Warren Buffett Revealed a Previously Undisclosed Secret to How He Beats Wall Street. Here's How It Can Help You Make Money, Too.

Warren Buffett shocked many attendees at Berkshire Hathaway's annual shareholder meeting earlier this month by announcing his plans to step down as CEO at the end of 2025. He noted that he had discussed the move with only two members of Berkshire's board -- his children, Howie and Susie. The legendary investor kept the secret from the rest of the board and executives.

While his passing of the baton to Greg Abel was the big story from Berkshire's shareholder meeting, Buffett also mentioned something many investors might have overlooked. He revealed a previously undisclosed secret to how he beats Wall Street.

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Buffett's secret

It's no secret whatsoever that Buffett has indeed outperformed Wall Street throughout his long career. Between 1965 and 2024, Berkshire Hathaway delivered an average annual return of 19.9%. During the same period, the S&P 500's (SNPINDEX: ^GSPC) average annual return was 10.4%. Berkshire's year-to-date gain is also well above the S&P 500's.

Most active fund managers emphatically don't beat the S&P 500. Between 2001 and 2024, there were only three years when a majority of these fund managers outperformed the index. On average, 64% of fund managers underperformed the S&P 500 each year.

How has Buffett beaten Wall Street? He has mentioned several ways in the past, including sticking to his circle of competence, focusing on valuation, and (most importantly) thinking long term. But the "Oracle of Omaha" hadn't discussed another important secret to his success until the recent Berkshire Hathaway shareholder meeting. Buffett told the audience:

It's one thing we've really never talked about here, but I spend more time looking at balance sheets than I do income statements. Wall Street doesn't pay much attention to balance sheets, but I like to look at balance sheets over an 8 or 10 year period before I even look at the income account because there are certain things it's harder to hide or play games with on the balance sheet than with the income statement.

Neither one gives you the total answer on anything, but you should understand what the figures are saying and what they don't say and what they can't say and what the management would like them to say that the auditors wouldn't like them to say. You learn more from balance sheets in my view than most people give them credit for.

What should you look at on a balance sheet?

I suspect that many investors, like Wall Street, don't focus on companies' balance sheets either. What should you look at on a balance sheet? I won't cover everything, but will highlight several important items.

Assets appear at the top of the balance sheet. Review the company's cash and cash equivalents, along with its short-term investments. A healthy cash stockpile (which includes liquid short-term investments) indicates a strong ability to invest in growth, pay dividends, and navigate turbulent economic periods.

Goodwill is another key intangible asset to review. It reflects how much a company paid for acquisitions that were greater than the fair market value of the acquired businesses.

Moving to the liabilities portion of the balance sheet, long-term debt is especially important. An exceptionally high debt load could increase the risk of investing in a stock. You'll also want to evaluate the debt-to-equity ratio. It won't show up on the balance sheet itself, but can be easily calculated by dividing total liabilities by shareholders' equity. Higher debt-to-equity ratios can also translate to higher risk.

Don't only look at the latest balance sheet, though. You should examine any trends from previous balance sheets as well. (Remember: Buffett said he looks at balance sheets "over an 8 or 10 year period.") Rapidly growing long-term debt could be concerning. On the other hand, a solid upward trendline in shareholders' equity (book value) is typically a good sign.

How following Buffett's approach could make you money, too

Buffett famously has only two rules of investing: "The first rule of an investment is don’t lose [money]. And the second rule of an investment is don’t forget the first rule." Looking at companies' balance sheets can help you follow his first rule.

For example, if you're considering investing in a stock that isn't profitable yet, its cash position is extremely important. A company that isn't generating profits and doesn't have an ample cash stockpile could be forced to issue new shares, which dilutes the value of existing shares and usually causes the stock to decline. This happens relatively frequently with smaller clinical-stage biotech stocks.

Too much goodwill on the balance sheet could also lead to writedowns that result in a stock falling. A recent example of this happening was with Warner Bros. Discovery, which recorded a goodwill impairment of $9.1 billion last year and saw its share price sink.

Excessive debt can be problematic, too. Walgreens Boots Alliance is a case in point. The pharmacy company was close to becoming a Dividend King, with 48 consecutive years of dividend increases going into 2024. However, Walgreens announced it was suspending its dividend earlier this year. Its huge debt load was a major factor behind the decision. Walgreens' share price plunged immediately. The company is now set to be taken private by Sycamore Partners.

Unlike Buffett's decision to step down as CEO, focusing on companies' balance sheets before investing isn't one of his most jaw-dropping secrets. However, it's one that just might make you more money over the long run.

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Keith Speights has positions in Berkshire Hathaway. The Motley Fool has positions in and recommends Berkshire Hathaway and Warner Bros. Discovery. The Motley Fool has a disclosure policy.