Wednesday, May 8, 2013

Lessons Investors can learn from the book, The Warren Buffett Way

I don't look to jump over 7-foot bars; I look around for 1-foot bars that I can step over.” - Warren Buffett

Most of the financial advice we receive today is worthless by the end of the week.  That is because it is mostly context driven and that means it deals exclusively with the short-term.  There aren’t many really useful sources of long-term advice you can use to help manage your investments.

One of the best sources for long-term investment advice also happens to be the greatest investor of all-time, Warren Buffett.  His annual shareholder letters are must reads for anyone looking for practical advice on controlling your emotions and making smart investment decisions.

The Warren Buffett WayThere are also countless books that have been written over the years about Buffett that outline his investment style and temperament.  One of my favorites is The Warren Buffett Way by Robert Hagstrom.  It was first published in 1994, but the advice and lessons still ring true to this day.

In the book Hagstrom outlines Buffett’s investment tenet’s that he looks for to determine whether a stock or a business is a good candidate for investment.  What follows are those tenets as well as my thoughts on the lessons from each of them.

Business Tenets
I. Is the business simple and understandable?
Buffett has always said that he only invests in companies that he can understand.  That has meant that he has mostly stayed away from technology companies (until a recent IBM purchase) and focused solely on businesses that are not too complex.
Lesson: Complex investments are not necessarily better than simple investments.

II. Does the business have a consistent operating history?
This one is simple to determine and should keep you out of dangerous IPOs.
Lesson: New investment products may sound compelling but it pays to stick with securities or funds that have a legitimate history.

III. Does the business have favorable long-term prospects?
Just because a company has a great track record does not mean it will continue indefinitely into the future.
Lesson: Stocks are simply the sum of their discounted future cash flows.  Make sure your investment themes are based on where things are going and not where they have been.

Management Tenets
I. Is management rational?
Buffett has stated over the years that partnering with a solid management team that he can trust is a very important feature in his investment process.
Lesson:  As we saw in the crisis in 2008 there were many inept management teams at very large companies that cost their shareholders a lot of money through irrational decisions.

II. Is management candid with its shareholders?
You also need to look for management teams that are honest about their successes and failures.  If they are always making excuses when things go wrong it could lead to problems down the road.
Lesson: Admit your mistakes and be a good person, when investing or in life.  As Buffett has said, "It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you'll do things differently."

III. Does management resist the institutional imperative?
Buffett is not a fan of managers that look to please shareholders in the short-term at the expense of the long-term results.
Lesson: Focus your investments on the long-term and try not to pay attention to short-term noise in the markets.

Financial Tenets
I. Focus on return on equity, not earnings per share.
ROE is simply how efficient a company is at generating profits for shareholders.
Lesson: EPS numbers are much easier to manipulate with accounting tricks.  ROE shows how businesses use funds to create earnings growth which is much more important.

II. Calculate “owner earnings.”
Buffett stated that owner’s earnings = earnings + depreciation/amortization – capital expenditures.
Lesson: This is the real amount of money that a business owner receives from the company instead of an accounting-based number.

III. Look for companies with high profit margins.
Buffett likes to look for companies with high profit margins because that usually means they have a competitive advantage.
Lesson: It is very hard to for other businesses to compete with “moat” businesses as Buffett likes to call them (examples include Coca-Cola, Gillette, American Express and Geico).

Market Tenets
I. What is the value of the business?
Once you go through all of the other tenets you must still make sure that you can come up with an intrinsic value using some sort of valuation technique (DCF, P/E multiple, etc.)
Lesson: Good companies don’t necessarily make good stocks so you must determine whether or not it makes sense to make a purchase based on a stock’s worth and valuation (obviously, easier said than done).

II. Can the business be purchased at a significant discount to its value?
This is what has really set Buffett apart over the years.  He waits for the fat pitch to make his investments.
Lesson: The term margin of safety when making an investment has served Buffett well over the years.  The price you pay for an investment is the single largest determinant of future returns.

Buffett has always done a great job of making the complex sound simple.  His investment process is not quite as easy as just following these tenets and then blindly making investments.  There is a lot more homework and thought put into each purchase because he is such a long-term investor.

If you invest in individual stocks you can use these tenets as a starting point for your research.  Make sure you do your homework, though.

And if you don’t have the time or inclination to pick stocks you can still learn from Buffett by controlling your emotions in the face of uncertain investment outcomes.  You can also take his advice and buy simple, low-cost index funds if you don’t want to spend the time picking individual names.

Just because you will never be as good of an investor as Warren Buffett doesn’t mean you can’t learn something from his teachings.  It pays to take advice from legends.

About the Author:
The above is a guest post from Ben Carlson at A Wealth of Common Sense.  Ben writes about personal finance, investments, investor psychology and using your common sense manage your money.  You can follow him on Twitter (@awealthofcs).