Warren Buffett is perpetually one of the richest people in the world and is almost universally considered to be the greatest stock picker the world has ever known. He is currently CEO of Berkshire Hathaway and has 60 years of investment experience, aided by his long-term trusty colleague Charlie Munger.
While you might not ever be worth $50 billion, you can certainly learn a thing or two from ‘The Oracle of Omaha’ and greatly increase your wealth over the long term.
Although he has never officially written down his process for evaluating and choosing stocks, there is a lot that can be learned from his letters to his shareholders which highlight his principles.
So let’s look at what we deduce after analysing these letters:
1. Don’t lose money. It’s an obvious first principle but one he feels needs highlighting. Buffett’s philosophy is to purchase a stock for less than it’s worth and then let the rest of the world finally figure it out, too. This is commonly referred to as value investing and has been the cornerstone of his investing strategy from the very beginning.
* In fact, the rest of his principles revolve around the best ways to find the kind of companies that match his ideals.
2. The company must have strong profitability. Buffett prefers companies that are already profitable as opposed to companies that are likely to someday become profitable. There are several measures he utilises to determine this. Some of these include Return on Equity (ROE), Return on Invested Capital (ROIC), and profit margins.
* ROE – While no one knows for sure, the general consensus is that he wants to see an ROE of 15% or more.
* Profit Margins – In this case, we’re talking about dividing net income by net sales. Obviously, the higher the better.
3. The company must have low debt. Too much debt is bad for everyone, including companies. In case you thought we skipped ROIC above, we’re getting back to it now. Sometimes a company will appear to have a high ROE, but the number is actually artificially inflated. This can happen when the company is using debt to pay its bills. This is where ROIC comes into play.
* ROIC removes debt from the calculation by adding it back to the shareholder equity prior to completing the ROE calculation. You can simply divide the company’s total liabilities by shareholder equity. The higher the ratio is, the more a company is using debt to grow the company. Be careful.
* Companies with a lot of debt can be harmed when either interest rates rise or credit becomes harder to acquire.
4. The company must have competent management. Buffett has always placed a lot of emphasis on a company’s management team. He favours intelligent, humble management that doesn’t simply follow the crowd. He has stated that his company simply allocates capital; it does not provide management.
* He has traditionally stayed out of influencing a company’s management, but he insists that good management be present. Ensure the companies you invest in are being run by a competent management team.
5. Comprehension. Buffet refuses to invest in a business that he doesn’t understand. You will find that the businesses in which he invests are relatively simple. He largely avoids technology companies, because as he has stated, he doesn’t really understand that type of business. Although he now has billions of dollars invested in Apple, he didn’t invest until they were highly profitable and were the dominant player in the market. He would rather miss out on an opportunity than risk losing money. He prefers to stick to his mantra of only investing in what you are capable of understanding.
6. Be patient. It seems like Buffett has held some stocks since before the dawn of time. He held many stocks for 5 years or more before the stock ever rose even 1%. Value investing takes time; you’re going to have to be patient to see the returns. Don’t be in a rush.
While we can’t all be Warren Buffett, we can certainly follow his basic principles and improve our own investing results. Focus on underpriced companies with a history of profitability, little debt, and a competent management team. And remember to be patient!
If you can do these things consistently, you may be pleasantly surprised at the amount of wealth you can gain!
Although Warren Buffett’s preferred investment period is ‘forever’ he does offer some specific guidance for those amateur investors with short-term financial goals.
Most of us aren’t financial wizards and don’t even hold a job in a finance-related field. We’re teachers, managers, labourers, and engineers. Can the average person do a good job of picking stocks? That depends on a lot of factors.
Historically, Buffett has insisted that investing doesn’t require a high IQ, but it does take some experience to recognise a great investment. He also has several advantages the average person doesn’t. However, his basic strategies are available to all.
Buffett has suggested two different sets of instructions for non-professional investors.
If you lack knowledge about the stock market and are short on time, check out these tips:
1. Put 10% of your investment monies into short-term government bonds. This is money that can be accessed quickly and easily but isn’t rotting away in a checking or savings account.
2. Put the remainder in a low-cost index fund. While this isn’t the most exciting advice, it makes a lot of sense. Few managed funds are able to match the expense adjusted results of an index fund over several years. Plus, the expenses and the folly of the fund manager are too much of a disadvantage.
This is the exact advice Buffett has left for the trustee that will administer his wife’s trust. We have to assume he loves his wife, so it’s probably good advice for the rest of us. It doesn’t get much simpler than this. It also requires very little time and attention.
If you prefer to pick your own stocks, follow this advice:
1. Familiarise yourself with stock analysis. Buffett has frequently given this advice to business students. It consists of analysing every single stock on the NYSE. When students point out that there are thousands, Buffett’s response is, “Start with the A’s.”
* Warren Buffett has stated that it’s easy to recognise good companies after you’ve researched a few thousand of them.
2. Consider the margin of safety when you invest. Invest in companies that are available for a discount relative to the true value of the company. The greater the margin of safety, the greater the potential upside. The downside is also greatly reduced.
3. Invest in businesses, rather than markets. Buffett doesn’t recommend investing just because a certain type of economy exists. At the end of the day, it’s the quality of the underlying company that’s most important. The economy rarely enters the picture.
4. Keep it simple. According to Buffett, having anything beyond average intelligence is unnecessary when it comes to investing. Stick with businesses that are easy to understand. It’s easy to understand how a grocery store makes its money. Biotech companies are a little more complicated.
5. Be careful where you get your information. Buffet once said, “Never ask your barber if you need a haircut.” Who benefits if you follow a broker’s advice? Be sure to consider the source.
* Unfortunately, the more mysterious the source, the more credibility we tend to project onto the source. You might doubt your friend, but you convince yourself that the odd man on the bus certainly knows what he’s talking about.
Warren Buffett suggests an index fund for the armchair investor, but many enjoy investing and can do well on their own. It’s important to put in the necessary work to find solid investments. If you’re short on time, the index fund is probably your best option.
Investing is notoriously difficult to get right and it’s difficult to make a decent return without some element of risk but be sure to consider tax-efficient options to maximise your returns. Ultimately, your circumstances and appetite for risk will determine the best types of investment for you. However, using Warren Buffett’s insight should help you make better financial choices for your future. Despite being a billionaire, Warren Buffett has always led a relatively frugal lifestyle. This emphasises another of his beliefs, that it’s not just about making money, it’s also about carefully managing what you have, no matter how much or how little that may be.