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A safer way to buy individual stocks

2019-11-12, Michael Thompson

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A safer way to buy individual stocks

In this article we explain a safer way to buy individual stocks. Unless your education, passion, and career are devoted to it, we recommend against buying individual stocks (we recommend index funds). However, many of us can't resist the urge to set aside some money for individual stock picking. If we're going to do it anyway, let's talk about a safer way to do it.

This method leverages the research and wisdom of experts at Berkshire Hathaway (including Warren Buffett and Charlie Munger). They are well known for only buying stocks if they (1) understand the business, (2) believe it's reasonably priced and (3) are willing to own it for a very long period. While other experts share this philosophy, few execute it as well as Berkshire.

The Strategy

Berkshire is required by the SEC to disclose their US equity holdings quarterly. (All institutional investment managers with at least 100M USD in equity assets must do this in SEC Form 13F.) This gives us all a free look at what Berkshire has held and purchased, at least in the last several months. We'll start with this list of stocks, and down select from here.

The first down selection will remove all stocks in which Berkshire’s holdings have decreased since the previous 13F filing. If Berkshire is selling a stock there’s likely a good reason, and we don’t want to buy those.

We’ll now remove any stocks that have appreciated significantly more than the S&P 500 in the prior 4 months. These stocks are at a higher risk of being overpriced by Berkshire’s analysis. Berkshire may have even sold some of these recently - we can’t see what Berkshire has sold after the cutoff date in their latest 13F (which could be months ago).

We also want to remove stocks that have appreciated quickly after Berkshire’s filing. This could indicate an excess of people applying a similar strategy and effectively overvaluing the stock. The 13F filing includes a “filing date” you can use for this purpose.

At this point, you should have a list of over 20 stocks to choose from. They are less likely to fail than the average company, and should perform significantly better in a recession, on average. Admittedly, they probably aren't "sexy" and are unlikely generate massive returns. Some further information is provided below.

Help

If you want to apply this strategy, we can send you an email when each quarterly filing is publicized. We'll even show you the filling and do the down selection for you, providing a final list of companies to choose from.

Low Risk = Limited Upside

As usual with investing strategies, increased safety comes with a drawback: limited upside potential. We said Berkshire only buys stocks of businesses they understand. There will be (or are now?) businesses that will grow into the next Microsoft or Apple. Unfortunately, such companies will likely be based on novel technologies outside Berkshire's domain of expertise. Don't expect to capture these big prizes with this strategy.

Limit exposure to any one company

Even though this strategy will limit you to safer companies, we still don't recommend putting more than 30% of your savings into one company. Warren Buffett will be the first to admit that even he occasionally misevaluates a company. If you invest long enough, you're going to buy something that loses most or all of its value. If too much of your capital is in that asset, it can be devastating.

When to Sell

One drawback in this strategy is that we probably won't know when Berkshire decides to sell one of these stocks. At some point their analysis will indicate that the underlying business is no longer attractive (or at least that others are more attractive). We'd like to follow suit and sell ourselves. However, 13F forms are typically filed over a month after the end of the quarter, and they do not disclose any information after the end of that quarter. If Berkshire sells a stock on the first day of a quarter, we won't know for almost 5 months! So what do we do?

Of course, if you see a new filing that indicates they've sold, but the price hasn't dropped significantly yet, you've got a nice chance to escape. Barring extreme circumstances, we like to hold our stocks for at least a year. After that, we recommend re-applying the strategy above. Take the down-selected list and evaluate which companies you'd like to buy. Compare your choices with your current holdings and sell/buy accordingly.

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