Buffett’s Framework for Value Investing Explained in 1 Simple Flowchart

Value investing
An infographic that shows the Buffett's framework or value investing. It consists of 4 components: the circle of confidence, business fundamentals, defensibility, and valuation.

Introduction

Value investing is about simplicity. An unemotional lens through which prudent investors can view investment opportunities. This post provides the reader with a value investing framework that has been shared in some form or another in the past.

Its zen-like simplicity and timelessness are a testament to its universal applicability. This value investing framework breaks down into four components:

1. Circle of Competence:

As a long-term investor, you are concerned with business value. However, business value can only be established when you, as an investor, have a clear understanding of the business and can articulate a thesis around why the investment is prudent. This means that you have to be able to develop conviction around why you believe the business will gain market share and clearly articulate how that market share will result in increased profitability.

Every investment is an opportunity to buy an asset at today’s prices with the intent to capitalize on it when it’s worth more tomorrow. However, unless you intimately understand the space, it is challenging for you to articulate why the business will be worth more tomorrow.

This articulation is different from speculation in that it is a determination made after a deep analysis of the facts characterizing the industry, the competitors, and the market at large. This deep understanding is what has been dubbed the ‘circle of competence.’ Since it’s difficult for anyone to know everything about every industry, the degree of understanding of the industry is your first filter. No point venturing into unknown territories unless you’ve exhausted your opportunities in known areas first.

This is a self-fulfilling prophecy to a certain extent because you are more likely to discover stocks in areas you understand. But, anecdotally, I expect that about 50% of the stocks you encounter will fail this filter either because you don’t understand the space or realize that the industry faces headwinds.

2. Business fundamentals:

So you’ve found a stock in an industry you understand and like. The next step in the process is to benchmark the fundamentals of the business against the broader market. Does the stock outperform the market from a revenue perspective? What about earnings and free cash flow? But why benchmark the stock against the market instead of merely benchmarking it to the industry that it is a part of? My counter is that investing in the market is a hedge against diligence.

Simply buying an S&P500 index allows you to blindly bet on the market and generate 7% returns (see here). If you are going to painstakingly pick a stock, make sure it can outperform the market. While the past is not a predictor of the future, predictable companies will conform to their trend lines. About 60% of the stocks that make it past the ‘circle of competence’ filter will fail the fundamental screen.

3. Defensibility:

Defensibility deals with the notion that it is not enough for a company to expand its market share. A long-term bet also has to have an additional moat that prevents disruption. One way to measure this is to look at gross margin %. Since gross margin % indicates price-setting power, which, in turn, is an indicator of consumer demand, a business with a high gross margin % and healthy revenue growth is also likely to be a dominant player in their space.

Another factor in measuring defensibility is the effectiveness of the company’s management. In other words, how well does management use capital to generate returns for the investor? A company that generates a low return on invested capital (ROIC) is unlikely to command a premium. Conversely, a company that generates high returns on invested capital will be rewarded with a higher P/E ratio. About 50% of stocks will fail this filter.

4. Valuation:

The last filter is also the most important. At this point, you’ve found businesses that are clearly good prospects. All you have to do is buy them at a reasonable price. How do you determine reasonableness? You forecast future revenues based on history to understand what the earnings per share might look like in the future. The current value of these future earnings per share stream is the intrinsic value of the company.

The percentage by which the intrinsic value is greater than the price you are paying today is the margin of safety. The larger the margin of safety, the more likely it is that you will make a good return. There are different ways to determine the company’s intrinsic value ranging from comparable valuation: where you establish a value for a company by benchmarking it against the valuation of competitors using P/E ratios to discounted cashflow valuations that predict future cash flows and adjust them for time value. Unfortunately, about half the companies you evaluate will probably fail this filter.

5. What About Your Current Portfolio:

Perhaps even more important than finding new stocks to invest in is deciding when to stop owning a stock. Value investors would argue that you should plan to own a stock indefinitely as long as it continues to satisfy your filters.

Implied in that is the notion that when you follow the value investing strategy, you constantly reevaluate your portfolio to ensure each stock in your portfolio continues to meet the value investing criteria laid out above.

Bottom-line:

Value investing means investing in high-quality businesses that you understand and have efficient capital utilization and a decent margin of safety. They are stocks that you can buy at a discount, have solid fundamentals, predictable returns, and that you plan to own for the long term. Of course, this is easier said than done, which is why value investors tend to be extremely selective about what they hold.

Vikram R
Vikram Raghavan is a value investor, technologist, and Finexy co-founder. In addition to stock market investing, Vik also invests and advises startups on growth marketing and product management. Vik's work is focused on themes of marketplaces, micro-entrepreneurship, marketing automation, and user growth. Previously, Vikram led product and growth teams at Overstock.com, focusing on efforts across acquisition, new user experience, churn, and notifications/email. He holds an MBA in Finance from Temple University and a B.S. in Computer Information Systems and Finance from Bemidji State University.