How does Warren Buffett keep beating the S&P 500 and defy the laws of gravity to keep his sprawling empire and compounding machine―Berkshire Hathaway afloat? What are the secret ingredients of his investment style, that make him one of the richest men on Earth? We try to unravel the Buffett mystique.
The Unbeatable Compounding Machine
For more than 49 years, Warren Buffett’s Berkshire Hathaway has grown at a rate of almost 25% every year. To put things into perspective, if a 60 cm rose bush were to grow at this rate, within 37 years, it would grow to be as tall as the Empire State Building!
To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework. ―Warren Buffett
The most successful student of value investing guru―Benjamin Graham, pin-up boy of investment managers, the Oracle of Omaha, the unyielding CEO of Berkshire Hathaway, and the grand old sire of American capitalists, Warren Buffett is one of the few billionaires who made a substantial chunk of his early fortune, through pure investing.
The Key Investing Principles of Buffettology
While he started out as a diligent follower of Graham’s value investing approach, aimed at snagging companies trading at prices lower than their true value, over time, Warren Buffett has absorbed and assimilated a range of ideas from other master investors, like Philip Fisher, and developed his own. While a legion of analysts have tried to dissect Buffett’s approach to discover the holy grail of investing, very few have been able to replicate his success.
The master investor, who bought his first stock at the age of 11, doesn’t just buy securities now, but prefers buying controlling stakes in companies, assimilating them into the huge sprawling empire that is Berkshire Hathaway.
Ergo, it’s not possible to emulate him, as he casts such a huge shadow on the markets today, that his investments sometimes turn out to be self-fulfilling prophecies due to the high volume of funds he pours in. Even he made his share of mistakes, had missed opportunities, and lost a lot of money in the markets. It is just that he has avoided blunders and learned from his mistakes through clear introspection.
The growth of his company, which has been beating the S&P 500, almost continuously for decades, is testimony to the sound investing principles and mental framework that has helped him choose winners more frequently than others.
To sum up Buffett’s approach in the simplest of words, he goes after undervalued stocks, with strong financial fundamentals and growth prospects, holding them for the long term. He completely ignores the brouhaha and speculative trends of the market and entirely bases decisions on the study of a company’s balance sheet, market impact, and future potential. The prime imports from his approach have been outlined in the following lines.
Invest in what you understand
How do you beat Bobby Fischer? You play him at any game but chess. I try to stay in games where I have an edge, and I never will in technology investing. ―Warren Buffett
Go after your strengths, and invest in what you understand. Big suicidal mistakes in investing occur when decisions are made without a complete understanding of how a business or a particular industrial sector works. Buffett has always restricted himself to investing in businesses that he understands. A prime example is one of his biggest early bets and successes―Coca Cola, a company whose business model and future potential was rightly gauged by him.
In the 1990s, he avoided the Dotcom bubble, by eschewing Internet-based businesses, whose future prospects, he did not fully comprehend. Because he bases his decisions on understanding an industry, instead of relying on hearsay, he has been insulated from the speculation-driven insanity that periodically grips the markets. While this approach has also led to him missing out on a few good opportunities, it has largely saved him from large-scale losses.
Ergo, invest in your circle of competence, it being the set of business sectors whose products and services, as well as market value, are comprehensible to you, through personal experience. Only in this circle, can you have the conviction to make future predictions. While this may not always lead to winning bets, it will protect you from the pitfalls of speculative (the-quest-of-the-next-big-miracle) investing.
Go for companies with highly favorable long-term growth prospects
In the short term, the market is a popularity contest. In the long term, the market is a weighing machine. ―Warren Buffett
Investors like Buffett amass great fortunes as they stay invested for the long term in high-growth companies and have the dexterity to spot them early. All companies start small and the few who can identify their long-term value and prospects at that stage, to invest in them, ultimately reap big returns. When considering a stock, think of it for what it is―an opportunity to buy a quantum of ownership in a business. Evaluate its future potential and financial fundamentals, as well as market demand for its products and services. Invest only in companies that have good long-term growth prospects.
Buy undervalued growth companies
The best thing that happens to us is when a great company gets into temporary trouble . . . We want to buy them when they’re on the operating table. ―Warren Buffett
Once in a while, opportunities open up, when innovative companies with high growth prospects get into trouble due to temporary setbacks. Consequently, their stock value suffers, and Buffett has always capitalized on such opportunities where the company is trading at a 20% to 25% discount price of its true book value. He has been known to be greedy and opportunistic during such times, when the market has been fearful about a stock and has earned rich dividends from the recovery of the stock price, in the long term.
Choose companies with stable, consistent, and predictable earnings
Our approach is very much profiting from lack of change rather than from change. With Wrigley chewing gum, it’s the lack of change that appeals to me. I don’t think it is going to be hurt by the Internet. That’s the kind of business I like. ―Warren Buffett
The value of a stock is dependent on the projection of its future earnings and if they are highly predictable, it makes for a smart bet. A company whose products and services have enjoyed perennial demand and established large-scale market exposure, is bound to do well. Such businesses are the sure-things of the stock market, which may not necessarily post spectacular results in any quarter, but will keep the profit meter ticking steadily.
An example from Buffett’s portfolio is Gillette, a market leader in personal care products, primarily including men’s razors. Since the 1980s, it has been a household brand with a proven market share. It is known for constant innovation and predictable market earnings. In 1989, Berkshire Hathaway invested US$600 million in Gillette, an investment which grew to US$850 million within two years, besides earning a handy US$52.5 million dividend yield. When Procter & Gamble bought Gillette, Berkshire Hathaway being the largest shareholder, earned a handsome profit of US$645 million.
Another such example is See’s Candies, a manufacturer of candy and chocolates, whose products have been in high demand, throughout United States. Berkshire Hathaway’s US$57 million investment in the company has earned more than US$1.35 billion, in the ensuing years.
Go for companies with candid, trustable, and capable management
Over the years, as his style of investment has evolved, Buffett, along with his closest business partner, Charlie Munger (Berkshire Hathaway’s Vice-chairman) have also focused on looking at the quality and leadership capabilities of the management, provided all other financial parameters check out. A capable, trusted, and candid management is bound to make better decisions to widen the growth prospects of a business.
Opt for companies with a strong economic moat
Market leaders are set apart by the strong competitive advantage (economic moat) that they hold, over their competitors. It may be their level of product innovation, acquired monopoly in product or service demand, a sector pioneer’s head start, or any other advantage that keeps them sufficiently ahead of all competition. Buffett has always believed in investing such companies that have a strong protective moat.
Look for high return on equity
A parameter that is closely monitored by the master investor is the return on equity (ROE), quantified as Net Income/Shareholder’s Equity. It quantifies the net income earned by the company, for a small percentage of shareholder’s equity. It measures the benefit generated for the invested shareholder money. A consistently high ROE for more than 5 years, marks a company to be a safe bet for investing.
Pick businesses with high and stable profit margins
Another parameter that’s part of the Buffett scanner is the profit margin (Net Income/Net Sales x 100). To qualify for investment, the profit margin needs to be consistently high and growing for the past 5 years.
Focus on a few good bets
Wide diversification is only required when investors do not understand what they are doing. ―Warren Buffett
At the other extreme of non-diversification is over-diversification. Buffett believes in focusing on a few good bets for the long term and doesn’t believe in spreading himself too thin or over-diversifying. By focusing on a chosen few stocks that have passed his extremely detailed scanning test, he increases his holding in them over a period of time to bolster his bet. This also lets him invest in a high volume of shares of a company, in a single go, acquiring a significant, and at times, controlling stake in companies. The idea is to go all in and back a few chosen bets, after detailed analysis. Of course, this strategy requires a lot of conviction in your choices, and at times, the willingness to be a contrarian, when conventional market wisdom thinks otherwise.
Focus on parameters identifying undervalued investments
There are many other parameters that are a part of the scanner employed by the master investor. These include:
- Low Price-to-Book Ratio: This ratio (= Stock Price/Total Assets – Intangible Assets – Liabilities) allows you to screen stocks that are trading below their book value, a.k.a. undervalued stocks, which are bound to appreciate to their true value, in the future.
- Low Price-Earnings Ratio: This important ratio (= Market value per share/Earnings per share) can only be used to compare companies within the same sector, to separate those with high earnings, trading at relatively low prices. This parameter should never form the only screening criteria, as not all low P/E ratios indicate undervalued high-performance companies.
- Low Price-to-Sales Ratio: This parameter (= Stock price/sales per share) can be indicative of an undervalued stock. It determines the value of each dollar earned in sales per share, for a company. Again, this indicator shouldn’t be used in isolation, but only as part of a broad analysis of the company’s financial fundamentals.
- High Dividend Yield: The yield (= Annual dividends per share/Price per share) can separate out companies that pay out high dividends for every investor dollar put in.
In totality, these price multiples can together identify undervalued stocks, a rare breed that a value investor like Buffett prefers buying, as they have a high probability of appreciation compared to other stocks.
Be patient, hold on, it gets better
Our favorite holding period is forever. ―Warren Buffett
Lastly, the core principle of Buffetology―once you find a good thing after careful analysis, hold on to it, as with time, it only gets better. True investors are in it for the long run. Speculative day trading not only incurs high transaction costs and taxes, but also doesn’t add up to substantial profit, compared to a well-thought out long-term bet. Think like the owners of a business when buying a stock, and your approach to the whole process is bound to change.
Timeless Wisdom from the Oracle of Omaha
Lastly, some timeless quotes to live by, from the Oracle of Omaha, that should be pinned on every investor’s work desk.
Risk comes from not knowing what you’re doing.
Never depend on a single income. Make investments to create a second source.
If you buy things you do not need, soon you will have to sell things you need.
You only have to do a very few things right in your life so long as you don’t do too many things wrong.
Do not save what is left after spending, spend what is left after saving.
It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently.
You may not immediately make a killing on the stock market with Buffett’s principles, but you will certainly lose less money with his conservative value-investing approach, which is as good as a win, over a long period of time. An essential reading, is ‘The Intelligent Investor‘ by Benjamin Graham, as well as ‘Common Stocks and Uncommon Profits‘ by Philip Fisher, the two men, who have influenced Buffett’s approach. Also recommended reading is the compendium of Buffett’s letters to his shareholders, where he has expounded the essence of his technique, in his unique folksy way. Build a framework for choosing stocks, that’s customized according to your risk appetite in investing. Let rationality reign over passion in matters of money and investing, and you shall build a solid fortune over a lifetime.