Think Like Warren Buffett

Warren Buffett is probably the preeminent investor of our time. The combination of his investor returns, longevity, and folksy wisdom has made him very popular. Many small investors want to think like Warren Buffett. But what exactly does that mean and can you do it? I would argue it does not mean replicating his portfolio or his buys and sales though some investors may try. Buffett bought Coca-Cola (KO) and some other stocks decades ago when it was undervalued and expanding internationally. If you buy Coca-Cola today for the dividend and safety in order to copy Buffett’s portfolio, it is still the dominant soft drink company, but it is no longer growing as fast.

I have a written about Buffett before, but I am not an expert on him. You can read my recent article on Highlights from Warren Buffett’s Annual Letter for 2020 of from 2019. There are also biographies on the Buffett. But what does it take to think like Warren Buffett? Many investors try. Indeed, today, there is even a website with the same title as this article. It is unlikely that you will be able to replicate Warren Buffett’s success over an extended period of time. However, most everyone can still learn from him much like an everyday chess player can learn from reading about a Grand Master. The goal is to learn and improve your investing strategy and skill. With that in mind let’s see how we can think like Warren Buffett.

3 Things to Focus on To Think Like Warren Buffett:

Stocks Are a Business

Stocks are historically a piece of paper. Today, most of us trade online and stock certificates and record keeping are mostly digital. But stocks are more than that. Stocks represent ownership in a business. By buying a stock you are in investing in and becoming part owner in a business. So, the idea here is to think like Buffett you must think like as a business owner, which is long-term. Yes, you may be able to make profits trading on market volatility for stock price. But if you are thinking like a long-term business owner then are probably going to hold the stock for years. You will get a share of profits through dividends that you can reinvest and leverage the power of compounding.

Wait for The Fat Pitch

To think like Warren Buffett, you must wait for the fat pitch. This is an analogy to baseball where Ted Williams would wait for a pitch in the specific area of the plate where he had a higher probability of getting a hit. But Buffett’s thought process is much the same. He wants to swing for the fences when the right investment opportunity comes along. He suggests that investors act as if they owned a card with 20 investment choice punches in it. This would prevent investors from making bad investment decisions and improve their overall returns. The advantage of this philosophy is really only opportunity costs meaning you lost out on gains from an investment. There is no penalty. However, if you make a bad decision then you can lose your initial capital.

Intrinsic Value

To think like Warren Buffett, you need to be thinking about the intrinsic value of a company, which is how much is a business worth? The way Buffett looks at this is estimating future cash flows and then discounting them back to present time at an appropriate interest rate. This is a discounted cash flow calculation. There is a degree of uncertainty as future cash flows, and the appropriate interest rate are unknown. You must make some assumptions. There is a good article on how to calculate intrinsic value like Warren Buffett on nvstr (I am an affiliate of nvstr). The idea here is that if you buy a stock trading below its intrinsic value, i.e., a discounted percentage, are getting a deal. Once the market realizes the stock’s true intrinsic value the stock price rises. Of course, this requires patience.

Final Thoughts on Investing Like Warren Buffett

Thinking like Warren Buffett is simple in theory. There are numerous books and articles on him and his investing philosophy. In practice, it may prove more difficult since some investors may lack patience. Buffett is patient if anything. For instance, Buffett had unrealized capital losses at the nadir of the COVID-19 bear market but did not sell except for airline stocks. There is more to thinking like Warren Buffett such as margin of safety, ignoring market forecasts, reducing portfolio turnover, increasing your investment, looking at companies with wide moats, etc. However, I think the above three form the core principles of an investor seeking to think like Warren Buffett.

Chart or Table of the Week

Today I highlight Merck (MRK). Merck is large-cap pharma stock and one of the largest pharma companies in the world. Merck has a strong effort in development of oncology products. Merck operates in two segments: Pharmaceutical (~90% of total revenue) and Animal Health (~10% of total revenue). The stock is down about -9.5% year-to-date and simultaneously the yield is up to about 3.5%. A major risk is the cancer immunotherapy drug, KEYTRUDA, makes up about one-third of revenue or roughly $14 billion in sales. There is major competition, but drug does not lose exclusivity until 2028. Merck has raised the dividend for 10 consecutive years making the stock a Dividend Contender. The screenshot below is from Stock Rover*.

Source: Stock Rover*

Dividend Cuts and Suspensions List

I updated my dividend cuts and suspensions list at end of April. The number of companies on the list has risen to 523. We are well over 10% of companies that pay dividends having cut or suspended them since the start of the COVID-19 pandemic.

There were two new companies to add to the list this past month. These two companies were HollyFrontier Corporation (HFC) and AT&T (T).

Market Indices

Dow Jones Industrial Averages (DJIA): 34,757 (+0.66%)

NASDAQ: 13,814 (+0.47%)

S&P 500: 4,230 (+0.62%)

Market Valuation

The S&P 500 is trading at a price-to-earnings ratio of 44.9X and the Schiller P/E Ratio is at about 37.5X. These two metrics are up this past two weeks. Note that the long-term means of these two ratios are 15.9X and 16.8X, respectively. 

I continue to believe that the market is overvalued at this point. I personally view anything over 30X as overvalued based on historical data. Note that we are near or over 40X and valuation levels near the top of the dot-com era.

S&P 500 PE Ratio

Source: multpl.com

Shiller PE Ratio

Source: multpl.com

Stock Market Volatility – CBOE VIX

The CBOE VIX measuring volatility was flat this past week to 16.42. The long-term average is approximately 19 to 20.

Source: Google

Fear & Greed Index

I also track the Fear & Greed Index. The index is now in Fear at a value of 48. This is up 10 points this past week.

There are seven indicators in the index. They are Put and Call Options, Junk Bond Demand, Market Momentum, Market Volatility, Stock Price Strength, Stock Price Breadth, and Safe Haven Demand.

Put and Call Options are signaling Extreme Greed. In the last five trading days, put option volume has lagged call option volume by 60.54%. This is amongst the lowest level of put buying in the past two years.

Junk Bond Demand is indicating Extreme Greed. Investors are accepting 1.99% yield over investment grade corporate bonds. The spread is down further from recent levels indicating that investors are taking on more risk.

Market Momentum is indicating Greed. The S&P 500 is 7.19% over its 125-day average. This is further above the average than normal over the past 2-years.

Market Volatility is set at Neutral. The CBOE VIX reading of 16.42 is a neutral reading.

Stock Price Breadth is indicating Neutral as advancing volume is 13.38% more than declining volume on the NYSE. Market breadth is improving near the middle of its range its range.

Safe Haven Demand is in Extreme Fear. Stocks and bonds have provided a similar return over the past 20 trading days. This is close to the weakest performance for stocks over the past 2-years as investors move back into bonds.

Stock Price Strength is signaling Extreme Fear. The number of stocks hitting 52-week highs compared to those hitting 52-week lows is at the lower end of its range.

Source: CNN Business

Economic News

Federal Reserve Governor Lael Brainard in her remarks to the Economic Club of New York indicated that economic growth is expected to be the strongest in decades, fueled by fiscal support and pent-up savings accumulated during the pandemic.  However, there is the potential for growth to moderate if higher-income households return to pre-pandemic consumption levels. Brainard again reiterated that the sharp inflationary increases are expected to be temporary and are a result of supply-demand imbalances. Core PCE inflation is estimated to be 2.4% in April after adjustments.

The Federal Reserve’s May 2021 Beige Book economic conditions summary, prepared using data collected on or before May 25th, found economic activity expanded moderately in all Districts. Despite shortages of materials and labor, factory output increased. Low mortgage rates continued to drive strong demand for new construction, as purchases outpaced build capacity. Demand for professional and business services increased, while demand for transportation services was exceptionally strong. Many firms had difficulty hiring new workers, preventing some of them from increasing output. Selling prices increased moderately, while input costs rose more quickly as supply chain disruptions intensified cost pressures. Strengthening demand allowed some businesses, particularly manufacturers, builders, and transportation companies, to pass through much of the cost increases to their customers.

The U.S. Bureau of Labor Statistics reported the unemployment rate dipped slightly in May to 5.8% as compared to last month’s 6.1%  as 559,000 jobs were added, beating April’s revised total of 278,000.  Employment in May was still down by 7.6 million jobs as compared to pre-pandemic levels, with 9.3M remaining unemployed. Gains were reported in leisure and hospitality (+186,000), public and private education (+144,000), and in healthcare and social assistance (+46,000). Construction employment was down slightly (-20,000). The labor force participation rate was little changed at 61.6%, still down from 63.3% in February 2020.