Warren Buffett: The SIMPLE way to generate a 30% return per year

Warren Buffett is universally regarded as the greatest ambassador of all time. In fact, he started his professional investing career at just 25 years old when he formed his investment fund. He put just $100 into that investment fund and has parlayed that into a net worth of over 100 billion dollars. All this to say that Buffett knows how to invest successfully.

Given this impressive track record, you would think that Buffett has some sort of secret that is unattainable to the average person; however, that's not the case at all. What is so impressive about Buffett is that he has accomplished all of the success by following a very simple investment approach. In fact, Buffett's investment strategy can be boiled down to a simple checklist that I'm about to share with you during this video.

I've been studying Buffett for years and have read nearly everything he has ever written and every interview he has given. I'm boiling down everything I learned from Buffett into this one video. All I ask for in exchange is for you to hit that like button and subscribe to the channel because our community of investors is approaching 200,000 people strong, and it would be even better with you as a part of it.

Now, let's get into the checklist. The Warren Buffett investment checklist can be broken down into four distinct sections: understanding the company and the industry it operates in, financial management and valuation. Each of these sections contains a series of questions that Buffett considers when evaluating whether or not to make an investment.

Let's start with the first section: understanding the company and the industry it operates in. The first question that I want to hit on is: Is this business understandable? In other words, am I reasonably confident I know what the business's cash flows will look like over the next five to ten years? There is a reason why this question is the first one on the entire checklist; it acts as a filter. If your answer to this question is no, don't spend any more time looking at that stock and move on to the next opportunity.

Warren Buffett refers to this concept as the circle of competence. Picture a large circle. If you don't understand a certain stock, it is considered outside of your circle of competence and falls out of the circle. Here, for Buffett, stocks like Apple, Coca-Cola, and Bank of America fall within his circle of competence, while tech stocks like Nvidia, Salesforce, and Netflix, for example, likely fall outside of that circle.

The second part of this question is important: Do you know what this company's cash flows are going to look like over the next five to ten years? One of the biggest criticisms against Buffett is that he doesn't understand technology companies. Buffett even openly admits that; however, what most people miss is that it's not necessarily that Buffett doesn't understand the technology company's products and services. Instead, Buffett can't predict what the company is going to look like in the next five to ten years. Technology, by its nature, is rapidly evolving. The companies that are dominant now could be out of business in a decade.

When Buffett says he doesn't understand technology stocks, this is what he means. Now, we'll touch on this later in the video, so make sure to stick around to the end. But a critical factor for investing successfully is being able to value a stock, and to do that, you need to be able to accurately predict how much cash that stock will generate in the future. If you don't know what the company is going to look like in 5 to 10 years, it is virtually impossible to make that estimation with any degree of accuracy.

Just as a quick aside, you can grab a copy of this downloadable PDF using the link in my description. I'm in the process of putting together a value investing course and want to know what you would want to see included, so fill out a quick survey and I will send you a copy of this PDF directly to your email as a thank you.

The next item on the checklist I want to talk about is: Does the company and its industry have favorable long-term prospects? Part of being a good investor is minimizing the number of mistakes you make. For the most part, Buffett has been able to limit the number of investing errors he has made over his roughly 70-year career, but with that being said, he has made a few notable poor investments. Buffet bought 28 local newspapers in the early 2010s for 344 million dollars; he then sold all of them in 2020 for just 140 million. He also bought Dexter's Shoe, an American shoe manufacturer, in 1993, but not too long after the purchase, the business essentially went to zero due to competition from lower-cost foreign imports.

Making matters worse, Buffett paid for the deal with Berkshire stock. Those shares would now be worth 15 billion dollars. And then there's Berkshire Hathaway itself. When Buffett originally bought Berkshire, it was a failing textile manufacturer. Over time, Buffett transformed the business, but the original textile operations are long gone. All three of these failed investments shared one main attribute: they were all declining industries.

Buffett likes to explain this concept by using the example of the horseshoe industry. Back in 1910, when people got around using horses instead of cars, it didn't matter whether you picked the best company in the horseshoe industry; your investment was going to turn out poorly because the industry was destined to all but disappear. Make sure when you're looking at a stock that isn't in the business of selling horseshoes.

Does the business have a moat? What is a moat? It is the advantage a company has over its competitors that allows that company to be more profitable than the competition year in and year out. Just like how, in medieval times, a moat would keep invaders out of the castle, an economic moat keeps rivals from putting a company out of business. There are five main types of moats: economies of scale, switching costs, intellectual property, network effects, and brand.

The majority of companies have no moat, some have one of these, and the best companies in the world have multiple. Take Buffett's investment in Apple, for example. Apple has economies of scale; due to its large size, Apple can produce products at a fraction of the cost that it would take a new company. Apple also has switching costs; if someone wanted to switch to a competing product, it would be a headache. Apple also benefits from having an intellectual property moat and network effects.

But where Apple really shines is its brand. Apple has one of the most loyal customer bases of any company. The iPhone has become a status symbol of sorts in many countries, and this allows Apple to charge premium prices and be significantly more profitable than its competitors. While stocks can go up and down in the short term for seemingly no reason, over the long term, it is nearly impossible for a stock to generate high returns unless that business has a strong moat.

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Now let's get back to the checklist. Let's go to the financial section and jump to the question: Is leverage conservative? Leverage is just a fancy word to say debt. Buffett has said countless times that he looks for companies that are able to generate high returns without using excessive amounts of debt. Whether a company has a lot of debt or a little amount of debt is relative to how much money the company is making.

One method I like to use is calculating the company's net debt to earnings before interest and taxes, or EBIT for short. This helps you get a sense of how much leverage a company has and if it's manageable. Let's use one of Buffett's biggest holdings, Coca-Cola, as an example. All of these numbers I'm about to say are in millions. At the end of 2022, Coca-Cola had $39,149 in debt. The company also had $9,519 in cash. To find a company's net debt, you simply take the amount of debt the company has and subtract out the amount of cash that is sitting on its balance sheet.

This calculation shows that Coca-Cola has a net debt number of $29,630. The company's earnings before interest and taxes, or EBIT, was $10,909. Just as a quick aside, this number is also referred to in some financial statements as operating income. Net debt to EBIT is calculated by taking our net debt number of $29,630 and dividing it by the EBIT of $10,909. This gets us a net debt to EBIT of 2.72 times. The higher this number, the more leverage the business is using, and the lower the number, the more conservative the leverage amount.

It's also important to note that different industries have different typical amounts of leverage. The leverage that is considered conservative is different for the consumer staple sector that Coca-Cola operates in compared to the real estate industry, for example. The next item I want to talk about is: Are profit margins better than peers? Margins are a measure of how profitable a company is, or put another way, for every dollar of sales a company makes, how much of that is left over in the form of profit. Profit margins vary widely depending on the industry.

Automotive suppliers can have margins in the low single digits, while on the other end of the spectrum, technology stocks can have profit margins of 30%, 35%, or even 40%. That's why it's important to compare a company's profit margins to that of its peers in the same industry. So, say you're analyzing General Motors stock, a company that Berkshire owns in its portfolio. GM had a 6.6% operating margin in 2022. Is that good or bad? Well, it depends on what its peers' margins are. Ford had an operating margin of 4.0% in 2022, Mercedes-Benz was at 13.6%, and then there's Tesla, which had an operating margin of 16.8%. All of this information is extremely important to know when you're analyzing a company.

Let's move on to the management section of this checklist. These questions are designed to help you better understand the quality of management that runs the company. Using an analogy, the company itself is the ship, while the management team is the captain of that ship that makes sure it's on the right path to reach its destination. One of Buffett's best quotes is that he wants a business so good that a dummy can run it because eventually one will.

With that being said, no matter how good the business is, management still has an incredible amount of influence over how successful the business and ultimately your investment will be. One of the most important responsibilities a management team has is what is referred to as capital allocation. This is essentially what management does with all the money that is left over in the form of profit. One of the most powerful things for a long-term investor to know about a company is how management approaches share repurchases.

One of the questions in this section Buffett has written extensively about share repurchases in recent years in his famous annual letter to shareholders. Here's what he had to say about it in the 2020 annual report: "The math of repurchases grinds away slowly but can be powerful over time. The process offers a simple way for investors to own an ever-expanding portion of exceptional businesses." Here's the math behind what Buffett is getting at: Let's say there's a publicly traded company named ABC Corporation. The company has 100,000 shares outstanding. You own 5,000 of those shares, and this means you own 5% of the entire company, calculated by dividing the number of shares you own by the total amount outstanding.

Here's what happens when share repurchases enter the picture: Let's assume that each year the company repurchases 4% of its shares. That means each year the number of shares outstanding decreases by 4%. At the end of year 10, there are roughly 69,000 shares outstanding. Even though you didn't buy a single additional share, your ownership stake increased from 5% all the way to 7.2%. This is a 44% increase without you having to spend so much as another dollar buying additional shares in the company. Share repurchases are an incredibly powerful tool if used correctly. That's why it's so important for you as an investor to understand how management approaches the topic.

Buffett has seen his ownership stakes in stocks such as Apple, Coca-Cola, and American Express increase dramatically over the years because share repurchases have been working their magic. Let's jump to section number four in the checklist: valuation. No matter how amazing the business is, it is not worth an infinite price. The premise of so-called value investing is based on buying a stock for less than what it is truly worth.

These two questions in this section help you determine that. The first one is: Is the company trading for less than its intrinsic value? Calculating a stock's intrinsic value is a whole series of videos in its own right, and as a side note, make sure to hit the subscribe button and hit that bell icon to make sure you get notified when I do release that series of videos because I'm sure you'll find those videos incredibly valuable.

Let's say you made it all the way to this part of the checklist. The company you're analyzing has met all the criteria so far. Based on your analysis, you determine that the intrinsic value of the stock is one hundred dollars per share, which brings us to one of the most important concepts I have learned from studying Buffett: the margin of safety. The margin of safety is the difference between the intrinsic value of a stock and what it is currently trading at. So, if you determine the intrinsic value of a stock is one hundred dollars and it's currently trading at seventy dollars, that thirty dollar difference represents your margin of safety. The larger the margin of safety, the better. All else being equal, a margin of safety helps you follow Warren Buffett's two rules of investing: Rule number one, never lose money; and Rule number two, never forget rule number one.

The second question in this section is: Has the company's valuation been overly determined by short-term concerns? This helps you better understand what is causing the disconnect between your estimate of intrinsic value and the current stock price. A company’s stock price can fall for a countless variety of reasons; however, these reasons fall into two distinct categories: permanent or temporary.

An example of permanent would be the newspaper industry example we used earlier in the video. If a newspaper company's stock price appears cheap, it's likely for a good reason—the newspaper industry is in structural decline. Each year, the industry gets smaller and smaller as more and more newspaper subscriptions get canceled. As the number of subscriptions dwindle, so do advertisers' willingness to pay for ad space in the newspaper. I think it's a fair assumption to make that about the decline in the newspaper industry is permanent.

On the other hand, a company’s stock price may decline significantly for reasons that are temporary. This is where you, as an investor, want to be. Buffett has made his fortune buying stocks that fall into the temporary category. Buffett buying the railroad BNSF is a perfect example of this. When Buffett announced that he was buying out BNSF in late 2009, it was during one of the worst periods for the U.S. economy since the Great Depression. As a result, BNSF's stock had gotten hammered as investors were worried about how the poor economy would impact the railroad industry. However, Buffett knew that this was a short-term concern; eventually, the economy would recover and the railroad would begin its growth and profitability.

Buffett bought BNSF for 26 billion dollars, and now that business is worth an estimated 120 billion dollars. There are countless examples of Buffett using short-term stock price declines to his advantage.

We've made it to the end of the checklist, so make sure to grab a free downloadable copy of the checklist using the link in the description. All you have to do is answer a few questions that should only take a minute or two. I'm in the process of putting together a value investing course and want to make it the absolute best on the market, so I need your valuable input on what you would want to see in that course. Plus, as a thank you for answering a few questions, you will get an early bird discount in a downloadable PDF detailing Warren Buffett's investment checklist.

Thank you for watching this video, and talk to you again soon.