Warren Buffett is one of the most successful investors of the past 3 decades. The Warren Buffett investment strategy is to focus on the value of the business and its market price.
Once Warren Buffett finds a business he understands and feels comfortable with, he acts like a business owner rather than a stock market speculator. He studies everything possible about the business, becomes an expert in that field and works with the management rather than against them.
Buffett champions the value investment strategy and puts no credence in the daily volatility of stock prices. Nor does Warren Buffett care about the impact of the macroeconomic sentiment.
The Warren Buffett investment strategy maintains a long-term perspective at all times, and never loses sight of the underlying value of a business.
The Warren Buffett investment strategy in a nutshell
1. Never follow the daily volatility of the stock market
The market only exists to make provide liquidity, not to set values. Keep an eye on the market only for potential buying opportunities at severely discounted prices.
2. Don’t try and analyze macroeconomics
The Warren Buffett investment strategy ignores macroeconomics. If you can’t predict what the stock market will do from day to day, how can you reliably predict the economy?
3. Buy the business, not the stock
Treat a stock purchase as if you were buying the entire business, using the following tenets:
- Is the business simple and understandable from your perspective as an investor?
- Does the business have a consistent operating history?
- Does the business have favorable long-term prospects?
- Is management rational?
- Is management candid with its shareholders?
- Focus on return on equity, not earnings per share.
- Search for companies with high profit margins.
- For every dollar of retained earnings, has the company created at least one dollar’s extra market value?
- What is the value of the business?
- Can the business currently be purchased at a significant discount to its value?
4. Manage a portfolio of businesses.
The Warren Buffett investment strategy emphasizes being a business owner rather than a stock trader. A business owner focused on the long-term value, while a stock trader focuses on short-term gains and losses.
Foundations of the Warren Buffett investment strategy
Warren Buffett invests by his companies’ operating metrics, not by market volatility. Patience is a key component of the Warren Buffett investment strategy, which centers on the intrinsic value of the business. Warren Buffett’s whole approach is to look at a share purchase from the perspective of a business owner rather than as a stock market dabbler.
Warren Buffett investment strategy #1: Investing vs. trading
There is a huge difference between investing in a particular stock and trying to predict the direction of the market.
In spite of technology, it is still people that are market-makers. Investor sentiment has the largest influence on the short-term market movement. However, the long-term value of a stock is ultimately determined by the economic progress of the business, not the day-to-day market volatility.
Warren Buffett investment strategy #2: Mr. Market
Imagine you are the owner of a small business in partnership with Mr. Market. Every day, Mr. Market quotes you a price at which he is willing to buy your half of the business or sell you his half. While the business is sound and makes good progress, Mr. Market’s quotes vary widely according to the mood he is in.
When he is in an upbeat mood, his price is exceptionally high. Conversely, strike him on a bad day and he is very pessimistic and quotes an unusually low price.
If you were in business with Mr. Market and you tried to take advantage of his wisdom, you would be on an emotional roller coaster ride. Rather, it is Mr. Market’s pocketbook you should take advantage of, not his wisdom. It is disastrous if you fall under his influence.
The Warren Buffett investment strategy emphasizes that a successful investor should put aside the emotional whirlwind Mr. Market unleashes on the general market every day and exercise sound business judgment.
Warren Buffett investment strategy #3: Develop emotional stability
Investors must be financially and psychologically prepared to deal with the everyday market fluctuations. Develop the emotional stability to stomach large, 20%+ declines.
Warren Buffett investment strategy #4: Take advantage of buying opportunities
The Warren Buffet investment strategy treats price declines as opportunities to add more shares to your portfolio at a lower price. As long as you are investing in a soundly run business with good fundamentals, management and prices, the market will eventually acknowledge success.
Warren Buffett investment strategy #5: Have price discipline
The ability to say ‘‘no’’ unless facts are in your favor is a significant advantage for any stock market investor. Rather than constantly buying and selling shares in mediocre businesses on the strength of a rumor, Buffett buys and holds shares permanently in just a few outstanding, well-managed businesses. His approach is to wait patiently until a great investment opportunity surfaces at an attractive price.
Warren Buffett investment strategy #6: Manage failures well
Failures will come with success. The Warren Buffett strategy treats failures with temperament rather than emotion. Reduce the number of things you can get wrong and focus on the things you expect to get right.
Warren Buffett investment strategy #7: Ignore market rumors
Despite all the experience and educational qualifications found in investors, it still acts irrationally and with a ‘‘follow the mob’’ mentality. Buffett takes no comfort from having fellow investors agree with him, and does not lose confidence when they disagree.
Warren Buffett investment strategy #8: Treat stocks as entire companies
An investor and a businessperson should look at a company in the same way. The businessperson wants to buy the entire company while an investor wants a part.
The first question any management would ask is, ‘‘What is the cash generating potential of this company?’’ Over time, there will always be a direct correlation between the value of a company and its cash generating capacity. The Warren Buffett investment strategy emphasizes using the same business purchase criteria as company management.
Change your thinking from buying and selling shares in a company to buying and selling a business you want to own and you’ll have a much-improved perspective.
Warren Buffett investment strategy #8: Ignore short-term volatility
Short term price fluctuations should be ignored, as they provide no value in judging a company’s success. Instead, look at:
- Return on beginning shareholder’s equity.
- Operating margin changes.
- Debt level changes.
- The company’s cash generating ability.
That is, use economic criteria rather than price changes.
Warren Buffett investment strategy #9: Act like an owner
Relationship investing is critically important. With this approach, investors act like owners of the companies they own shares in. They provide patient capital allowing management to pursue long-term growth opportunities.
Investors should hold stocks long-term and work with management to improve corporate performance.
Warren Buffett investment strategy #10: Let management do its job
Warren Buffett usually assigns voting rights for shares he purchases to the management of the company. That sends the clear signal that he is not seeking changes. He avoids companies in need of major overhauls. He also avoids confronting management to improve shareholder returns.
Buffett simply would not invest in any company which he considers requires a change in officers before true value can be realized. He does not look for a company which is undergoing a turnaround or restructuring exercise, as this creates a situation in which there are too many variables.
Warren Buffett investment strategy #11: Hold for the long-term
Buffett is quite content to hold any security indefinitely, so long as the prospective returns on equity capital of the business are satisfactory, management is shareholder-oriented and competent, and the market does not overvalue the business. Generally speaking, Buffett sells only when the stock price shows the market is appreciably overvaluing the business by his reckoning.
Warren Buffett’s mentors
The Warren Buffet investment strategy is a mix of the strategies put forward by two legendary investors, Ben Graham and Philip Fisher.
From Graham, Buffett learned the margin of safety approach – that is, use strict quantitative guidelines to buy shares in companies that are selling for less than their net working capital. Graham also emphasized that following the short-term fluctuations of the stock market is pointless and that stock positions should be long term.
From Fisher, Buffett added an appreciation for the effect that management can have on the value of any business, and that diversification increases rather than reduces risk as it becomes impossible to closely watch all the eggs in too many different baskets.
The Ben Graham investment strategy
Author of Security Analysis and The Intelligent Investor, Graham is widely considered as the first professional analyst.
Ben Graham grew up in New York and had a science degree from Columbia University. By the age of 25, he was a partner in a brokerage firm earning $600,000 per year. He was financially ruined by the 1929 crash and had to rebuild his fortune.
Graham’s investment philosophy was that a well-chosen, diversified portfolio of common stocks, based on reasonable prices, were the soundest possible long-term investment anyone could make.
To Graham, the distinction between an investment and a speculation was:
An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting those requirements are speculative.
An investment requires safety of principal and a satisfactory return. Safety is a relative term, and can never be determined in an absolute sense.
Similarly, the concept of a satisfactory return (whether dividend income or stock price appreciation) is also subjective.
Similar to Ben Graham, the Warren Buffett investment strategy also emphasizes on identifying the margin of safety, which is to invest only in companies which have a large margin between earnings and fixed costs. In a downturn, companies with a margin of safety are most likely to ride out a recession well. Applying this concept to a stock, buy shares only in a company for which the share price is below its intrinsic value as determined by assets, earnings, dividends and future prospects.
Graham strongly advocated the margin of safety approach with investment in common stock of growth companies. His approach to investment was to purchase growth company shares when the overall market is trading at a low price or when growth company shares are trading below their intrinsic value. However, since buying at market lows is everyone’s objective, there is no competitive advantage in that approach. Therefore, Graham suggested that identifying undervalued stocks, regardless of market sentiment, was the key to stock market investment success.
Intrinsic value is closely linked to a company’s future earning power and fixed costs. It is hard or real assets plus the future value of the earnings those assets will produce.
Graham advocated two approaches to buying shares:
- Buy for less than two-thirds a company’s net asset value.
- Focus only on low price-to-earnings ratio stocks.
These stocks will generally be out of favor with market sentiment. The market inefficiency, created by emotions, generates valuable opportunities for the rational investor.
The Phil Fisher investment strategy
Author of Common Stocks And Uncommon Profits, Fisher was a stockbroker who set up in business just after the 1929 crash.
Fisher focused on companies with an ability to grow sales and profits over the years at rates greater than the industry average. He classified these types of companies as:
Fortunate and able
Companies which work aggressively to create larger markets for their products, and are in a position to benefit from events outside the company’s control.
Fortunate because they were able
Companies which continually carried out research and development to produce better products and new markets.
Fisher studied a company’s sales organization in addition to its research and development capabilities. He also looked at profit margins and accounting controls. Fisher believed marginal companies never succeeded over the long run. He looked for companies which were dedicated to maintaining their competitive advantage and strengthening their market position.
He also looked for companies which could grow without requiring additional equity financing. If a company expanded on the strength of its products and services rather than by expanding its capital base, Fisher thought that boded well for the future.
Above-average management capabilities in companies were also keenly sought by Fisher. He saw as a good sign any management who communicated freely with shareholders when the company was experiencing unexpected hard times. The management should also have an ability to develop good working relations throughout the company.
Fisher examined the unique distinguishing characteristics of each company. He looked for clues by interviewing customers, vendors, competitors, and consultants. He always tried to garner an accurate picture of relative strengths and weaknesses by his research.
Fisher suggested it was better to hold stock in a few outstanding companies than a large number of average companies. He always invested within his own circle of competence – that is, with businesses he understood and felt comfortable with. This is also a key tenet of the Warren Buffett investment strategy.
Key thoughts of the Warren Buffett investment strategy
The farther one gets from Wall Street, the more skepticism one will find as to the pretensions of stock-market forecasting or timing.
I have long felt that the only value of stock forecasters is to make fortune tellers look good.
The most common cause of low prices is pessimism – sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of rational buyers.
An investor should act as though he had a lifetime decision card with just twenty punches in it. With every investment decision, his card is punched, and he has one fewer for the rest of his life.
As time goes on, I get more and more convinced that the right method in investments is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risks by spreading too much between enterprises about which one knows little and has no special reason for special confidence. One’s knowledge and experience is definitely limited and there are seldom more than two or three enterprises at any given time which I personally feel entitled to put full confidence.
The reasonable man adapts himself to the world. The unreasonable one persists in trying to adapt the world to himself. Therefore all progress depends on the unreasonable man.
Can you really explain to a fish what it’s like to walk on land? One day on land is worth a thousand years of talking about it and one day running a business has exactly the same kind of value.
Invest within your circle of competence. It’s not how big the circle is that counts, it’s how well you define the parameters.
Rationality is the quality that Buffett thinks distinguishes his style with which he runs Berkshire – and the quality he often finds lacking in other corporations.
Beware of past performance proofs in finance. If history books were the key to riches, the Forbes 400 would consist of librarians.
After we buy a stock, consequently, we would not be disturbed if markets closed for a year or two. We don’t need a daily quote on our 100 percent position in See’s or H.H. Brown to validate our well being. Why, then, should we need a quote on our 7 percent interest in Coke?