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Take Warren Buffett's Advice: Don't Buy Any Stocks in 2023 Unless It Passes This Test

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Some things just go together. Adele and singing a power ballad. Lebron James and playing basketball. Warren Buffett and investing in stocks.

But while Adele and Lebron regularly do their thing, Buffett is content to avoid investing in stocks at times. Of course, the Oracle of Omaha bought 19 shares per Berkshire Hathawayda portfolio in 2022 (that we know so far, at least). However, it’s not out of the question that Buffett could buy little or no stock in the new year.

The reason is that the legendary investor has very strict criteria that he applies before buying even one share in a company. Take Buffett’s advice: don’t buy any stocks in 2023 unless they pass this critical test.

Warren Buffett with people in the background.

Image source: The Motley Fool.

Buffett’s two steps

Buffett wrote to Berkshire Hathaway shareholders in 2013 that he and his longtime business partner, Charlie Munger, use essentially the same approach to buying stocks that they use to buying entire companies. There are two steps to this process:

  1. Estimate the company’s earnings range five or more years into the future.
  2. Buy the stock if it is available at a reasonable price, relative to the lower end of the estimated earnings range.

There is an important word that Buffett used in the first step of this process. He wrote that he and Munger had to determine if they could sensitive estimate the profit of a company.

Anyone could pluck earnings projections out of thin air. Buffett, however, would insist that detailed research and careful analysis be performed to estimate earnings.

Note that it specifies that a range of earnings be estimated. The multibillionaire knows that it is impossible to accurately project the future earnings of any company. The best anyone can do is determine a realistic range.

The period five or more years into the future is also key. Companies may be able to generate strong gains in the short term but unable to do so in the long term.

going deeper

An obvious question about Buffett’s two-step process is: How can an investor estimate a company’s earnings range? The most important prerequisite is that you understand the company’s business well enough to make an educated guess.

Buffett emphasized this in his 2013 letter, stating, “It is vital, however, that we recognize the perimeter of our ‘circle of competence’ and stay well within it.”

The best place to start estimating future earnings is to look at a company’s financial statements. Look at current and past earnings to get a baseline. Check the balance sheet to ensure that servicing any debt does not detract from earnings growth.

Examine industry trends and the competitive landscape. A company that dominates a fast-growing market will be more likely to increase its profits than one with a lot of competition in a stagnant market.

Also, don’t hesitate to look at Wall Street analysts’ earnings projections. Just remember that the goal is to estimate earnings at least five years into the future, not just the next few quarters.

There is also another question that needs to be addressed: what is a reasonable price relative to the lower end of the range of estimated earnings? This will vary as the company grows. However, the average price/earnings estimate of the S&P 500 going back to 1950 it is 19.6. A stock that trades well below this level, compared to the lower bound of its projected earnings, should have a reasonable margin of safety.

Two stocks that pass the Buffett test

Are there stocks that pass this Buffett test in 2023? I think yes.

I would put Western Oil (OXY 1.14%) in the list without doing any detailed analysis. Buffett clearly believes that the oil and gas producer is reasonably valued, relative to his future earnings potential, because he recently bought a lot of Berkshire stock.

If we just look at the stocks that Buffett doesn’t own, I think Medical Properties Fund (MPW -0.80%) (MPT) stands out. The Health Real Estate Investment Fund (REIT) leases properties to hospital operators.

Analysts estimate it could increase earnings by an average of 6.5% per year over the next five years. I think that’s an achievable estimate, considering MPT has increased its earnings by more than twice that rate over the past five years.

But let’s be more pessimistic and assume that MPT will only grow earnings by 3% per year over the next five years. The stock trades at about 4.6 times that lower projected earnings. That’s a compelling valuation that I think makes MPT worthy of serious consideration, especially with its juicy 10.5% dividend yield thrown into the mix.

Maybe Occidental and MPT won’t bring big returns. Buffett himself acknowledged in his 2013 letter that he sometimes makes mistakes. If he does, you and I will too. However, only buying stocks that pass your critical test should help you avoid disastrous mistakes.

Keith Speights holds positions at Berkshire Hathaway. The Motley Fool holds positions and recommends Berkshire Hathaway. The Motley Fool recommends the following options: January 2023 $200 Berkshire Hathaway Long Calls, Berkshire Hathaway $200 January 2023 Short Calls, and Berkshire Hathaway $265 January 2023 Short Calls. The Motley Fool has a disclosure policy.