Warren Buffet’s Simplest Tenets of Value Investing

Posted by Keystone Financial

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imagesLessons on Value Investing from the World’s Greatest Success Story

If you have been in the investing world for any period of time you are undoubtedly familiar with the man who many label as the greatest investor of all time – Warren Buffet. For those who require a little background, Warren Buffet is the self-made billionaire who built an empire through an unwavering focus on the simplest tenets of value investing. For nearly 50 years, Warren Buffet has earned prominence as the genius behind Berkshire Hathaway and has generated its investors a staggering average compound rate of return of 19.8% per year (1965 – 2011). This has resulted in an overall gain of 513,055%, compared to the S&P500 which returned 6,397% including dividends. An investment of $1,000 would have grown to over $5.1 million with the power of compounding returns.

Many detractors to Buffet’s value-investment style claim that his success cannot be replicated by individual investors. Often cited is Buffet’s solid reputation as a capital allocator and the deep investigative resources of his investment company Berkshire Hathaway. Undoubtedly Warren Buffet is a genius and we would not expect that any but the most gifted individuals would ever be able to replicate his success in its entirety. Nevertheless we can easily dispel the myth that reputation and resources were the ingredients to his success. Going back to 1956, before Buffet was a world famous billionaire (or millionaire for that matter), he was a relatively unknown man who operating his first investment partnerships out of an office in his bedroom. The limited partnerships were started with his own capital and a few some contributions from family and friends. He had no world renowned reputation, no staff of highly-skilled MBAs, and no special resources outside of himself. Buffet recognized the most basic and useful facets of valuing investing and applied the concepts to generate great success. Throughout the years he has participated in numerous interviews and writes a letter to his shareholders on an annual basis. Through these small snippets of information the general public has been able to gain some insight into how Buffet views the investing world. The following are a couple of his most well read quotes with a little insight into how anyone can use them to better far more intelligent investors. 

“Price is what you pay. Value is what you get.”

Separating value from price is the most fundamental tenet of Buffet’s investment strategy. Pretty much everybody has a basic understanding of what the word “value” means but unfortunately this is rarely applied to investment decisions. There is a saying that most investors spend more time researching the purchase of their television set than they do their investments. This is largely due to a lack of knowledge and valuation skills which is why many investors rely on stock price movements as a signal of investment quality. When Buffet starts researching a stock he says he intentionally will not look at the market price. Instead he starts with valuing the underlying business as if it were a private company. He looks at the cash flow…he determines whether or not the business model is sustainable and if the earnings are being inflated by too much leverage (debt). Buffet then determines what we would pay for the actual company without any consideration for the fact that it is publicly-listed. If after making this determination the current stock price is significantly below his measurement of intrinsic value then he may move forward and make his purchase.

“I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.”

Don’t worry…nobody is planning on closing the market for the next five years. What Buffet is saying is that he doesn’t buy a stock with the intention of following the short-term market fluctuations and selling in and out on whims. When Buffet buys a stock, he is buying an ownership interest in an underlying company. This is largely the reason that Buffet is so successful. Rather than wasting his energy following day-to-day market oscillations (as many investors do), he focuses on the business that he has acquired and gauges success based on sustainable generation and growth of the underlying cash flow. Many businesses generate returns for their shareholders through the distribution of cash flow in the form of dividends. A successful company will also be able to grow their dividends over time. Eventually success is recognized in the markets. Although it can take time for value to be realized, there are very few examples of companies that produce strong and growing cash flow over time without either this eventually being recognized in the share price or by an independent buyer looking to acquire the company.

“We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”

We are often asked by clients whether or not we utilize a timing strategy to move in and out of the markets with changes in the business cycle. Although market timing may appear to be a sound investment strategy, in practice, the results investors generate are far from astonishing. “Hindsight is 20-20, while foresight is legally blind”. The truth is that there are no magical indicators that will tell you (with consistent success) when to buy and sell stocks. If there were then we would expect to see at least one of these magical market timers (or technical analysts) on Forbes list of the world’s richest people (but we have not). Buffet as well does not subscribe to the traditional idea of market timing. He has however been able to apply his value investment methodology to creating a somewhat modified version of the strategy. If we take a step back to 2008 at the time of the stock market crash we will remember the fear that plagued the markets. Stock market prices dropped to levels not seen in over a decade causing private and professional investors to rush to the exits. Although fear was abundant and the outlook was grim, this was exactly the best time to be greedy with many very high-quality companies available for purchase at a fraction of their real value. If we go back to the summer of 2000, when the NASDAQ’s chart (along with the charts of many other exchanges) was nearly parabolic, investor optimism was high and greed pushed market valuations of internet stocks well beyond reasonable levels. This was undoubtedly a good time to be fearful. We would never suggest that you try and time the markets based on anyone’s assessment of market sentiment. This won’t produce any better results than any other market timing strategy. However, the next time market valuations have undergone expansion far beyond historical ranges, and experts are justifying the sentiment with the mantra “everything is different now”, you might want to consider separating yourself from the crowd and become a little more fearful. 

“Success in investing doesn’t correlate with I.Q….. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”

This has got to be my favorite quote from Warren Buffet. It gives hope to every ordinary investor who believes that they cannot compete with the pros. While Buffet is commonly referred to as the “smartest man in the room”, he himself openly confesses that his skills outside of capital allocation are fairly limited. And within this skillet Buffet utilizes only the simplest and most basic techniques in investment analysis. There are no super computers systems, no Nobel prize winning mathematicians, and certainly no new age strategies in the Berkshire Hathaway investment management office. The biggest asset (aside from their near $400 billion in capital) is their underlying philosophy that investment success is derived from purchasing high-quality, cash flow positive businesses at undervalued prices and holding those businesses over a long-term horizon. By controlling the emotions of fear and greed, individual investors can set themselves apart from the investment heard and create for themselves a very practical competitive advantage that the vast majority of people (including professionals) do not have.

Say you were in the market to purchase a private business. After months of searching you finally find an attractive opportunity. You are able to purchase a growing business, generating positive cash flow, with a solid and secure financial position, an effective and ethical management team, and a price that is significantly less than your assessment of the real intrinsic value. Assuming you are very positive on the long-term prospects of this new company and plan to own it long into the future, would you really care if the market of potential “private-business” acquirers dries up for a couple of years? You are not planning on selling the business and you are potentially benefiting from every dollar of cash flow that is generates (whether from dividends or ownership of a larger company in the event the cash flow is reinvested). In this situation, the astute business person would not spend their time following the day-to-day or minute-to-minute changes in the availability of potential acquirers.


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