning history. If the lender’s earning or debt level is all over the place, it might be a risky deal. This is the same when you are investing in companies. When we calculate the intrinsic value of the company later, we use its past data to predict future growth. The more stable its history is, the more confident we can be in our prediction. When assessing a company’s balance sheet, we want to look for these good signs: Book value per share — hopefully steadily increase.
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Learn More »To summarise, we covered the 4 rules that Warren Buffett used before investing in a stock: A stock must be managed by vigilant leaders D/E < 0.5 Current ratio > 1.50 2. A stock must have long term prospects This can reduce the tax we pay. Ask yourself whether the business will still be around in 30 years. 3. A stock must be stable and understandable Book value per share — hopefully steadily increase.
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