Simple but not easy: How to invest as Buffett intended
The recipe to most happy investing outcomes is painfully simple. But if it were that easy, wouldn't everybody do it?
A quote that I keep coming back to, and have quoted in my writing on more than one occasion, is the following piece of advice from Warren Buffett:
“Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now.”
The reason I keep coming back to this quote is that earnings growth is the foundation of most happy investing outcomes. In the simplest terms, an investor’s return from each individual stock rests mostly on three variables:
- Dividends received during the holding period
- Increases or decrease in company’s ability to generate profits on a per-share basis
- What value the market is willing to put on a company’s ability to generate profits
All three depend on earnings in one way or another. A sustainably higher dividend, for example, requires higher profits from which to pay it. And as much as anything, how the market assigns a value to those earnings will be dictated by expectations of how those earnings might grow in the future.
If a business is worth X million dollars when you buy it in 2025, and by 2030 that business is 1) earning considerably more than it did in 2025 and 2) appears to be in a position to keep growing those earnings in the future, the business will almost certainly be worth more in 2030 than it was in 2025.
So as long as you didn’t overpay for your ownership interest in the first place, then you should obtain a satisfactory result from your investment in such a company. Of course, this falls squarely in the ‘simple but not easy’ box.
How can you be “virtually certain” that a company’s earnings will be a lot higher in ten or twenty years? I personally find this rather hard and wrote some thoughts on it here. How can you narrow the field and find potential candidates for such a Buffett-esque approach? That’s what we’ll tackle today.
I propose we start by looking for three things. These are not the only ways to potentially find good companies trading at fair or good prices. They might not even be the best. But they are, I would argue, among the simplest to start working with.
Two simple criteria for sustainable earnings growth
Earnings per share growth can come from a few different sources. It could come from selling more of the products and services you already sell. It could come from entering new markets and selling new products and services. It could also come from raising the price you charge customers.
With the aim of keeping things simple, I am going to focus on selling more of the products and services already being sold. To do this, I am going to look at two main things: 1) the likelihood of growing demand for these products and services and 2) the strength of the company’s competitive position.
The second point is important because a growing market that is showering its incumbents in profits will attract competition. So we don’t just need growing demand, we need something that leaves our company unfairly well positioned to keep turning higher demand into rewarding profits.
Certain elements of this competitive advantage can also pave the way for the other earnings growth levers we mentioned. For example, a brand or switching costs can underpin pricing power. You can read more pricing power in my article about Warren Buffett’s favourite thing to see in an investment.
Two earnings growth criteria in action
An area I see a lot of potential for these two criteria to play out in is medical imaging. On the demand front, I find it hard to believe that there will be less demand for medical imaging and scans worldwide in ten or fifteen years than there is today.
For one, the world’s population is ageing. I also find it hard to believe that humans will stop 1) wanting to know what is wrong with us or 2) wanting to get better. I also find it hard to believe that developing economies won’t move towards the same standards of care that we enjoy in the West.
As for competition, the medical imaging market and its various sub-niches have been dominated by the same small group of players for many years. This suggests that these companies, which include Siemens Healthineers, Philips and GE Healthcare, enjoy a structural advantage over the competition.
A big part of this is down to switching costs. If you are a hospital, retraining your staff on a different company’s machines entails cost and disruption risks.
Our analyst Alex Morizov also sees large hospitals increasingly wanting to work with fewer, not more vendors: “Imaging customers tend to be sticky and frequently limit their relationship to a sole vendor across modalities”, he writes in his research report on Siemens Healthineers (FRA: ETR).
The big imaging players also have a scale-based advantage when it comes to innovation. Morozov continues: “even revolutionary technology innovations tend to be replicated within a few years among the Big Three, discouraging customers from switching on technology alone”.
The so-called Big Three generally funnel 8-10% of their revenues towards research and development, giving them budgets magnitudes bigger than smaller competitors can afford.
Long story short, I think that leading medical imaging companies embody two of the key criteria we are looking for. Not only does there seem a very good chance that demand for their products and services will continue to rise. These companies enjoy what looks like a strong position within their market.
Don’t overpay
So far, the message has been simple: consider investing in companies that you think are well placed to keep growing their earnings. If that sounds too simple to be true, this is where it gets harder: overpaying for your initial stake in that business can have a drastic impact on your results.
Let’s say that you get the ‘earnings growth’ part right over ten years and the company you have invested in doubles their earnings per share. Unfortunately, though, you bought at a time where people were unusually high on the company’s prospects and the P/E was at a multi-decade high of 30x.
If the market’s idea of a fair price for this company reverts back to a more normal 17x, look at the drag the initial overpayment has on the return from owning the stock.
Figure 1: Potential impact of starting valuation on returns. Source: Author
Even when you add dividends to arrive at a total return, it would likely be lower than or comparable to a government bond. A rich starting valuation has the potential to undo the underlying business’s good work.
Seeking to buy shares without an obvious potential overhang in this regard is what I believe Buffett was referring to when he suggested a “rational” purchase price.
As I alluded to above, one way to look at this might be to assess how a company’s valuation multiples today compare to its own past. I explored this in a past edition of my Bookworm column, which shared a legendary fundie's important advice for using this method.
While historical valuations can give you a decent look at how in or out of favour a company’s shares are at the moment, there is obviously a lot more to valuing a share than that. For a good overview of things you may want to consider, read this article by my colleague Mark LaMonica.
Cheap often has baggage
Given that we have lived through an era where stocks have performed very well for a very long time and “quality” stocks have been especially in vogue, you may be wondering how companies of this ilk ever become cheap (or merely not very expensive).
I’d say that it generally takes two forms. One is a market wide event, where sentiment towards a whole asset class or country takes a battering. It is barely visible on a long-term chart by this point, but Microsoft’s value plunged 25% within a month in early 2020 – and it wasn’t alone.
If that example seems too cherry picked, consider the widespread disgust that most companies tied to the fate of China’s economy have faced from investors in recent years.
If you can find a company with solid long-term growth prospects that gets caught up in such a panic, you may have found an attractive opportunity. Whatever is giving you that opportunity is likely to be in the headlines a lot, though, so you’ll need an iron stomach.
The second form of opportunity is when something happens to change the market’s perception of a particular company or its industry.
Maybe the company messed something up and are going to spend the next couple of years underearning as they rectify the mistake or paying damages. Perhaps a new technology or trend has come to the fore and people are fretting about the firm’s future ability to generate cash.
Your job in these situations is to ascertain whether the problem markets are fretting about is temporary or permanent. Whether the problem is overegged, or even whether it is really a problem at all. The case of ResMed, which sells sleeping apnea devices and home health software, comes to mind.
Our analyst Shane Ponraj thinks that Resmed (ASX: RMD) can continue to grow its sales and profits at a healthy clip for several years. After all, a lot of people suffer from sleep apnea but around 75% of people who suffer from it still go untreated.
The market seems to share this view most of the time. But on two separate occasions in recent years, ResMed’s valuation has suffered a sudden case of the wobbles. Why? Because data on GLP-1 diabetes and weight loss drugs like Ozempic suggested that it may reduce cases of sleep apnea too.
Shane’s analysis found no evidence that GLP-1s would meaningfully reduce the market opportunity for ResMed. Which, in hindsight, might have made the dip an attractive time to buy into a high quality business with strong growth tailwinds.
Figure 2: Resmed 5Y return chart. Source: Morningstar
Being able to do this confidently, however, requires you to have an insight that goes against the prevailing narrative or fear and, in most cases, a longer time horizon than a market obsessed with short-term newsflow.
As I said, the practice of investing in companies with attractive long-term earnings growth prospects at fair prices sounds simple. In practice, it is far from easy. I also think it has most promise for a very specific kind of company – namely established, large concerns with proven business models.
A closing thought
The high-level stock picking criteria I’ve discussed today are not enough to rubber-stamp an investment. To do that, you also need to blend in investing criteria that are crafted with your own situation and financial goals in mind. Read more about this in Mark’s four-step guide to defining an investing strategy.
