Tips from Warren Buffett

Widely regarded as the most successful investor of all time, Warren Buffett is a luminous example of the school of value, or rather intelligent, investing. With an initial war chest of $105,000 in 1956 garnered from his close friends and family, Warren grew it to over $45 billion over the next 50 years, making him the second richest man in the world. How did a single simple man from the quietest of all cities, Omaha, manage to bulldoze his way to such position, and in the process, became a major owner in some of the most important businesses in the world? Though he is widely recognized as being an investor, the bulk of Buffett’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 Buffett does, it is tough to replicate his type of astounding wealth-building feat. Nevertheless, not being able to be like Buffett doesn’t mean unable to be at least like Graham. So, by understanding and applying the basic principles 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.

“There’re only two courses investment students need to learn – How to value a business & How to think about market prices. This of course is not the prevailing view at most business schools [but it doesn’t dampen its importance].” – Warren E. Buffett

Thus, in an attempt to answer the two questions as raised. The following will shed some light to unraveling the answers.

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 one of the cornerstones of Buffett’s investment style. Whenever he evaluates an opportunity in investment, he thinks of it as a business, and not as pieces of papers of stocks. He even noted that investment is best approached in the most business-like manner. This makes him look closely at the business’s fundamentals, earnings prospects, financial health, and management. On the converse, this style of evaluating a business bars 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, rumors, or brokers. By adopting Buffett’s approach, you can save yourself a lot of grief later on, although in the short term, it would seems that you forego a lot of easy and quick profits.

Stick to businesses 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 record of compounding over 20 percent of annual returns over a 50-year investment time span, a feat hardly matched, or rather unmatched, by very few investment managers. Though some technology companies delivered some of the best returns during this period, Buffett has never owned one for the simple reason that he could not understand the long term economic prospects of these companies. 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 “franchises” or “moats”

“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

Bulk of Berkshire Hathaway’s holdings in marketable securities are concentrated in no more than ten businesses – such as Coca Cola, P&G, Johnson & Johnson, Moodys, and American Express. These are examples of businesses that have a significant hold over their market that they are in. This can be attributed to the inherent competitive advantages, whether it be a highly recognizable brand, or near-monopoly status in a geographical area. This in turn leads to fantastic earnings growth (that far exceeds inflation rate) and, consequently, great investment performance. What counts in the best kind of business to own is the question if such a business can raise price as it wants to without losing market share.

A couple of test on how to evaluate how good a business is to ask two questions: 1) How long does the management takes to think before they decide to raise prices; 2) Will the core business strength be the same as it is five or ten years from now? You have to decide whether the business will still be around, and if there’s any other way people can get the same service from different sources. In determining the ability to raise prices, you’re only looking at a marvelous business when you look in the mirror and say “mirror, mirror on the wall, how much should I charge for Coke this fall?” and the mirror says “more.” On the other hand, when you say, for example in a commodity-like business, when you get down on your knees, summon all the priests, rabbis, monks, and just about every holy ones, and pray to rise for “just half a cent.” Then you get up and they say “We won’t pay it.” It’s just a lousy business. An example is if you walk into a convenience store and you say “I’d like a Hershey bar” and the man says “I don’t have any Hershey bars but I’ve this unmarked chocolate bar, and it’s 20cents cheaper than a Hershey bar.” And if you just walk out of the store and cross the road and look for a Hershey bar, that’s a great business.

Over time, you will find only a few companies that meet these stringent standards. So when you see one that qualifies, you should buy a meaningful amount of stock.

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

“You must also resist the temptations to stray from your guidelines: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upwards over the years, and so also will the portfolio’s market value.” – Warren Buffett

Berkshire Hathaway’s investment of $10 million in 1973 in the Washington Post Company had grown to more than a billion by 2003. While a lot of us may be able to do this occasionally, Buffett has been able to do so with startling regularity. One of the reasons he is able to achieve so is because he holds for the long term and is not quick to dance in or out or the business as would the market suggests so. In fact, he stuck with WPC for two years even though its price fell below his purchase price significantly because he understood the fundamentals of the business and believed it was undervalued. Even once it became profitable, he was not quick to exit because it is firstly not easy to find a great business at a fair price that can be purchased in a meaningful amount and also, good management cannot be purchased at any price. 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 the long run.

Ignore short-term fluctuations in price

“Charlie and I let our marketable equities tell us by their operating results – not by their daily, or even yearly, price quotations – whether our investments are successful. The market may ignore business success for a while, but eventually will confirm it.” - Warren Buffett

One of the most famous quotes of Benjamin Graham that is imprinted and cast in stone in Buffett’s mind is “In the short run, the stock market is a voting machine, in the long run, it is a weighing machine.” The stock market has an incurable 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 overly depressed or overdriven by euphoria. Ben Graham, having one of the best brains in understanding the behavior of the market participants, told the story of an imaginative character – Mr. Market. If Mr. Market is happy, he will offer you an extraordinary high price to buy out your stake for he fears you will make more than him. If he is depressed, he will sell you his stake at a low price for he fears you will unload your interest on him. One of the pillars to Buffett’s strategy is to ignore short-term fluctuations in price. If he does, it is to take advantage of it, not to let it guides him. He does not sell a stock because the market suddenly drops. Neither, does he buy because it goes up. He will only buy the stock once he thinks that the business fundamentals are correct and at a good price. If the business is great but the price is not, he will wait. He waited for over 50 years before he buys his first share in Coca Cola. Even if the stock dips after he purchases it, he does not worry so long as its fundamentals are good. He said: “The less they sell for, the better I like it. Any time any thing gets cheaper, I like it better than I did the day before.” Had he got jittery due to short-term price fluctuations, he would have been a lot less richer than he is currently.

Buy good businesses when prices are down or at rational prices

“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 his 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 buyers should much prefer sinking prices.” – Warren Buffett

“Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now.” – Warren Buffett.

On 19th October 1987, all global stock markets crashed. The Dow Jones Industrial Average suffered its greatest single-day drop in its history by 22%. Every stock on the market fell. Most people sold their holdings in panic that day. Buffett, however, was scooping them up. He made the single largest stock purchase of his life that day. While all others hit the panic button, Buffett scooped up ten percent 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 franchise, great long-term prospects both in price and product, and the ability to expand because of globalization. If the market was willing to sell it at an unreasonable cheap price, he was willing to scoop it up with both hands. Coca Cola became one of his most famous and successful investments in Berkshire’s portfolio. By 2006, Berkshire’s gain on it was over $11 billion.

Besides purchasing businesses when prices drop, it is also important to purchase at a rational price. Investors must realize that it takes time for the stock to play catch up to the high price that they pay depending on how high they value each dollar of earnings in multiples. Investors who bought Coke in late 1990s at an earning multiple of 50 are still suffering about 20% deficit. Investors who bought Coke in the same period at an earning multiple of 30 is making at an average compounded return of 3%.

Be a passive investor, not an active trader

“Indeed, we believe that according to 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 unusual 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. As a result, he has a very low turnover portfolio, very low brokerage fees and has not paid very much in the nature of capital gain taxes (of course, capital gain tax in stocks is not applicable in Singapore).

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 Berkshire’s portfolio is the small number of stocks in it. This number has rarely exceeded 10 stocks (for the long term holdings). Buffett believes that there’re 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 (of course not retail investors because most do not have the kind of money, this is referring to fund houses, pension funds and such) fill up their portfolios with more than fifty stocks. As a result, even if a stock appreciates 100 percent, the impact on their net worth will only be 2 percent. 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 in order to make a big difference to the net-worth positively.

Invest only when there is a Margin of Safety

Buffett believes that the concept of margin of safety by Benjamin Graham is the most important cornerstone to the field of investment. Though it is slightly difficult to understand at times, it does not diminish its importance. It can be loosely defined as the difference between price and value. Price is easy to see but value is not, thus arising in the difficulty in understanding this concept. If the value of what you buy is higher than the price you pay for it, you have a 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. If you are putting your money in a business bought 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’re seemingly scientific approaches such as discounted cash flow which are taught in most corporate finance textbooks. In practice, it is both highly subjective and very difficult for an individual investor to apply with accuracy. However, there’re some simplified ways that are more easily understood but has its own pitfalls. One way is to purchase stocks at a price below its net working capital.

Ignore macroeconomic events

“Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage & price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8% and 17.4%. But, surprise – none of these blockbuster events made the slightest dent in Ben Graham’s investment principles. Nor did they render unsound the negotiated prices of fine businesses at sensible prices. Imagine the cost to us, then, if we had let the fear of the unknowns cause us to defer or alter the deployment of capital. Indeed, we’ve usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist. A different sort of major shock is sure to occur in the next 30 years. We will neither try to predict those nor profit from them. If we can identify businesses similar to those we have purchased in the past, external surprises will have little effect on our long-term results.” – Warren Buffett

Market participants generally have the habit to try to guess what the Fed is doing, what price oil will be in the next few months, or raise or fall in inflation. Buffett does not think it makes any difference whatsoever to an investor in stocks what they do today. Although his view is apparently not in line with the general public, I’m inclined to agree with him. Not because it came from him but more important, it’s better to be approximately correct than to be precisely wrong. He went on to explain that he wouldn’t care if the Fed raise their rates in terms of what he’d do in stock, even if he knew exactly what the Fed did do. The important thing in investing is to buy stocks in good businesses, at a reasonable price. Anybody that is buying or selling stocks based on what the Fed is doing, or what they think they’d do at their next meeting is destined not to have a great financial future. People who think they can dance in and out based on some tips or signals are only going to make their brokers rich, but they are not going to make themselves rich.

Intelligent investing = one that has both growth and value

“In our opinion, the two opinions are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous, and whose impact can be negative as well as positive.” – Warren Buffett

Most analysts think that value investing and growth are strategies of opposite poles. They think these two approaches are mutually exclusive where the fundamental investing are based on stocks with low price to earnings ratio, or price to book ratio, and growth strategies with the exact opposite characteristics. However, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments.

In Buffett’s initial investment career, he was famous for not paying two or three times book value of any company. In fact, he nearly forego buying See’s Candies because the owner wanted $30 million but Buffett was only willing to pay $25 million but fortunately, the owner then lower his price. This original strategy of paying low price to book ratio was effective for a while, but thanks to Charlie Munger, Buffett discovered it is far better to pay a fair price for a great business rather than a great price for a fair business.

Thus, opposite characteristics as advocated by Graham are in no way inconsistent with a “value” purchase. Indeed, value is what happens when a business can deploy a dollar to finance growth that creates more than a dollar in long-term market value. The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.

The problem with the traditional Graham method lies in that it may take an extended period in order for 50 cent to appreciate to a dollar. You don’t want a dollar bill that’s sitting for 50 cents and it’s only going to be a dollar bill ten years from now. What you should want is a dollar bill that’s going to compound at 12% for a long run.

With all that have been said, Buffett’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, no one said that becoming a billionaire is easy.