This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
Arguably the world's greatest stock picker isn't picking many stocks these days. Warren Buffett has been a net seller of stocks for eight consecutive quarters. I suspect when Berkshire Hathaway discloses the transactions it made in the fourth quarter of 2024, that count will increase to nine.
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. Buffett is a master stock picker because he's highly selective about which stocks he buys.
Your chances of investing success will likely be greater if you're as picky as Buffett. Don't buy any stock in 2025 unless it passes this Buffett test.
A two-part test
Can we really know the "magic" process Buffett uses to select the stocks he buys? Actually, yes. In his 2013 letter to Berkshire Hathaway shareholders, the legendary investor revealed exactly what he does to select stocks. Buffet revealed a two-part test in that shareholder letter. By the way, it's very similar to the process he uses to identify companies for Berkshire to acquire.
Buffett first determines whether he can "sensibly estimate an earnings range for five years out or more." The operative word there is "sensibly." He doesn't pluck numbers out of the air but instead thoroughly reviews a company's business along with industry trends to make the best earnings estimate possible.
Note that five years is a minimum estimation period. Buffett wants to avoid investing in a business that might temporarily deliver strong earnings growth only for that growth to quickly evaporate. In his letter to Berkshire shareholders, Buffett wrote that 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. He will buy a stock only if it's reasonably valued using this approach. Again, if the stock doesn't pass this second step, he moves on.
Simple, yet difficult
This two-step test used by Buffett might seem simple. However, it's more difficult to follow than you might think.
For one thing, "sensibly" estimating a company's earnings over five years or more can be challenging. If you've ever wondered why Buffett didn't invest in Apple or Amazon earlier than he did — or never bought stocks such as Nvidia that turned out to be massive winners — it's because he couldn't project their future earnings with enough confidence.
In his 2013 shareholder letter, Buffett explained that he needed to recognise "the perimeter of our 'circle of competence' and stay well inside of it." He knew (and still knows) how important understanding a business and industry is to estimating earnings.
It's also tough in some market environments to find stocks valued attractively enough to pass the Buffett test. That has clearly been the case in recent quarters. Otherwise, you can bet Buffett would have bought more stocks instead of amassing a cash stockpile of over $325 billion for Berkshire.
US stocks that might pass the Buffett test in 2025
Are there some stocks that might pass the Buffett test in 2025? I think so.
Energy Transfer (NYSE: ET) is 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 (NGLs), and crude oil for years to come. The company also pays a juicy distribution that yields around 6.5%.
Don't look for jaw-dropping growth from Energy Transfer, but average annual growth of between 3% and 5% should be easily attainable. That's how much the company expects to grow its distribution. Even at the low end of this range, Energy Transfer's valuation looks attractive, especially considering its distributions provide a solid head start to a double-digit annual total return.
Buffett probably views Occidental Petroleum (NYSE: OXY) as one of the few stocks that meet his test. He has continued to regularly scoop up shares of the oil and gas producer, most recently during a sell-off last month.
I also like Oxy's prospects. However, investors should note that Berkshire owns warrants that allow it to buy the stock at a predefined share price. This undoubtedly makes the stock even more attractive to Buffett than it will be to other investors who don't benefit from such a deal. Occidental Petroleum might pass the two-step test for Buffett but not for others.
This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
