For the first time in six decades, Warren Buffett is no longer CEO of Berkshire Hathaway(NYSE: BRK.A)(NYSE: BRK.B). But that doesn’t mean he is disappearing into the sunset. Buffett remains chairman of Berkshire’s board of directors and will continue to be involved in major decisions.
More importantly, the investing wisdom Buffett has imparted over the years remains relevant. There’s one example of advice the “Oracle of Omaha” gave in the past that I think is especially applicable as the new year begins.
8Image source: The Motley Fool.
In his 2013 letter to Berkshire Hathaway shareholders, Buffett provided what I believe to be some of the best investing advice ever given. He identified a test consisting of two simple steps that he and his longtime business partner, Charlie Munger, used to determine whether to buy a stock.
I can’t say it any better than Buffett himself, so I’ll use his own words. He wrote:
When Charlie and I buy stocks– which we think of as small portions of businesses– our analysis is very similar to that which we use in buying entire businesses. We first have to decide whether we can sensibly estimate an earnings range for five years out, or more. If the answer is yes, we will buy the stock (or business) if it sells at a reasonable price in relation to the bottom boundary of our estimate. If, however, we lack the ability to estimate future earnings– which is usually the case– we simply move on to other prospects.
The first step in Buffett’s test is to determine if the earnings for a stock can be estimated for at least five years into the future. Note that he wasn’t talking about plucking numbers out of the air. Buffett insists on being able to “sensibly” project earnings.
The second step is contingent upon a positive answer to the first step. If Buffett doesn’t think he can project earnings for a stock for the next five or more years, he moves on. If he can, though, he checks to see if the stock’s valuation is reasonable relative to the lower end of his projected earnings range. He buys a stock only if the valuation appears to be attractive.
Buffett’s two-step test is easy to understand. However, it’s exceptionally hard to execute. The primary challenge is estimating a stock’s earnings over the next five years.
The legendary investor provided one key prerequisite for making earnings projections in his 2013 letter to Berkshire shareholders. He stressed that he focused only on stocks within his “circle of competence.”
Evaluating stocks of companies you understand can increase the likelihood that your earnings projections are sound. You’ll be more likely to recognize industry trends and competitive dynamics that could impact future earnings growth.
However, Buffett acknowledged that he still made mistakes, even with his scope limited to businesses within his wheelhouse. You could make mistakes as well. That’s why it’s essential to follow the second step of his test, which involves valuing using the lower end of projected earnings rather than a more optimistic projection.
Are there any stocks that appear to pass Buffett’s test as 2026 begins? Yes, but not many. Buffett has been a net seller of stocks for 12 consecutive quarters and amassed a record-high cash stockpile for Berkshire for a reason. However, there are still some appealing stocks in the market.
AbbVie(NYSE: ABBV) is one great example. The big drugmaker has successfully navigated its Humira patent cliff. It should be able to deliver robust earnings growth over the next five years. The stock is attractively valued. AbbVie also pays a healthy forward dividend yield of 3%. And it belongs to the elite group of stocks known as Dividend Kings, which have increased their dividends for at least 50 consecutive years.
A recent Buffett purchase could also qualify – Nucor(NYSE: NUE). The large steelmaker could benefit from the continued surge in data center construction and increased general infrastructure investments in the U.S. Nucor’s low forward price-to-earnings ratio of 14.5 looks appealing relative to its growth prospects over the next five years.
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Keith Speights has positions in AbbVie and Berkshire Hathaway. The Motley Fool has positions in and recommends AbbVie and Berkshire Hathaway. The Motley Fool has a disclosure policy.
