Widely considered the most successful investor of all time, Warren Buffett is a luminous example of the school of value investing. Starting with an initial fund of $105,000 in 1956, Buffet grew it to $45 billion over the next 50 years, making him the second richest man in the world. Though he is widely recognized as being an investor, the bulk of Buffet's wealth was built through intelligent use of leverage offered by his insurance companies. Since most individual investors do not have access to the type of capital that Buffet does, it is not easy to replicate his astounding wealth-building feat. However, by understanding and applying the basic guidelines of Buffett's investment approach to their own investing decisions, most long term investors can comfortably beat the returns of all but the best mutual fund managers.
So, how did Buffet accumulate the huge fortune that he eventually gave away to the charitable foundation run by his best friend, Bill Gates? One of the greatest attractions of Buffett for investors is that his investment methodology is easy to understand. However, it is far more difficult to apply because it calls for large amounts of patience and calm when your stocks move against you. It is also difficult to apply because it requires an orientation towards research and the ability to understand the complexities of accounting and finance. But for those willing to invest time and effort into mastering this approach, superlative investment performance over the long term is guaranteed.
Invest in Businesses, Not in Stocks
"Whenever we buy common stocks for Berkshire's insurance companies (leaving aside arbitrage purchases), we approach the transaction as if we were buying into a private business. We look at the economic prospects of the business, the people in charge of running it, and the price we must pay." -- Warren Buffett
This is the cornerstone of Buffett's investment style. Whenever he evaluates an investment opportunity he analyses it as a business and not as a stock. This makes him look closely at the company's fundamentals, earnings prospects, financial health and management. Conversely, this style of evaluating a business prevents him from buying a stock just because it is going up even though it has dubious prospects. A lot of investors tend to buy stocks based on tips from friends, acquaintances or brokers. By adopting Buffett's approach, you can save yourself a lot of grief later on.
Only Buy Businesses that You Understand
"Did we foresee thirty years ago what would transpire in the television manufacturing or computer industries? Of course not. Why, then, should Charlie and I now think we can predict the future of other rapidly evolving business? We'll stick instead with the easy cases. Why search for a needle buried in a haystack when one is sitting in plain sight?" -- Warren Buffett
Buffett has a track record of generating 21 per cent annually compounded returns over a 50-year time frame, a feat matched by very few investment managers. Though technology companies delivered some of the best returns during this period, Buffet has never owned one for the simple reason that he could not understand the long term prospects of these companies and evaluate them thoroughly. So the next time you get a tip to buy a "hot" company that you do not understand, you should ask yourself: "If the greatest investor in the world will not invest in something he doesn't understand, should I?"
Buy Companies with Defensible 'Franchise'
"As Peter Lynch says, stocks of companies selling commodity-like products should come with a warning label: 'Competition may prove hazardous to human wealth'." -- Warren Buffett
Most of Buffett's portfolio companies, such as Coca Cola, Gillette (now Procter and Gamble), American Express and Washington Post, are businesses which have a significant hold over their market. This is because they have inherent competitive advantages, whether it be a highly recognizable brand, or near-monopoly status in a geographic area. Such companies can typically raise their prices without fear that customers will walk away. This in turn produces fantastic earnings growth and, consequently, great investment performance. So, before you make an investment in future, try to understand whether the company you are investing in has a strong and defensible market position and whether it can raise prices if it needs to.
Hold for the Long Term
"We are willing to hold a stock indefinitely so long as we expect the business to increase in intrinsic value at a satisfactory rate . . . we do not sell our holdings just because they have appreciated or because we have held them for a long time." Warren Buffett
Buffett's companies have generated enormous returns for him. For example, his investment of $10 million in 1973 in the Washington Post Company had grown to more than $1 billion by 2003. While a lot of us may be able to do this occasionally, Buffett has generated such returns with startling regularity. One of the reasons he is able to do so is because he holds for the long term and is not quick to enter or exit businesses. In fact, he stuck with WPC for two years even though its price fell below his purchase price because he understood the fundamentals of the business and believed that it was undervalued. Even once it became profitable, he was not quick to exit because he believed that it had greater potential. He held it through several bull and bear markets and no greater proof is needed than the return he achieved to show that he was right in holding it for so long.
Ignore Short-Term Fluctuations in Price
"Charlie and I let our marketable equities tell us by their operating resultsnot by their daily, or even yearly, price quotationswhether our investments are successful. The market may ignore business success for a while, but eventually will confirm it." Warren Buffett
The stock market has a tendency to overreact on both the upside and downside. Often the market ignores the fundamentals of a business and reacts sharply to news flow. Sometimes entire sectors become either unduly depressed or overpriced. One of the key pillars of Buffett's approach is to ignore short-term fluctuations in price. He does not sell a stock because the market suddenly decides to drop. Neither does he buy one because it is going up. Once Buffett has calmly evaluated the fundamentals, he will buy the stock if its price is right. If the stock dips after he has purchased it, he does not worry so long as its fundamentals are good. Had he gotten jittery due to short-term price fluctuations, he would have been a lot less richer than he his currently.
Buy Good Businesses When Prices are Down
"If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they feel elated when stock prices rise and depressed when they fall. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices." Warren Buffett
On 19 October 1987, all global stock markets crashed. The Dow Jones Industrial Average actually suffered a decline of 22 per cent, the greatest single-day drop in its history. Every stock on the market fell. Most people sold their holdings in panic that day. Buffett, however, was buying! He made the single largest stock purchase of his life that day. While all others around him hit the panic button, Buffet bought 10 per cent of Coca Cola for $1 billion. Not only was it his largest single stock purchase, he also became the single largest shareholder in the company. In his analysis, Coca Cola had a great business, great long-term prospects and the ability to expand because of globalisation. If the market was willing to sell it at an unreasonably cheap price, he wanted to scoop it up with both hands. And scoop it up he did! Coca Cola became one of the most successful investments in Berkshire's portfolio. By 2006, Buffett had made over $11 billion on Coke since he bought it.
Don't Be an Active Trader
"Indeed, we believe that according the name 'investors' to institutions that trade actively is like calling someone who repeatedly engages in one-night stands a romantic." Warren Buffett
Buffett is an atypical investor not only because he is highly successful, but also because he does not even look at stock tickers. He believes that trading too much is a tax-inefficient and costly approach to investing. Consequently, he has a very low turnover portfolio, very low brokerage charges and has not paid very much in the nature of capital gains taxes.
Do Not Over-Diversify
"If you are a know-something investor, able to understand business economics and to find five to ten sensibly priced companies that possess important long-term competitive advantage, conventional diversification makes no sense for you." -- Warren Buffett
A striking aspect of Buffett's portfolio at Berkshire is the small number of stocks in it. This number has rarely exceeded 10 stocks. Buffett believes that there are very few outstanding investment opportunities at any given point of time and that one should invest enough in each of those to make a substantial difference. In contrast, most people fill up their portfolios with more than fifty stocks. As a result, even if a stock appreciates 100 per cent, the impact on their net worth will only be 2 per cent. Investors who want to generate truly outstanding returns should identify a small number of great businesses at the right prices and invest a significant amount of their money in each of them.
Invest Only When There is a Margin of Safety
"Margin of safety" is a slightly difficult concept to understand. It can be loosely defined as the difference between value and price. If the value of what you buy is higher than the price you pay for it, you have a high margin of safety. If the price you pay is greater than value, you have a low margin of safety. When the margin of safety is high, the investor need not worry about short-term fluctuations in price and can buy more if he or she has the resources to do so. Also, if you are investing in a situation with a significant margin of safety, you are likely to make a higher return because you are buying at a relatively low price.
However, how does one quantify this margin of safety? It is admittedly a grey area. There are seemingly scientific approaches, such as the discounted cash flow, which are taught in most corporate finance textbooks. In practice, though, it is both very subjective and very difficult for an individual investor to apply. However, there are other short cuts which are more approachable. Since the discounted cash flow ultimately crystallizes into the price / earnings (P/E) ratio, one way of estimating the margin of safety is to look at the P/E ratio. A low P/E means there is a margin of safety. But even this approach has its pitfalls. Slow growing, lousy companies often tend to have low P/E ratios. And, sometimes, very promising companies have high P/E multiples.
One way around this problem is to divide the P/E ratio by the growth rate of the company's profits to arrive at its price-earnings to growth ratio. Thus, if a company's P/E is 20 and the growth rate of its profits is 20 per cent, its PEG is 1. Oftentimes, a PEG of less than 1 implies that there is a significant margin of safety. A PEG of greater than one means that the margin of safety is not very high.
That said, PEG is not the holy grail of valuation and there are several ways to value a company -- and all these approaches have their flaws. You can consider your time well invested if you spend some time researching valuation by reading a corporate finance textbook.
Thus, Warren Buffet's investment approach is easy to understand, but calls for significant effort on your part to understand businesses, evaluate them and invest successfully but then, nobody said that becoming a billionaire was easy!
Excerpted from Intelligent Stock Market Investing by N J Yasaswy. Price Rs 280.
The author is an authority on investing and finance and has written several books on these subjects.
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