As frequently as investors might hear about Warren Buffett’s time-tested value-investing philosophy, there’s a lot that people still don’t know about how the Oracle of Omaha evaluates stocks.
In particular, there are three things about his investing style that are especially under the radar. Let’s learn about them and look at a couple of examples that demonstrate his thinking.
1. He’s not a fan of being reliant on R&D spending
Most investors don’t know that Buffett dislikes companies that need to consistently spend a lot of their revenue on research and development (R&D). Let’s take a major pharmaceutical company like Eli Lilly (LLY -2.79%) as an example to explain his thinking. In 2021, it spent more than $7 billion on developing new medicines against its total revenue of $28.3 billion. For the money, it advanced a handful of its myriad clinical trials and preclinical projects. And that’ll allow it to eventually commercialize at least a few of its programs to generate more revenue than it does today. But if Eli Lilly one day decided to stop its R&D investments, its competitors would eat its lunch in a matter of years because they would develop and commercialize better therapies.
Such a result speaks directly to why Buffett doesn’t like companies that spend a lot of their revenue on R&D; the pressure to innovate against other companies’ products frequently increases as more competitors enter a market, but it rarely decreases. In other words, R&D-intensive industries are rife with spending races that can erode returns over time. Nonetheless, Buffett is willing to compromise on his preference if it’s for powerful businesses like Apple (AAPL 0.12%), so investors trying to mimic his style should take note to avoid being too dogmatic.
2. Dividends aren’t usually his thing
Buffett isn’t a fan of dividends either. When companies pay dividends, they distribute capital to shareholders that potentially could have been reinvested into the business for the purpose of growth. Therefore it’s reasonable to expect that dividend payers will expand more slowly specifically because they are giving money away, and expanding slowly is often a one-way ticket to losing ground against competitors. The other salient point is that sometimes dividends are paid out because management can’t find a good place to invest the excess capital being generated by operations. Both of these situations are regrettable to the Oracle of Omaha, and that’s before even getting into the issue of taxes.
Buffett dislikes paying taxes on his capital gains. To get around that, he simply holds shares for longer than a year, so that when he does eventually sell, he gets taxed once at the lower long-term capital gains rate. When receiving dividends, investors are on the hook for the associated taxes every quarter, but they’re also on the hook for the capital gains taxes after selling. Plus, because the company has less capital to throw into growth, effectively investors may end up experiencing lower price returns on top of their additional tax burden. And all of the above is quite distasteful to Buffett.
Once again, keep in mind that he’s willing to compromise for the right company. Apple’s forward dividend is a measly $0.92 per share, which works out to be a forward yield near 0.60% and a payout ratio of 14.3%. In contrast, Eli Lilly’s forward dividend rate is $3.92, whereas its forward yield is near 1.2%, and it pays out a massive 52.4% of its earnings. It’s no surprise that Buffett owns Apple and not Eli Lilly.
3. Most healthcare stocks aren’t usually his thing either
Healthcare businesses are few and far between in Buffett’s portfolio. He holds shares of DaVita, McKesson, Johnson & Johnson, and Royalty Pharma. Notably, Johnson & Johnson is the only pharmaceutical company in his lineup, and he has no exposure to biotech or healthcare real estate investment trusts (REITs). Given his distaste for R&D spending and dividends, the absence makes sense. But there’s another reason that likely motivates him to stay away from most pharma and biotechs: They need to take a lot of risks to survive.
Biopharma businesses doing drug development need to initiate a bunch of programs to investigate in clinical trials because the odds of any single program failing to demonstrate its safety and efficacy are quite high. To put it differently, making new medicines is an inherently risky and failure-prone process — and Buffett is an avid risk minimizer.
In the context of Eli Lilly and Apple, his reasoning becomes even clearer. Whereas Apple knows it can find a market for a new iPhone and that it can develop a new iPhone without a high chance of catastrophically failing along the way, many of Eli Lilly’s candidates for becoming life-saving medicines end up getting shelved after flopping in clinical trials. And to Buffett, that’s wasted money that could’ve been put to use in a more reliable type of investment to yield better returns for shareholders.
Alex Carchidi has positions in Apple. The Motley Fool has positions in and recommends Apple and Eli Lilly and Company. The Motley Fool recommends Johnson & Johnson and McKesson and recommends the following options: long March 2023 $120 calls on Apple and short March 2023 $130 calls on Apple. The Motley Fool has a disclosure policy.