Some things just go together. She sings Adele and a powerful ballad. Lebron James and playing basketball. Warren Buffett and investing in stocks.
But while Adele and LeBron regularly go about their business, Buffett sometimes shies away from investing in stocks. Of course, the Oracle of Omaha bought 19 shares Berkshire Hathaway‘s portfolio in 2022 (as far as we know anyway). However, it is not out of the question that Buffett may buy some stocks in the new year.
The reason is that the legendary investor has very strict criteria that he applies before buying even one share of a company. Take Buffett’s advice: Don’t buy any stocks until they pass this critical test in 2023.
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Buffett’s two steps
Buffett wrote to Berkshire Hathaway shareholders in 2013 that he and his longtime business partner Charlie Munger take the same approach to buying stocks as they do when they acquire all companies. This process has two steps:
- Estimate the company’s earnings five or more years into the future.
- Get the stock at a reasonable price relative to the lower end of the estimated earnings range.
There is an important word that Buffett uses in the first step in this process. He wrote that he and Munger should determine what they could do wisely estimate the company’s earnings.
Anyone can pull earnings forecasts out of thin air. However, Buffett would insist on detailed research and careful analysis to estimate earnings.
Note that it states that the range of earnings will be estimated. The multibillionaire knows that it is impossible to accurately predict the future earnings of any business. The best anyone can do is determine the realistic range.
A period of five or more years into the future is also key. Companies can make strong profits in the short term, but not in the long term.
Digging deeper
An obvious question about Buffett’s two-step process is: How can an investor evaluate a company’s earnings? The most important requirement is that you understand the company’s business well enough to make an educated guess.
Buffett emphasized this in a 2013 letter, saying, “But it’s critical to know the perimeter of our ‘circle of ability’ and stay well within it.”
The best place to start estimating future earnings is by looking at a company’s financial statements. Look at current and past earnings to get a baseline. Check the balance sheet to make sure that paying off any debt won’t hinder earnings growth.
Explore industry trends and the competitive landscape. A company that dominates a fast-growing market will increase its profits more than a company with a lot of competition in a stagnant market.
Don’t hesitate to look at Wall Street analysts’ earnings forecasts as well. Remember, the goal is to estimate earnings over at least five years, not just the next few quarters.
There is another question to address: What is a reasonable price relative to the lower end of the estimated earnings range? This will change depending on the growth of the company. However, the average price-earnings estimate S&P 500 If we go back to 1950, it is 19.6. A stock that trades well at this level should have a reasonable margin of safety compared to the low end of its projected earnings.
Two stocks that pass the Buffett test
Are There Stocks That Pass the Buffett Test in 2023? I think so.
I would put Occidental Petroleum (OXY 1.14%) in the list without any detailed analysis. Buffett clearly believes the oil and gas producer is reasonably valued relative to its future earnings potential, as he recently bought a lot of stock for Berkshire.
Just looking at stocks that Buffett doesn’t own, I think Medical Properties Trust (MPW -0.80%) (MPT) stands out. A Healthcare Real Estate Investment Trust (REIT) leases properties to hospital operators.
Analysts estimate it could grow earnings by an average of 6.5% annually over the next five years. I think that’s an achievable estimate given that MPT has more than doubled earnings over the past five years.
But let’s be more pessimistic and assume that MPT only grows earnings by 3% each year for the next five years. Shares are trading at about 4.6 times this low forecast earnings. That’s an attractive valuation that I think makes MPT worthy of serious consideration, especially with a juicy 10.5% dividend yield thrown into the mix.
Maybe Occidental and MPT won’t bring big returns. In a letter written in 2013, Buffett admitted that he sometimes made mistakes. If he does, so will you and I. However, buying only stocks that pass critical testing should help you avoid catastrophic mistakes.
Keith Speights holds positions at Berkshire Hathaway. The Motley Fool owns and recommends positions in Berkshire Hathaway. The Motley Fool recommends the following options: January 2023 Berkshire Hathaway $200 calls, January 2023 short $200 Berkshire Hathaway calls, and January 2023 $265 Berkshire Hathaway calls. The Motley Fool has a disclosure policy.