Before making an investment, Warren Buffet always ask himself hard questions. The easiest to understand is through a baseball analogy. In the recent HBO Documentary 'Becoming Warren Buffett', Buffett said:
“The trick in investing is just to sit there and watch pitch after pitch go by and wait for the one right in your sweet spot, And if people are yelling, ‘Swing, you bum!’ ignore them.”
Basically, just wait for the fat pitch. Unlike an professional fund manager, no one is going to fire you if you don't invest all your cash. Warren Buffet is not afraid to keep his cash and pass on investments and this gives him an edge when the time comes to investing in unique opportunities.
Here are the key investment checklists:
- Is the business simple and understandable?
- Does the business have a consistent operating history?
- Does the business have favorable long-term prospects?
- Is management rational with its capital?
- Is management candid with the shareholders?
- Does management resist the “institutional imperative”? In other words, do they avoid groupthink.
- Is the focus return on equity?
- What is the rate on “owner earnings”? Owner earnings is an extrapolated estimate of an owner’s earnings (free cash flow) over a defined period (typically a year).
- Is there a high profit margin?
- Has the company created $1 of market value for every $1 retained?
Financial analysis: Focus on return on equity, not earnings per share. Free cash flow. High profit margins, and most importantly, how good will the company be in 10 years versus the competition from peers.
What is the value of the business?
- Can the company be purchased at a significant discount to its value? This is Buffett’s last and most important question. It should be noted that he has done this countless times over the years.
Making your due diligence before investing in a stock will make the difference between amazing or mediocre returns.
Even though this website more about personal finance, investment knowledge is an important aspect of your wealth and net worth building. Unless you are willing to spend significant time studying a business, it might be better to simply invest in an index fund.
Given your interest and capabilities, should you try to pick stocks or simply dollars cost average with low-cost index funds? Doing nothing else but indexing low-cost index funds can be quite attractive and efficient (efficient relative to the time and effort required) . If you add compouding over multiple years if not decade, you should be create significant net worth. For most people this will be the best choice.
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