Warren Buffett has built his fortune by buying shares in businesses he believes can compound wealth over many years. While the Oracle of Omaha doesn’t typically buy ASX shares, his investing principles can still help Australian investors identify potentially attractive shares.
Here are five things to look for.
Buy businesses you understand
Buffett has repeatedly stressed the importance of staying within his circle of competence.
That means understanding how a company makes money, what drives its earnings and what could threaten its competitive position.
On the ASX, that could mean favouring familiar businesses such as Commonwealth Bank of Australia (ASX: CBA), Woolworths Group Ltd (ASX: WOW) or Wesfarmers Ltd (ASX: WES), provided their valuations make sense.
The point isn’t to buy familiar names blindly. It’s to avoid investing in ASX shares you can’t properly assess.
A durable competitive advantage
Buffett’s famous economic moat is central to his strategy. I’d look for ASX shares with something that makes it difficult for competitors to steal customers and profits.
That could be a powerful brand, network effects, switching costs, intellectual property, scale or a structural advantage in an industry.
A company with a strong moat can potentially maintain attractive returns on capital for years.
Consistent earnings and cash flow
Great stories aren’t enough. I’d want to see evidence that a business can consistently generate profits and cash.
Strong cash flow gives companies more flexibility to reinvest in growth, reduce debt, pay dividends and potentially buy back shares.
This is particularly important when looking for long-term compounders. A business that repeatedly needs fresh capital to survive isn’t the sort of ASX share Buffett typically favours.
A strong balance sheet
Debt can magnify returns when things go well â and magnify problems when they don’t.
Buffett has long emphasised financial strength and the ability of businesses to withstand difficult economic conditions. I’d therefore examine a company’s debt levels, interest costs, cash position and ability to meet its financial obligations.
A robust balance sheet can give an ASX share the flexibility to take advantage of opportunities when weaker competitors are struggling.
A sensible valuation
Perhaps the biggest mistake investors can make is confusing a great business with a great investment. Even an exceptional company can produce disappointing returns if investors pay an excessive price.
I’d therefore compare the price of an ASX share with earnings, cash flow, growth prospects and the company’s historical valuation.
Buffett doesn’t try to predict what a share will do next month. He focuses on whether the price makes sense relative to the underlying business.
The Buffett test
Finding Buffett-style ASX shares isn’t about discovering a secret formula. I’d look for understandable businesses with durable moats, reliable cash generation, strong balance sheets and attractive valuations.
Then comes the hardest part: having the patience to let those businesses compound.
As Buffett’s strategy demonstrates, successful investing is often less about finding the next hot ASX share and more about avoiding bad businesses and paying too much for good ones.
The post 5 things Warren Buffett looks for before buying ASX shares appeared first on The Motley Fool Australia.
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Motley Fool contributor Marc Van Dinther has no position in any of the stocks mentioned. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has positions in and has recommended Wesfarmers. The Motley Fool Australia has recommended Wesfarmers. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.