Berkshire Hathaway’s CEO has perhaps some of the most down-to-earth tips when making an investment decision. His approach has come to be known as the Four Filters Formula. Here, in simplified form, are Warren Buffett’s four filters explained:
1. Understand the business – considered to be most important.
Understanding a business involves thorough research of company literature (e.g. company 10K filings, website), industry journals and other information. But that’s not all. Buffett says many investors make a common mistake by not really understanding a business’ products before investing in it. Investors should acknowledge their limitations and stick to businesses and industries with which they feel comfortable.
2. Look for a business with a continuing competitive advantage.
Finding a company that has an appealing, unique product <i>today</i> is fairly easy but finding one that will continue to grow and prosper, and even dominate the market in time, is something else. Characteristics of superior competitive advantage could include patents and intellectual property, brand recognition and massive economies of scale. These factors make it hard for competitors to gain dominance over such a company.
3. Invest with able and trustworthy company managers.
The trustworthiness and talent of the management are important factors in sizing up a company. Also look for managers who have their own wealth tied up in the company and with an owner’s mentality.
4. Pay a price that makes sense and affords a margin of safety.
As it’s defined, Margin of Safety is the difference between the intrinsic value of a stock and its market price. Buffett uses years of experience (and the preceding three principles) to try to determine if a company’s share price is undervalued.
Buffett and partner Charlie Munger have used and refined this approach since the 1970’s in adding to the Berkshire Hathaway portfolio. As a testament to the formula’s success, that company has grown into a conglomerate with a net worth of $65 billion in 2017.