The following are what I consider are the
five main keys to Buffett's methods of investing.
1. Businesses that you understand:
Focus on areas that you have the most background in or the
most interest in. Often this will mean from a consumer's
perspective. Buffett, for example, does not invest in tech
companies because he says that he does not understand the
market for their products or services. He focuses on "consumer"
foods (Coca Cola, Dairy Queen, etc), newspapers (Washington
Post, Buffalo News), insurance companies (GEICO) and retail
furniture stores (Nebraska Furniture Market, Star Furniture).
2. Strong economic moat: Look for
companies that have a protection against their competitors.
This could be geographical, patents, brand name, entry costs,
and so on. When companies have a strong economic moat, then
financial forecasts can be more reliable. USA examples of
such companies are Coca Cola and Intel. An Australian example
is Westfield Holdings and ARB Corporation Ltd.
After teaming up with Charlie Munger, Warren
Buffett has often talked about the importance of an economic
moat for companies that he would consider investing in.
Just as a moat around a medieval castle kept the castle
safe from intruders, an economic moat around a company keeps
the company safe from competitors and other profit-draining
The following are some of the remarks that
Warren Buffett had made about economic moats over the years.
If you own See's Candy, and you look in
the mirror and say, 'mirror, mirror on the wall, how much
do I charge for candy this fall?' and it says 'more',
that's a good business. (Omaha World Herald, 1994; See's
Candy is fully owned by Berkshire Hathaway.)
Wonderful castles, surrounded by deep, dangerous
moats where the leader inside is an honest and decent
person. Preferably, the castle gets its strength from
the genius inside; the moat is permanent and acts as a
powerful deterrent to those considering an attack; and
inside, the leader makes gold but doesn't keep it all
for himself. Roughly translated, we like great companies
with dominant positions, whose franchise is hard to duplicate
and has tremendous staying power or some permanence to
it. (Berkshire Hathaway Annual meeting, 1995)
You need a moat in business to protect you
from the guy who is going to come along and offer (your
product) for a penny cheaper. (Warren Buffett Talks Business,
The key to investing is not assessing how
much an industry is going to affect society, or how much
it will grow, but rather determining the competitive advantage
of any given company and, above all, the durability of
that advantage. The products and services that have wide,
sustainable moats around them are the ones that deliver
rewards to investors. (Fortune, 1998)
3. Sales and earnings growth: You can
still get good returns from companies that have poor growth
figures if they pay out most of their earnings as dividends
or use them for share buybacks. Nevertheless, at least a
reasonable level of growth is often important for the management
and employees to have a sense of achievement which then
translates into higher productivity and less unrest. I also
look for companies with earnings that have a high STAEGR®
or stability of earnings growth. (STAEGR® is a trademark
of Dr. John Price.)
4. Return on equity: If you think of
equity as your money, then return on equity is a measure
of how well management is doing with your money. It is virtually
impossible for a medium to long-term investment to be satisfactory
if the return on equity is low. Each year in the annual
report of Berkshire Hathaway Buffett stresses the importance
of finding companies with a high return on equity. I look
for companies that have 15 percent or more return on equity
and return on capital.
5. Not too much debt: If debt is too
high, then the company is vulnerable to credit squeezes
and may have difficulty in raising money for expansion.
Look at the debt to equity ratio, the current ratio and
the quick ratio.
Each year in the annual report of Berkshire
Hathaway, Buffett writes that one of the criteria he looks
for is "businesses earning good returns on equity while
employing little or no debt".
Of course, even with the best of companies
you can still pay too much. But as a general rule, Buffett
says that he would rather pay a fair price for a great company
than great price for a fair company.
The next step is to determine what is a fair
price to pay for individual companies. Conscious Investor
has proprietary tools that allow you to determine the "target
price" to pay for companies under a margin of safety
set by the user.
Once all this is done, Buffett says that he
is willing to wait indefinitely to but the stock he wants
at the price he is willing to pay.
Other criteria for Buffett's methods
6. Investment period Buffett buys stocks
as if he will be holding them for the rest of his life.
I think it is a little like getting married. When you pop
the question, your intention is that it is going to be a
marriage for the rest of your life. It might not end up
that way, but this is what guided your decision.
On a number of occasions Buffett has referred
to himself as a "Rip Van Winkle" investor, an
investor whose "favorite time frame for holding a stock
In the 1986 Berkshire Hathaway Annual Report,
Buffett wrote that "we expect to keep permanently our
primary holdings, Capital Cities/ABC, Inc., GEICO Corporation,
and The Washington Post. Even if these securities were to
appear significantly overpriced, we would not anticipate
selling them, just as we would not sell See's or Buffalo
Evening News [companies fully owned by Berkshire Hathaway]
if someone were to offer us a price far above what we believe
those businesses are worth
Despite the enthusiasm
for activity that has swept business and financial America,
we will stick with our 'til-death-do-us-part policy."
A few years later he added Coca Cola to his
list of permanent stock holdings.
7. Management Buffett never interferes
with the management of any company that he invests in or
buys. He once said, "If they need my help to manage
the enerprise, we're probably both in trouble." He
likes to buy companies with owners whose passion about their
business far exceeds their passion about making money.
8. The Big Picture Buffett says that
he enjoys work so much that he feels like tap dancing each
day he comes to work. He explains that he does not begrudge
paying taxes because he would much rather be on the paying
side than on the receiving side. Also he recognizes that
it is only in the USA that he could have made the profits
that he has. He also explained the importance of working
with people he likes.
The following quote is a good way to end this
brief look at the investing methods of Warren Buffett which,
I believe, are relevant in all regulated stock markets and,
in particular, the Australian market.
We're not pure economic creatures, and that
policy penalizes our results somewhat, but we prefer to
operate that way in life. What's the point of becoming
rich if you're going to have a pattern of operations where
you continually discard associations with people you like,
admire, and find interesting in order to earn a slightly
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