As 2024 gets underway, many investors may be itching to make moves in the stock market. After a banner year for equities in 2023 that saw widespread gains, opportunistic buyers may sense the possibility of capitalizing on continued growth. However, legendary investor Warren Buffett offers a timely warning for would-be stock pickers – press pause, and make sure any potential investments pass his straightforward quality test first.
Buffett, who turns 93 this year, remains one of the most successful stock pickers of all time thanks to a career-spanning strategy of patience and discipline. In a 2014 letter to shareholders of his conglomerate Berkshire Hathaway, he laid out a two-part process for determining whether a stock is a fit for the portfolio. With markets facing lingering macroeconomic uncertainties as interest rates rise, Buffett’s principles provide a prudent framework for investors looking to make informed decisions at the start of the new year.
The Buffett Test
Buffett’s test is remarkably simple. First, one must be able to “sensibly estimate an earnings range for five years out or more” for the company in question. This, he acknowledged, is often difficult to do with a high degree of confidence. If unable to reasonably forecast earnings, Buffett advises moving on to alternative prospects.
For companies where estimating future profits seems feasible, the second part of the test calls for only purchasing shares if “the stock is reasonably priced relative to the lower end of the estimated earnings range.” In other words, sufficient margin of safety is required to compensate for the uncertainty inherent in long-term projections.
Buffett emphasizes sticking strictly to this methodology, asserting that prevailing economic or market conditions should not factor into the decision-making process. As he wrote in 2015, he and long-time business partner Charlie Munger “have never foregone an attractive purchase because of the macro or political environment, or the views of other people.” Discipline and valuation-focused analysis must rule the day.
Easier Said Than Done
Living up to Buffett’s standard is easier said than done, as he readily acknowledged. For one, accurately predicting a company’s earnings five or more years into the future demands deep sector expertise and research most retail traders lack. As Buffett himself noted, such confidence in projections is “usually the case.”
Even for more familiar industries, unforeseen disruptions or black swan events can alter outcomes. Meanwhile, the quality of available information varies significantly between publicly disclosed financial statements of large corporations versus smaller, private businesses.
Buffett also conceded that mistakes have been made applying the principles over decades, despite efforts to minimize risks by concentrating on areas of strong competence. No framework provides a guarantee of perfection. For average investors, prudently estimating long-term cash flows presents a particularly steep challenge.
Still, by keeping analysis grounded in fundamentals and not losing discipline amid market fluctuations, Buffett’s doctrine cultivates habits likely to serve investors well over the long haul. With patience and homework, some companies may indeed clear the high bar for 2024.
Two Stocks That Could Pass the Test
While Buffett has been slower to deploy capital in recent market upswings, a couple names could plausibly meet his criteria according to outside analysts. Homebuilder D.R. Horton (DHI), in which Berkshire took a new stake in late 2023, stands out as one.
Despite roaring 71% higher last year, DHI still trades at a mere 11.4 times forward earnings estimates. That discount implies the market anticipates little bottom-line growth, despite a nationwide housing shortage spurring record sales. But with interest rates projected to decline somewhat in 2024, Horton is well-positioned structurally and financially to keep boosting output and profits for years ahead at attractive prices.
Tech giant Meta Platforms (META) represents a stock Buffett likely avoids personally but could theoretically pass muster. It generates ample cash and continues right-sizing expenses after past investment cycles. Should AI advertising and the metaverse live up to potential, META’s current 0.79 PE-to-growth ratio looks undervalued relative to analysts’ projected near-8.5% annual earnings expansion the next five years.
For the Average Investor
Of course, for most people without Buffett’s resources, simply identifying two companies poised to consistently outearn estimates half a decade hence presents an insurmountable barrier. Recognizing these limitations, Buffett advocates low-cost index funds as a perfectly adequate alternative for the masses.
In his view, any investor diligently contributing over time to a total stock market fund “is virtually certain to get satisfactory results” – without shouldering individual equity research burdens or volatility. And with the S&P 500 still off roughly 15% from all-time highs despite recent recovery, even a simple portfolio rebalancing now could prove advantageous in 2024.
So while opportunities may exist for disciplined stock pickers equipped to pass Buffett’s test, his advice for new year’s investing remains as timely as ever: proceed carefully, check your thesis, and remember low-cost diversification need not be a compromise for average investors simply looking to participate in long-term market returns. Patience and perspective will likely serve traders and savers alike in the coming year.
