How to invest like Warren Buffett – 3 of his favourite stocks

Every year, arguably one of the greatest ever investors, Warren Buffett, releases his annual letter directed toward shareholders of Berkshire Hathaway – the company where he holds the titles of both CEO and chairman. Whether you hold Berkshire shares or not, the letters are often filled with nuggets of wisdom that all investors can learn from.

Here are our key takeaways from Buffett’s most recent annual letter to investors, and a closer look at three stocks held in Berkshire’s portfolio.

This article isn’t personal advice. If you’re not sure if an investment is right for you, seek advice. Investments and any income they give you can fall as well as rise in value, so you could get back less than you invest. Past performance is not a guide to the future.

Takeaway 1

“Charlie and I are not stock-pickers; we are business-pickers”

Buffett’s referring to Charlie Munger here, a long-time partner and vice-chairman at Berkshire. This quote reflects one of the core investing principles held by both men. The premise is simple, find the types of businesses you’d hope to never have to sell.

Take Coca-Cola and American Express as examples, the latter of which we’ll dig into later. Buffett built the bulk of Berkshire’s stakes in both businesses back in the mid-90s. It cost around $2.6bn to build these holdings, split roughly 50/50 across both businesses. At the end of 2022, the combined holdings were valued at close to $50bn.

To quote Buffett once more “The weeds wither away in significance as the flowers bloom. Over time, it takes just a few winners to work wonders.” – when investing, time is your friend. Of course, not every investment will work out and there’s no guarantee they’ll always be as successful as these examples.

Takeaway 2

“Gains from value-accretive repurchases, it should be emphasized, benefit all owners – in every respect”

Share buybacks can be a contentious topic, but it’s a strategy of returning capital and increasing investor ownership that Buffett’s a fan of. There’s one key caveat though, buybacks need to be done when the price is right.

Just as the age-old investing mantra ‘buy low, sell high’ applies to you and me, the same premise holds for company buybacks. Buy at the wrong price, and it’s a value destroyer for shareholders.

Dividends vs share buybacks – what investors need to know

3 of Warren Buffett’s favourite stocks

Remember, investing in individual companies isn’t right for everyone. That’s because it’s higher risk, your investment depends on the fate of that company. If that company fails, you risk losing your whole investment. If you cannot afford to lose your investment, investing in a single company might not be right for you. You should make sure you understand the companies you’re investing in and their specific risks. You should also make sure any shares you own are part of a diversified portfolio.

To buy US shares you must first complete and return a US government W-8BEN form.

American Express

We touched on this earlier, Buffett’s love affair with American Express (Amex) is a long tale starting way back in the 90s. Here in the present day, the stock’s still a key part of Berkshire’s portfolio at around 5% at the end of 2022.

It’s not often you associate brand power with a business in the financial sector, but it’s one of American Express’ key attractions. It helps explain why people are willing to splash out close to £600 a year for the top-tier card. Of course, the host of perks helps sweeten the deal. It’s an attractive proposition for customers as the group added a record 12.5m new card accounts in 2022.

Broadly speaking, Amex makes money from two ways – cardholders and merchant partners.

The bulk of revenue comes from fees charged to merchants based on transactions using Amex cards. Discount Revenue, as they coin it, rose 25% last year and made up 58% of the record $52.9bn in annual net revenue.

Like many banks, Amex has had to step up its provisions for debt defaults in the face of growing economic uncertainty. Total provisions for 2022 totaled $2.2bn, a significant hit to the bottom line. Taken in context though, that’s less than half of the hit taken in 2020 when creditors prepared for the pandemic.

We also see Amex cardholders being relatively resilient and we can see that in the data. The year ended with only 1% of card member loans being 30 or more days overdue, compared to 1.5% in pre-pandemic times. We expect that to worsen as we move through 2023, but it’s not in worrying territory yet.

Chart showing card debt 30+ days overdue

Source: American Express 2022 fourth quarter results presentation.

It’s easy to see the attraction. A strong brand, robust customer base and multiple revenue streams aid resilience. The balance sheet is in decent shape too, with a CET1 ratio (a measure of a financial company’s resilience) comfortably in the target band.

There are elements to be cautious of though. Economic conditions have a real potential to upset things and the valuation based on book value is a little ahead of the long-term average.

See the latest American Express share price and how to trade

Apple

It’s hard to talk about Buffett’s investments without giving a mention to Apple. It’s by far his largest holding – representing almost 40% of Berkshire’s total portfolio at the last count.

Buffett’s well-renowned for only investing in businesses which he understands – as he calls it, sticking within his circle of competence. But because the tech industry isn’t his strong suit, many eyebrows were raised when he started building his position in Apple back in 2016.

However, it’s not really the tech side of Apple that’s the key attraction for Buffett. It’s some of the other aspects like strong brand power, healthy cash flows and a management team that focuses on what consumers want.

The whole Apple ecosystem of products and services are purpose built to complement each other and work together seamlessly. And as far as we’re concerned, they’ve repeatedly hit the nail on the head.

Apple’s made itself an indispensable part of many people’s lives – evidenced by the extreme brand loyalty its consumers show when it’s time to upgrade their phone.

Strong cash flows help fund the mammoth share buyback program – something we already know Buffett’s a fan of. Since 2016, Apple’s returned more than $450bn to shareholders in the form of buybacks alone.

Apple’s share buybacks

Source: Apple annual reports.

But there are some issues to keep in mind.

A large proportion of Apple’s products are made in China, meaning it’s very exposed to supply chain issues there. Extended Chinese lockdowns, coupled with rising China-US tensions have already disrupted operations. And while wheels are in motion to diversify some production away from China, it will take both time and money to set up production elsewhere.

To add to that, Apple must continually stimulate consumer demand through frequent and successful product introductions. Services like Apple Music rely on continued iPhone sales.

For now, Apple’s rising to the challenge with yearly cycles of iPhone and iPad launches, as well as developing new products like Airpods. But stimulating demand could become more difficult, especially if cost-of-living pressures continue to mount.

We don’t doubt Apple’s ability to deliver, but those strengths are well priced in – its valuation sits comfortably ahead of the longer-term average.

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Moody’s Corporation

Sitting at number eight on the list of Buffett’s biggest holdings is Moody’s Corporation, which he first bought back in 2000.

Moody’s is a financial services company and a market leader in the bond rating industry. Its $5.5bn revenues are split between Investors Service and Analytics, which are the credit ratings and financial research arms respectively.

In order to raise cash, businesses and governments often issue debt in the form of bonds. But before investors buy these bonds, they want to know the likelihood of default and the severity of any potential losses. That’s where a rating agency like Moody’s Investors Service comes in. It provides an independent and standardised rating service, which helps investors compare the quality of different bonds.

Source: Moody’s.

The party issuing the debt opens its books, pays Moody’s to assess the risks involved, and receives a rating on the bond in return. A lower credit rating indicates there’s more risk involved. That normally means yields must be higher to compensate investors for the extra risks.

In this space, Moody’s is one of the dominant market players. Brand recognition and significant economies of scale give the group what Buffett calls a “wide moat”. This effectively means there are obstacles that make it difficult for new competitors to enter the market.

Strong pricing power affords the group very attractive margins too – with gross margin and operating margin currently sitting above 70% and 40% respectively.

Then on the Analytics side, investors pay for access to Moody’s top-quality research and analytical tools. Even if the market enters a downturn, Analytics should provide a robust source of revenue as asset managers and traders will be keen to maintain access to Moody’s vast pools of data.

However, there are challenges.

Revenues and profits were both down in 2022, reflecting both a record year before and a challenging business environment.

The fact companies pay Moody’s to get a rating also creates a potential conflict of interest. It’s alleged these conflicts contributed to Moody’s mispricing mortgage-related debt in the run-up to the 2008 financial crisis. Since then, there’s been increased scrutiny from regulators who are keen to increase competition. This would inevitably put pressure on Moody’s margins.

See the latest Moody’s share price and how to trade

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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