Important Updates for Investors
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The
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Despite the U.S. national debt, there is a silver lining for income
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Treasuries, is going to take its toll on the dollar, and
international income investors could reap the rewards in the form of
higher dividends. |
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| Invest
Like Warren Buffett |
Published: June 12, 2006
Admittedly, the title of
today's article is a little deceptive.
One could just as easily say, "Hit Homeruns like Babe Ruth."
Unfortunately, simply replicating the hitting mechanics of one of
baseball's greatest players will not give anyone the ability to slam a
95 MPH fastball nearly 530 feet -- which, incidentally, is how far the
Babe's final homerun is estimated to have traveled.
Similarly, just reading about the investing methodologies of Warren
Buffett -- the Babe Ruth of the financial world -- is not going to give
anyone the ability to make millions in the stock market overnight.
Knowing Buffett's investing approach is one thing -- putting it into
practice is a different matter entirely.
Countless investors have tried to emulate his style, but there is still
only one Warren Buffett.
However, none of this is to imply that Buffett's accumulated wisdom
should not be learned -- and applied. Following in his footsteps might
not make you a billionaire, but it could certainly help your portfolio
hit a few homeruns in the years ahead.
The Early Years
For those who are not familiar with Buffett's illustrious career and
meteoric rise to fame, a brief recap might be in order.
Warren Buffett was born in Omaha, Nebraska on August 30th, 1930. It
didn't take long for the man who would one day be known as the
"Oracle of Omaha" to show a strong entrepreneurial spirit and
a remarkable aptitude for money and finance. At the age of eleven, he
was already working in his father's brokerage firm.
That same year, Buffett made his first stock market investment,
purchasing three shares of Cities Service Preferred for $38 per share.
Buffett then held fast when the stock plunged (something older and more
experienced investors have trouble doing), and eventually sold it at $40
for a modest gain. However, the shares eventually skyrocketed to around
$200 -- perhaps ingraining the buy-and-hold philosophy that has since
defined Buffett's career.
After high school, Buffett studied at the University of Pennsylvania's
prestigious Wharton School of Business. Later, he attended graduate
school at Columbia and was taught by none other than Benjamin Graham --
considered by many to be the "father of value investing."
Buffett excelled under the tutelage of his new mentor, and years later
would eventually be hired to work at Graham's Wall Street firm.
With Buffett's net worth steadily rising, it was in 1956 that he moved
back to Omaha and convinced seven family members and friends to invest
in Buffett Associates (later known as Buffett Partnership Limited). From
a humble beginning with just over $100,000 in assets, the partnership
would enjoy tremendous returns under his leadership, racking up a gain
of +1,156% during the first decade alone.
Naturally, this stellar performance attracted many subsequent investors,
and the partnership thrived during the bull market of the late 1960's
(making $40 million in 1968 alone). However, citing a lack of quality
investment ideas, Buffett chose to dissolve the partnership the
following year. Those original investors who stuck with him from 1956 to
1969 were richly rewarded, earning extraordinary annual returns of
around +30% during that period.
Over the next year, Buffett liquidated nearly all of the portfolio's
holdings. One of the few exceptions was Berkshire Hathaway -- a small
textile company that Buffett had begun buying seven years earlier at $8
per share (at the time, the firm had $16.50 per share in working
capital). The partnership would eventually become Berkshire's largest
shareholder, and Buffett quickly assumed control of the company --
naming himself Chairman. At this point, his personal net worth was
already in excess of $25 million.
The rest, as they say, is history.
Buffett proved to have a magical touch when it came to allocating
Berkshire's capital, and the company's investment portfolio (and shares)
zoomed higher through the years -- trouncing the major averages by a
wide margin. By the early 1980's, Berkshire's stock had climbed to $750
per share and Buffett himself had already become a household name. But
he was just getting started.
Despite losing nearly one-fourth of its value in the great Bear Market
crash of 1987, Berkshire rebounded quickly and soared to approximately
$7,500 per share by early 1990.
Towards the end of the decade, Berkshire shareholders watched from the
sidelines as tech stocks raced higher and higher. Never one to invest in
a complicated business he couldn't understand (and sticking to his
philosophy of being fearful when others are greedy), Buffett avoided the
tech sector entirely.
As a result, Berkshire began to lag the broader markets, causing some
people to mistakenly claim that its aging chief had lost his touch.
Other critics (many of them daytraders) asserted that buy-and-hold value
investing itself was an outdated concept. However, all of this talk was
silenced several years later when the tech-driven bubble came crashing
down -- completely vindicating both Buffett and his investing approach.
Last Friday, Berkshire Hathaway shares closed at the astounding price of
$91,750 -- making the personal net worth of its chairman somewhere in
the neighborhood of $44 billion. Those who followed Buffett's lead and
invested $10,000 in Berkshire Hathaway in 1965 would be sitting on a
cool $51 million as of last year.
This almost inconceivable track record of success has made Warren
Buffett the world's second richest individual and has secured his status
as one of the most legendary investors of all time.
Buffett's Key Investing Principles
Fascinating though Buffett's biography may be, there are bigger
questions that need to be answered. Most importantly: What type of
companies does Buffett invest in, and as an investor, how can you profit
from his approach?
Unfortunately, there is no simple answer to that question. Looking back
over the past five decades, Buffett has made money on small companies
and large companies, stocks and bonds, domestic and foreign firms -- and
even outright speculation on foreign currency and commodities futures
contracts.
Yet, while it is difficult to draw up a formulaic investing approach
based on Buffett's past stock selections alone, his comments and actions
have yielded some very valuable insights. At the same time, by analyzing
the commonalities within Berkshire's portfolio, we can better determine
the traits that Buffett searches for in a prospective investment.
With that in mind, we have distilled many of Buffett's core philosophies
into the following checklist:
What makes the company stand out? Does the firm have a
well-defined economic moat? Does it benefit from any sustainable
competitive advantages? From a macroeconomic standpoint, how attractive
are the fundamentals of the industry in which the company competes?
How unique is the business? Has the company found a way to
differentiate its products, or does it sell commodity-like items with
little pricing power? How strong are the firm's profit margins?
Does the firm generate strong returns on capital? Have returns on
equity (ROE) been consistently higher than 15%? How about returns on
invested capital (ROIC)? How do these key profitability metrics stack up
against those of industry rivals?
Is the company financial healthy? Does the firm maintain a strong
balance sheet, or is it highly leveraged? Is it generating sufficient
cash flows to adequately service and pay down its outstanding debt
obligations? How capital intensive is the business?
Can management be trusted? Do leaders candidly admit mistakes? Are
the incentives of a company's managers aligned with the interests of
rank and file shareholders? Does the stock have relatively high insider
ownership? Has the firm made rational decisions with its retained
earnings? Is management committed to delivering long-term shareholder
value, or does it destroy value by employing tactics designed to meet
arbitrary short-term earnings targets and appease Wall Street analysts?
When searching for Buffett-like stocks, you should ask yourself each of
the questions listed above. Those that fail to qualify in all five
categories are probably better left untouched.
Before nailing down your portfolio, though, keep in mind that stock
selection is only part of the bigger picture. When weighing the
investment criteria above, do so in conjunction with these five
time-tested Buffett tenets that have formed the foundation for his
success:
Stick with what you know. With investments in well-known firms
like Coca Cola, Gillette, and Wal-Mart, Buffett believes in owning
established companies with recognizable brands and easily understood
business models. Those who invest in companies they don't understand may
not spot potential problems until it's too late.
Avoid cloudy earnings visibility. When it is difficult to accurately
forecast future cash flows, it becomes nearly impossible to calculate
fair value with any degree of precision. Not surprisingly, Buffett shuns
hot IPO's, risky technology companies, rapidly changing industries, and
young firms that have not yet proven they can successfully navigate a
challenging operating cycle.
Diversification is for beginners only. Buffett believes strongly
that intelligent investors should focus on their best investment ideas
and maintain concentrated portfolios. (Not surprisingly, over
three-fourths of Berkshire's assets are tied up in just eight
companies.)
Invest for the long term. With a preferred holding period of
"forever," Buffett clearly is a big practitioner of
buy-and-hold investing.
Don't buy a share, buy a business. Buffett stresses the
difference between being a trader and an investor. Resist the temptation
to track day-to-day price fluctuations. If a company's business
fundamentals are improving, then it will eventually be reflected in the
share price.
As a rule, Buffett places a premium on the importance of experienced and
trustworthy management. He also looks for mature, well-run companies
with high returns on capital and sustainable competitive advantages. In
many cases, his actions go against conventional Wall Street thinking,
but then again, marching along with the herd has never made anyone stand
out from the crowd.
Of course, it goes without saying that while Buffett is always on the
lookout for fundamentally sound companies, he is equally concerned with
valuation. Similar to our mission here at Half-Priced Stocks,
Buffett has made a fortune by finding quality companies that are trading
significantly below the discounted value of their future cash flows.
In His Own Words
Rather than attempt to explain many of his core beliefs, it is far
easier to simply let Buffett speak for himself -- his statements seldom
need further elaboration:
"It is far better to buy a wonderful company at a fair price than a
fair company at a wonderful price."
"Look at market fluctuations as your friend rather than your enemy;
profit from folly rather than participate in it."
"We simply attempt to be fearful when others are greedy and to be
greedy only when others are fearful."
"We're perfectly willing to trade away a big payoff for a certain
payoff."
"If you don't feel comfortable owning something for ten years, then
don't own it for ten minutes."
"The future is never clear, and you pay a very high price in
the stock market for a cheery consensus. Uncertainty is the friend of
the buyer of long-term values."
"The speed at which a business' success is recognized is not that
important as long as the company's intrinsic value is increasing at a
satisfactory rate. In fact, delayed recognition can be an advantage: it
may give us the chance to buy more of a good thing at a bargain
price."
Putting it all Together
Because he has consistently displayed an uncanny ability to turn almost
anything he touches into gold, Buffett's moves are closely scrutinized,
and his comments can move the markets. Every year, thousands of
investors read Berkshire Hathaway's shareholder letters and annual
reports looking for clues.
This begs the question -- exactly which individual companies does
Buffett currently hold in his portfolio at Berkshire Hathaway? Thanks to
form 13-F (which all public companies must file quarterly with the SEC),
we can answer that question definitively.
The following is a list of Berkshire Hathaway's 20 largest positions
(out of 38 total) as of last quarter . . .
Important Note: Throughout the
remainder of this article, editors Nathan Slaughter and Paul Tracy
provide a closer look at Warren Buffett's current stock holdings, as
well as an in-depth analysis of several additional companies that meet
many of Buffett's stringent investment criteria. However, in order to
view the remainder of this article, you'll need to subscribe to our
value investing newsletter -- Half-Priced Stocks. After
you subscribe you'll receive immediate access to this full article, as
well as our monthly Half-Priced Stocks newsletter and a
host of additional premium content. Please visit one of the following
links to continue . . .
Note:
The above article was merely a small excerpt from
a recent issue of our premium value investing newsletter -- Half-Priced
Stocks. The mission of Half-Priced Stocks is to
help our readers identify securities that are trading at a steep
discount to their intrinsic net worth. In some cases this
discount can reach up to 50% or more, giving savvy value
investors the chance to purchase quality stocks for just pennies
on the dollar. To learn more about our Half-Priced Stocks
service, please visit the following link:
https://www.StreetAuthority.com/subscribe-hps.asp |
Thanks for reading!
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Nathan Slaughter
Editor
Half-Priced Stocks, The ETF Authority
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