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Warren Buffett - The Value Investor

Warren Edward Buffett is an American business magnate, investor, and philanthropist.

Warren Edward Buffett is an American business magnate, investor, and philanthropist. He is widely considered the most successful investor of the 20th century.

Warren Buffett is the primary shareholder, chairman and CEO of Berkshire Hathaway and consistently ranked among the world's wealthiest people.

He was ranked as the world's wealthiest person in 2008. In 2012, American magazine Time named Warren Buffett one of the most influential people in the world.

Buffett is called the "Wizard of Omaha", "Oracle of Omaha", or the "Sage of Omaha" and is noted for his adherence to the value investing philosophy and for his personal frugality despite his immense wealth.

Warren Buffett is also a notable philanthropist, having pledged to give away 99% of his fortune to philanthropic causes, primarily via the Gates Foundation.

    "When we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever." - Warren Buffett

How Warren Buffett Does It...

In this section, we look at how Warren Buffett goes about investing and finding multibagger stocks...

The First Rule in Investing

Warren Buffett once famously said:

    "Only follow two rules in investing
    Rule #1: Do not lose money, and
    Rule #2: Do not forget Rule no. 1"

Warren Buffett's Checklist to Screen Potential Investment Candidates

In his letters to shareholders, especially from the earlier years, Warren Buffett had followed the practice of putting out a list of key points that a company needs to satisfy if it wished to get acquired by his investment vehicle - Berkshire Hathaway.

He looks to invest in companies, which have...

  • Demonstrated consistent earning power. Future projections are of little interest to Warren Buffett, nor are 'turnaround' situations.
  • Businesses earning good returns on equity while employing little or no debt.
  • Management in place. Warren Buffett says that he can't supply it.
  • Simple businesses. If there is lots of technology, Warren Buffett says he will not understand it.
  • An offering price. Warren Buffett won't waste his time or that of the seller by talking, even preliminarily, about a transaction when the price is unknown.

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Warren Buffett on Which Companies Make the Best Investments

In his 1991 letter to shareholders, Warren Buffett delivered advice to help you analyse a business. Based on his enormous experience in analysing companies, Warren Buffett classifies them into two main types:

  • A business
  • A franchise

Warren Buffett believes that many companies fall in some middle ground between the two and can at best be described as weak franchises or strong businesses.

Business vs Franchise

This is what he has to say on the characteristics of each of them:

Warren Buffett says, "An economic franchise arises from a product or service that:

  • is needed or desired,
  • is thought by its customers to have no close substitute, and
  • is not subject to price regulation.

The existence of all three conditions will be demonstrated by a company's ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital."

He further goes on to add, "In contrast, a 'business' earns exceptional profits only if it is the low-cost operator or if supply of its product or service is tight. Tightness in supply usually does not last long. With superior management, a company may maintain its status as a low-cost operator for a much longer time, but even then, unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management."

We believe investors can do themselves a world of good by applying this advice as they go about selecting stocks to invest in.

If one were to visualise the financials of a company possessing characteristics of a 'franchise', the company that emerges is the one with a consistent long-term growth in revenues with high and stable margins, which arise from the pricing power the franchise enjoys.

On the other hand, a 'business' would be one with erratic growth in earnings owing to frequent demand-supply imbalances or one with a continuous decline after a period of strong growth owing to the competition having caught up.

Warren Buffett's Liking for Companies with Economic Moats

Moats are indicative of the strong walls built around a castle in pre-historic times that offered stiff resistance to enemies looking to attack them.

Warren Buffett has likened 'moats' to the competitive advantages that a company enjoys in the marketplace.

The moat enables a company to command higher profit margins and superior return on capital.

The stronger these advantages are, the more difficult it is for competitors to take the market share away from the company and put pressure on prices.

Hence, any investor looking to invest in a company should ideally look at those businesses, which have consistent history of higher margins and superior return on capital.

Warren Buffett on Price vs Value

Once an investor has zeroed in on a good 'franchise' that he believes will be able to sustain high returns and profitability well into the future, should he go ahead and invest in the company without further considerations?

We believe otherwise.

Even the best of businesses bought at expensive valuations will not lead to attractive returns.

So, how does one determine what are 'attractive valuations'?

In his 1992 letter to shareholders, Warren Buffett has explained the concept of valuations in as easy a manner as possible.

Warren Buffett seems to be a firm believer in using the 'discounted cash flow' (DCF) approach to valuations.

So, what is DCF and how does it work?

DCF is a valuation technique, the purpose of which is to arrive at future cash flows that a company is expected to generate over its lifetime and adjust it for time value of money.

The resultant value is nothing but the company's 'intrinsic value'.

Since different people will have different assumptions about a company's future cash flows, intrinsic value might vary from person to person.

This value is compared to the prevailing stock price to judge the investment worthiness of the stock.

If the intrinsic value is higher than the actual stock price of the company, then the stock offers an investment opportunity. The greater the discount to the intrinsic value, the more attractive the investment opportunity.

Conversely, if the intrinsic value is lower than the current market price, then the stock is 'over valued' and should be avoided.

Investors who've tried using the DCF would know that cash flows of not all companies can be predicted with great degree of certainty. This is due to their past history of inconsistent performance and the nature of the businesses.

Furthermore, even in cases where cash flows can be predicted with some degree of certainty, one is not sure whether they will actually fructify.

What should be done in such cases? Warren Buffett has dealt with these two issues as well and this is what he has to say on them.

Warren Buffett Hates Changes

Warren Buffett says, "Though the mathematical calculations required to evaluate equities are not difficult, an analyst - even one who is experienced and intelligent - can easily go wrong in estimating future "coupons." At Berkshire, we attempt to deal with this problem in two ways. First, we try to stick to businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change, we're not smart enough to predict future cash flows. Incidentally, that shortcoming doesn't bother us. What counts for most people in investing is not how much they know, but rather how realistically they define what they don't know. An investor needs to do very few things right as long as he or she avoids big mistakes."

The Circle of Competence

Simple, isn't it? Focus on what you know and leave aside what you do not.

In other words, define your 'circle of competence'.

Warren Buffett is famously known to have shunned technology stocks in the late 1990s at a time when they were a rage and anyone not owning them was labeled as stupid.

At that time, he had argued that technology stocks fell outside his circle of competence and hence, he was not comfortable owning them.

Investors can draw some very big lessons from this incident and develop a discipline that makes them avoid anything that falls outside their circle of competence.

The Concept of Margin of Safety

After performing the valuation analysis, should you go ahead and invest?

The answer is no. Here's where Warren Buffett's concept of Margin of Safety kicks in.

Pay as little as possible for your mistakes...

Warren Buffett says, "We insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success."

Civil engineers, who construct bridges, always insist on using a 'margin of safety' in the maximum load a bridge can carry at any given time.

Thus, if a signpost on a bridge says 'maximum payload capacity 1,000 ton', one can be sure that the engineers have designed the bridge in such a way that it can carry weight 20% to 30% more than the designated payload capacity.

This is done to not only account for any errors that must have crept in while designing but also for the errors made while projecting the future traffic needs of the bridge.

Similarly, since doing DCF involves predicting the future, which as we all know is uncertain, errors are bound to creep into our analyses. Thus, having a margin of safety is important, as in the case of a bridge construction.

Warren Buffett learnt this technique from his mentor Benjamin Graham and widely believes it to be the cornerstone of investment success.

Thus, whenever you do DCF next, consider buying only if your estimations are at least 50% more than the current market price of the stock. Even if you go wrong in your assumptions, capital loss can be minimised.

Warren Buffet's Top Stock Investments

Much of Warren Buffett's success has been attributed to his knack for picking companies with sustainable competitive advantages and holding them for very long periods of time.

Here are some of his favorite stock investments over the years.

  • Apple Inc.
  • Bank of America
  • Coca-Cola
  • American Express
  • Kraft Heinz
  • Wells Fargo
  • JP Morgan Chase & Co.
  • Moody's
  • Goldman Sachs
  • General Motors

Majority of the companies that Warren Buffett and his team have bought were dividend payers.

Dividend stocks are often profitable, have time-tested business models, and usually have transparent outlook.

Most of the stocks from the above list have had dividend payouts and are the silent heroes that have been padding Warren Buffet's pockets for decades.

Top Holdings in Warren Buffett's Latest Portfolio

Below are the top holdings in Warren Buffet's current stock portfolio:

Company % of Portfolio
Apple Inc. 44.20%
Bank of America 10.90%
Coca Cola Co. 8.80%
American Express Co. 7.10%
Kraft Heinz Co. 5.10%
Moody's Corp. 3.30%
Wells Fargo & Co. 3.00%

Warren Buffett's Investing Mistakes and Conclusions Drawn

Warren Buffett says, "An investor needs to do very few things right as long as he or she avoids big mistakes."

This is true because investing is not a perfect science and hence, mistakes cannot be completely eliminated. A few of them might creep in every now and then.

In fact, even Warren Buffett has acknowledged that he has made quite a few mistakes in his investment career.

In a section titled 'Mistakes of the First Twenty-five Years' from the 1989 letter to shareholders, Warren Buffett has reviewed some of the major investment related mistakes that he has made in the twenty-five years preceding the year 1989.

Here are some of the conclusions he has drawn from them...

  • Quality Over Quantity

    Buffett says, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

    In the early years of his career, Warren Buffett bought into businesses based on statistical cheapness rather than qualitative cheapness.

    While he experienced success using this approach, the difficult time faced by the textile business made him realise the virtue of a good business i.e. businesses with worthwhile returns and profit margins and run by exceptionally smart people.

    While one may make decent profits in an ordinary business purchased at very low prices, lot of time may elapse before such profits can be made.

    Hence, he feels that it is always better to stick with a wonderful company at a fair price, as according to him, time is the friend of a good business and an enemy of a bad business.

  • Mistakes of Inactivity

    This is what Warren Buffett has to say - "Some of my worst mistakes were not publicly visible. These were stock and business purchases whose virtues I understood and yet didn't make. It's no sin to miss a great opportunity outside one's area of competence. But I have passed on a couple of really big purchases that were served up to me on a platter and that I was fully capable of understanding. For Berkshire's shareholders, myself included, the cost of this thumb-sucking has been huge."

    Warren Buffett rounds off the list with a masterpiece of a comment. It gives us an insight into his almost superhuman like risk aversion qualities and goes us to show that he will hardly ever make an investment unless he is 100% sure of the outcome.

    It comes out brilliantly in this, his last comment on his investment mistakes of the past twenty-five years.

  • Staying Away from Leverage

    In his 1989 letter to shareholders, Warren Buffett said, "We wouldn't have liked those 99:1 odds - and never will. A small chance of distress or disgrace cannot, in our view, be offset by a large chance of extra returns. If your actions are sensible, you are certain to get good results; in most such cases, leverage just moves things along faster. Charlie and I have never been in a big hurry: We enjoy the process far more than the proceeds - though we have learned to live with those also."

To sum up, invest in businesses that besides being easy to understand have strong fundamentals and are run by able and honest managements.

Second, always beware of the irrationality that may lead you to take decisions that would harm you in the long run.

Finally, no matter how good the opportunity, do not borrow funds to make investments i.e. always invest with your own funds.

Warren Buffet's View on Gold Investing

Warren Buffett has always been averse to investing in gold. He has never had the yellow-metal in his asset allocation.

But that changed recently when he bought a gold mining stock.

What gives?

Did the Covid-19 pandemic force him to have a 180-degree change of view on gold?

Is this truly a case of 'error of omission' as Buffett would call it? Is his exposure to gold significant? Should you too shun stocks and significantly increase your exposure to the yellow metal?

Let's find out...

Here are Links to Some Very Insightful Equitymaster Articles and Videos on Warren Buffett

Lessons From Buffett

Books Recommended By Warren Buffett

  • Security Analysis

    With more than one million copies through six editions, 'Security Analysis' is one of the most influential financial books ever written.

  • The Intelligent Investor

    Terming it as the best book on investing ever written, Buffett believes that 'The Intelligent Investor' is a must read for all investors.

Warren Buffett Quiz

Are you a Warren Buffett fan? How much do you know about him really? Take the Quiz and find out! Score a perfect 10 and earn bragging rights for doing so! Join 13,000 Warren Buffett Fans... Test Your Warren Buffett Quotient Now!

Warren Buffett Stock Screener

Now that you have read about Buffett and how he picks stocks, here's the million dollar question - Which Indian stocks match Buffett's stock picking criteria? Indeed, this is a difficult question to answer... But we are here to help you get started! Just use Equitymaster's Advanced Stock Screener and you could find your answer right away!

How has Warren Buffett influenced your stock picking style? Tell us!