How to Find Undervalued Stocks the Warren Buffett Way

Warren Buffett is a living legend. He needs no introduction.

During his 54-year tenure heading Berkshire Hathaway, Buffett has generated consistent return for his shareholders.

His rules have redefined the world of investing.

His uncanny ability to distil investment ideas into simple and sound ground rules has made him a popular investment guru. Many investors around the globe try and follow these rules to emulate his success.

The Relationship Between Buffett and Value Investing

The Oracle of Omaha has always resisted the temptation of investing in what is supposedly going to be the 'next big thing'. No wonder he stayed away from cryptos!

He has this strange aptitude to always pick the top undervalued stocks that prove to be long term profitable investments.

To understand his investment mindset, we need to dig into his past.

Warren Buffett's investment principles were developed at Columbia Business School under the great value investor Benjamin Graham. His book 'The Intelligent Investor' is widely accepted as the bible of value investing.

Now you may wonder why Buffett's own company Berkshire Hathaway does not follow the advice he gives to other prospective investors. His portfolio contains stock investments in companies like Coca Cola, American Express, and Wells Fargo.

To the average investor, these stocks are definitely not undervalued, nor do they represent the principles of value investing that Buffett claims to follow as his guiding principle.

Well, when these shares were purchased, they ticked all the right boxes of value investing.

How to Find Undervalued Stocks the Warren Buffett Way

According to Warren Buffett, the way to identify undervalued stocks is through the practice of value investing.

This is essential to ensure that the risk of loss is reduced to a minimal. Most importantly, the principles of value investing are almost a fool proof investment style.

Generally, investors know Buffett as one of the best stock pickers. But you need to dig really deep to understand that value investing is not really about picking stocks.

It is Warren Buffett's style of thinking that leads him to pick undervalued yet profitable stocks.

This outcome is a by-product of value investing.

No doubt, your goal is to follow in his footsteps. To do that, you need to follow the three basic principles of value investing.

#1 Holding Time

In Warren Buffett's own words, his favourite holding time is 'forever'.

Here you need to understand the difference between a trader and an investor.

The trader buys stocks because they are only interested in gains for the short term or intraday trading profits.

On the other hand, investors look at long-term gains and buys stocks with the intention of holding on to them for years.

To be successful with the Warren Buffett way, investors must move out of the trader mindset and mould into the investor mindset, to begin with.

#2 Quality Stocks

Warren Buffett believes that 'if the business does well, the stocks eventually follow'. Hence the reason why Buffett only invests in companies that have strong and robust fundamentals.

Typically, these companies will be managed by a strong leadership team, will have a reasonably high promoter holding and can sustain themselves in the long term by having an edge over their competitors.

Finally, they must have an excellent range of product or service offerings and be loved by their customers.

These are the type of companies that will be in business forever.

#3 Undervalued Stocks

So, now you have the quality stocks that you have combined with a long term holding strategy. Will this be enough to deliver gains in the future?

Not always.

The problem with this strategy is that the gains will be average, and the holding time may be far too long.

Therefore, to make the strategy more fool proof, you need to integrate a third angle that will help you pick the right stocks.

This is known as price valuation which will help you find the best quality stocks that are undervalued and will yield profits in the future.

Buffett's Methodology to Identify Undervalued Stocks

Warren Buffett will only purchase quality stocks that are available at discounted price levels. But the question is how will Buffett or anyone else for that matter know if the price is discounted or not?

To understand the price valuation of a stock, Buffett looks at the following.

#1 Intrinsic Value

Intrinsic value estimation should be the basis of driving all stock investment decisions.

But the problem with this is that most investors do not know what intrinsic value really is and how they should be estimating it.

Those not well versed with intrinsic value, they will look at the company's price charts and consider it to be the intrinsic value instead.

Often, the market value of stocks is inflated. It only highlights what the investor needs to spend in order to acquire one share of the company. But it does not tell if the price the investor is paying is fair or not.

So, how do you know what is the fair price of the stock?

The fair price of a stock is when the market price is below the stock's estimated intrinsic value.

Read our guide on intrinsic value to understand the concept better.

#2 Understand the Business

Why do most people get into investing in stocks? The possibility of getting reasonably good returns when the price trend moves upwards.

The idea obviously is to buy low and sell at a high price.

But there is a problem with this scenario. Rarely can the average retail investor accurately estimate the ups and downs of the market. There are very few people who really know how to time the market movements.

Therefore, what Warren Buffett does instead is focus on stocks that offer long term value.

This brings another challenge to the common investor. How will you know which stocks offer long term value?

Looking at these parameters will get you there.

High Return on Capital Employed (RoCE)

Ideally, the companies you have shortlisted must have a high RoCE.

RoCE is nothing but an estimation of how much profit the business is able to generate on the basis of the invested capital. Companies that demonstrate high RoCE for a reasonably long duration of time will qualify on your list of stocks to invest in.

Quality of Management

This is a key point of consideration when you are employing the Warren Buffett methodology of picking undervalued stocks.

Buffett puts a lot of emphasis on the quality of the leadership team who are at the helm of the company and are responsible for its management and operations.

In his words, Warren Buffett likes managers who 'behave and think like an owner of the company'. The reason behind this is such managers will always work toward the ultimate goal of increasing shareholder value.

But how will a layman investor gauge the quality of the company's top managers? Simple. By carefully going through the annual reports and checking for rationale use of capital.

It falls under the purview of senior managers of the company on how to use the 'retained earnings' of the business. The way they choose to act will determine if building shareholder value in the long term is a possibility.

A seasoned investor like Warren Buffett will look at how these mature companies use this capital which is outlined in the annual reports. It gives him a lot of insights into the character, honesty, and transparency of the senior management.

The other parameter that investors should look out for in the annual reports is their frankness in reporting the results.

With Buffett's trained eye, he will carefully go through the messages shared in the report by the chairman, managing director (MD), chief executive officer (CEO), and chief financial officer (CFO).

If the reports discuss both achievements and failures, this is a big tick in Warren Buffett's book.

Using the stock screener to find undervalued stocks

Now that you know the steps here's how you can filter stocks which fall under the Warren Buffett category.

Consider companies which have a higher market cap as these will be established businesses.

Check the company's PE multiple and price to book value.

Return on Equity (ROE) should be greater than 15% (for consistent years).

Debt to equity should be less than 1.

Five-year earnings growth should be high (higher the better).

If you apply these filters, an initial list of stocks should get you started...

On Equitymaster's powerful stock screener, we have specifically designed a screen which takes into consideration Buffett's filters.

Check out the Warren Buffett Stock Screener here.

We also have a screener on the most undervalued stocks in India.

Also take a look at our editorial last month on the 3 Indian stocks that pass the Warren Buffett filter.

Final words: Keep it Simple

Investors like Warren Buffett keep on reiterating that one should invest in businesses or assets that they understand.

This means one needs to innovate and not blindly follow market trends, analyst recommendations or what other investors are doing.

It means looking at companies that offer sustainable competitive advantages and come with a margin of safety.

It is as simple as that.

Happy Investing!

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. Learn more about our recommendation services here...