How Warren Buffett picks shares to buy

Legendary investor Warren Buffett is revered by many investors because he combines a strong investment track record with an openness to sharing his approach. I think many of the principles he applies in picking shares are useful for me as an investor too. Here are some of the factors which help Buffett pick shares.

Knowing  a great business exists

It sounds obvious, but one can’t buy a share without knowing it exists. For some of Buffett’s investments, such as Coca-Cola and NetJets, Buffett was aware of the company before he invested, as a customer. But in many cases, Buffett has made lucrative investments only because someone who ran a business brought it to his attention. That’s why the annual report of Buffett’s company Berkshire Hathaway regularly includes a rundown of the criteria for the types of businesses it wants to buy.

As a private investor, I don’t have people fielding ideas to me the way they do to Buffett. So I need to do my own research – reading up on businesses and finding out about companies even when I am not a customer. It’s not coincidence that the single biggest use of Buffett’s working hours is reading.

Warren Buffett on competitive advantage

Warren Buffett looks for what he calls a “moat” – basically a competitive advantage. For example, owning a rail network is a form of moat. The cost and difficulty of building an alternative would likely put competitors off trying it. That gives a train network pricing power, allowing it to improve its profitability.

While Buffett likes skilled management, it’s ultimately not a sustainable business moat. Management changes. What Buffett is looking for is a structural element of a company’s business model which makes it hard or even impossible for competitors to challenge its position.

Buying on strength not weakness

Unlike value investors, Buffett actively seeks to avoid turnaround situations. Those are ones where a struggling company has seen its share price fall. It wasn’t always so. Berkshire Hathaway was originally a textile company and Warren Buffett spent years hoping its fortunes would improve before finally closing the mills. Based on experiences such as that, Buffett has no interest in catching a falling knife. Instead he looks for companies that are performing well and whose business prospects seem strong for years to come.

Buffett’s purchase of Apple shares illustrates this. When he bought into the company in 2016 – almost a decade after the iPhone launch – many investors already reckoned Apple shares looked expensive. Fast forward just five years and his $36bn stake is now worth $128bn – and that’s not including money from shares he sold. That gain demonstrates the principle of focussing on the business outlook of a company not just its share price.

Warren Buffett and risk

Crucially, Warren Buffett studies carefully to understand shares he may buy. But he doesn’t put all his eggs in one basket. He invests in a range of shares to achieve diversification. That way, he can manage his risk. No matter how good a share may be – and Apple has been phenomenal for Buffett – he recognises that diversification is an important risk management tool. There are lots of great companies out there, after all, if one knows where and how to search for them.