Warren Buffett, the world’s greatest stock picker, isn’t picking many stocks these days. Buffett has been a net seller of stocks for eight consecutive quarters. There’s a reason Buffett isn’t buying many stocks, and it’s the same reason he ranks among the greatest investors of all time: he is highly selective about which stocks he buys.
In his 2013 letter to Berkshire Hathaway shareholders, Buffett revealed a two-part test he uses to identify companies to invest in. First, he determines whether he can sensibly estimate an earnings range for five years out or more. He thoroughly reviews a company’s business and industry trends to make the best earnings estimate possible.
If he can’t estimate future earnings, he moves on to the next stock. Buffett’s second step is to buy a stock only if it trades at a reasonable price relative to the lower end of his estimated earnings range. If the stock doesn’t pass this second step, he moves on.
This two-step test might seem simple, but it is more difficult to follow than you might think. Estimating a company’s earnings over five years or more can be challenging.
Buffett’s selective stock buying strategy
Buffett explained that he needed to recognize “the perimeter of our ‘circle of competence’ and stay well inside of it.” He knows how important understanding a business and industry is for estimating earnings. It’s also tough in some market environments to find stocks valued attractively enough to pass the Buffett test. This has clearly been the case in recent quarters, as Buffett has amassed a cash stockpile of over $325 billion for Berkshire instead of buying more stocks.
Some stocks that might pass the Buffett test in 2025 include Energy Transfer, a leading North American midstream energy company. Even with the increasing use of renewable energy, Energy Transfer’s pipelines should transport natural gas, natural gas liquids, and crude oil for years to come. The company also pays a distribution that yields around 6.5%.
Average annual growth of between 3% and 5% should be easily attainable. Buffett also views Occidental Petroleum as one of the few stocks that meet his test. He has continued to regularly scoop up shares of the oil and gas producer.
However, investors should note that Berkshire owns warrants that allow it to buy the stock at a predefined share price, making the stock even more attractive to Buffett than to other investors who don’t benefit from such a deal. Warren Buffett’s two-part test for stock picking emphasizes the importance of careful earnings estimations and sensible valuations. As we approach 2025, it may be prudent for investors to adopt a similarly selective approach, ensuring greater chances of long-term success by following Buffett’s time-tested strategy.
