Value Investing: Key to Buffett's Success Is More Than "Cheap" Stocks

Editor’s Note: With Warren Buffett’s recent birthday, we wanted to highlight what the Oracle of Omaha is really looking for as a value investor.

Warren Buffett, the Oracle of Omaha, is the most recognizable, revered and oft-quoted stock market investor of all time.

We know him as a “value investor.” And because of Buffett, what we think of as “value investing” is one of the most recognized investment strategies.

I recently wrote about my proprietary Green Zone Power Ratings system’s “size” factor (one of the six metrics my system uses to rate stocks between 1 and 100.)

Few think of themselves as “size-factor investors.” But identifying as a “value investor” somehow carries with it a certain cache — a badge of honor that’s difficult to criticize.

Buffett played the value game well before we had a name for it. (No one used the term “value investing” before 1992.)

Most of Buffett’s admirers have concluded that he simply has a God-given talent for identifying great companies that sell for less than they’re worth.

The Oracle has never relied on “quant” models, computers or algorithms. It’s easy to assume his extraordinary success comes from a combination of hard work and sheer talent.

But what if I told you that the value factor— which we can reduce to an algorithm, requiring no human interaction — can almost fully explain Buffett’s investment performance … and wipe out the story of his special Midas touch?

With a more optimistic spin…

What if I told you that you could perform just as well as Buffett if you simply use the value factor when selecting stocks?

How the Value Factor Works

Hundreds of academic studies have shown that you can earn market-beating returns if you simply buy stocks that are priced “cheaply” and avoid buying “expensive” stocks.

A word of caution: Novice investors often view stocks as expensive based on their share price alone — so they buy five shares of a stock that trades for $20 per share rather than one share of a $100 stock because it’s “cheaper.” But when our Green Zone Power Ratings system identifies “cheap” stocks, that refers to more than the share price.

We can determine what stocks are “cheap” and “expensive” using simple ratios, including the price-to-earnings (P/E) ratio. P/E is the most popular, and we include it — along with several others — in the value factor of our Green Zone Power Ratings system here on Money & Markets.

Let’s look at a simple example.

Stock ABC sells for $20 per share (i.e., the market price is $20). ABC has produced earnings of $4 per share over the prior 12 months.

ABC’s stock has a price-to-earnings ratio of 5. ($20 price divided by $4 earnings equals 5.)

Any time you see these ratios presented with the price portion first, as in “price-to-earnings,” it’s more desirable to buy a stock with a lower ratio, which indicates it’s “cheaper,” or a “better value,” than a stock with a higher ratio.

For most investors I know, the “value investing” approach is intuitive — it just makes sense!

How Value Investing Is Like Home Shopping

Imagine you’re in the market for a new home.

You find two 3,000-square-foot houses, built by the same builder on the same block:

In the example above, you’d want to buy House 1, right?

You’d say, “House 1 is a better value.”

You know that because when you divide the price you pay by “what you get” for that price. In the example above, the better value seems clear.

But it’s equally important to know what you’re getting for the price you pay.

I suggested you’re getting the exact same 3,000-square-foot house. But it’s rarely that simple.

Maybe one house is constructed of wood and the other concrete block. Perhaps one was built in the 1900s while the other was built in the last 20 years. Or what if one has a pool, and the other doesn’t.

Stocks are similar. When you decide whether to buy Stock A or Stock B, it’s not always easy to see what you’ll get from each company.

The Best Value Stocks Aren’t Just “Cheap”

That’s why the “quality” and “growth” factors we use in my Green Zone Power Ratings system are also important.

It’s easy to reduce Buffett’s M.O. to “value,” or “buying companies for less than they’re worth.”

But that’s not the whole story. In Buffett’s own words: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

It’s important to consider other major tenets of his approach, which include:

• Solid fundamentals.
• Strong earnings power.
• Potential for continued growth.

All things equal, the value factor tells us it’s better to buy a “cheap” stock than an “expensive” one. But in the stock market, all things are rarely “equal.” When buying a stock that’s attractively valued, you also have to be certain the underlying company is of high quality and with strong growth prospects.

That’s the real key to value investing.

To good profits,