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