Take Warren Buffett’s advice: Don’t buy stocks in 2024 unless they pass this test

Thinking about buying stocks at the start of the new year? You might want to hit the pause button.

No, I’m not recommending that you avoid the stock market completely. That may prove to be a mistake in the long run. However, I think there is a quote by Warren Buffett that all investors should keep in mind. Follow Mr. Buffett’s advice. Don’t buy stocks in 2024 unless they pass this simple test.

Image source: Motley Fool.

buffett test

In his annual letter to Mr. Buffett, berkshire hathaway (BRK.A 0.50%) (BRK.B 0.53%) In a shareholder document released in 2014, he explained the tests he and longtime business partner Charlie Munger applied before purchasing stock. Although Munger passed away in November 2023, there is no doubt that Buffett will use this same process in 2024.

Buffett’s test has two steps.

1. Determine if you can “judiciously estimate your revenue range beyond 5 years.”
2. If the answer to the first step is yes, then only buy the stock if its price is reasonable compared to the lower end of the expected return range.

You might wonder if Buffett bends the rules from time to time. For example, would he buy a stock even if it passed the test and the overall economic outlook looked uncertain? Would he buy the stock if Wall Street hated it? The answer is a resounding “yes.” he wrote to Berkshire shareholders nearly a decade ago.

In 54 years we have [he and Munger] In all the years we’ve worked together, we’ve never given up on an attractive purchase because of the macro environment, the political environment, or other people’s opinions. In fact, these topics never come up when we make decisions.

easier said than done

The Buffett test for buying stocks is simple, but easier said than done. The most difficult part is estimating a company’s earnings over the next five years.

Mr. Buffett readily acknowledged that he and Mr. Munger were often unable to estimate future earnings with any degree of confidence, calling this “normal.” When this happened, he succinctly stated, “[W]Just move on to another prospect. ”

He also noted that he and Munger sometimes made mistakes in stock purchases. By staying “within our capabilities,” we have been able to minimize such failures, but we have not completely eliminated them. This is an important point. Investors will be able to more accurately estimate the future returns of stocks in industries they are familiar with.

2 stocks that will pass the Buffett test in 2024

Buffett hasn’t bought many stocks in recent quarters, which is evidence that he hasn’t found many stocks that pass his test. However, I think some stocks will pass the Buffett test in 2024.

DR Horton (DHI 0.64%) In my opinion, it’s one of them. Buffett began investing in this homebuilding company in 2023. Despite the company’s stock price soaring 70% last year, DR Horton trades at just 11.4 times forward earnings. That makes the stock an attractive value even if the company barely increases its profits over the next five years.

However, DR Horton should be able to deliver solid revenue growth. The United States continues to suffer from a severe housing shortage. The company should be able to build and sell more homes for years to come, as the Fed has indicated that interest rates are expected to decline slightly in 2024.

Next, let’s talk about stocks that Buffett doesn’t own. meta platform (meta 1.39%). It’s no exaggeration to say that Mr. Mehta does not fall within the purview of legendary investors, so Mr. Mehta will likely be reluctant to estimate future returns. But Wall Street seems to believe it could pass the Buffett test. Meta’s price-to-earnings ratio (PEG), based on analysts’ five-year earnings growth forecasts, is a low 0.79. A PEG ratio below 1.0 is considered an attractive valuation.

Over the past five years, Meta has grown its revenue by an average of nearly 8.5% per year. However, financial performance has improved. Assuming the company slightly outperforms its historical earnings growth, the stock looks like a reasonable value.

Buffett’s simple choice

Each investor should follow Buffett’s two-step process for themselves before purchasing stocks in 2024. But don’t worry if you’re nervous about estimating your earnings. Buffett has a really simple option that requires no testing at all.

In a 2014 letter to Berkshire shareholders, he argued that most investors would be better off putting their money into lower-cost investments. S&P500 Instead of picking individual stocks, we recommend using index funds. Buffett even predicted that following this advice would “almost certainly yield satisfactory results” in the long run.