Buffett has a particular style for investing in common stocks. This style is made up of two steps. First, decide whether the downside risk is low. Generally speaking, low P/E metrics suggest low downside risk. Second, analyze the stock's growth potential and consider its intrinsic value and margin of safety. A stock is worth buying if the margin of safety is high, even if its P/E is above the market P/E or above the company’s historical average P/E.
It must be noticed that not all investments will turn out to be wonderful growth stocks. However, a low downside risk means the loss will not be much. The gains can still be very high, particularly if a few investments turned out to be truly successful. Even if only one out of every five of the stock investments does well, the overall return can be high.
Let's take Berkshire's (BRK.A, Financial)(BRK.B, Financial) example. From 1987 to 1991, Berkshire invested a total of about $2 billion in five convertible preferred stocks: Champion International, First Empire State, Gillette, Salomon Inc. and U.S. Air. All these investments could be characterized as value investments because the downside risk was low. Out of these five, only Gillette turned out to be a good growth stock. In 1990, Berkshire invested $600 million in Gillette, which was taken over in 2005 by Procter and Gamble (PG), with Berkshire receiving about $5 billion in Procter and Gamble stock in exchange. Over the 15-year period, Berkshire earned about 16 percent per year, which was twice the rate on the S&P 500 index for the same period. The other four investments essentially generated normal returns.
Buffett's example is very clear and following his practices, there is a two-step process worth looking at. First, consider his practice of investing only in his circle of competence. In the two-step process, it is necessary to compute a stock’s intrinsic value, which requires reliable earnings forecasts for several years in the future. Forecasts can be made well only when there is understanding of the company or when it is in the circle of competence. Second, Buffett rarely invests in high-tech or fast-growing industries. He usually invests in traditional industries.
If Buffett has never invested in fast-growing industries, how could he have earned so much money? The answer is quality of management. He acquires a company only if the current management comes with the acquisition. This is rather unique because most acquirers replace the incumbent management with a new team of their own. Why? To start with, it is obvious that if the acquired business was successful under the existing managers, they should not be replaced. If the acquired company was a private company, as is frequently the case, the CEO was probably also the owner. In economic parlance, this reduces the principal-agent, or conflict of interests, problem. Buffett also promises those who sell their firms to Berkshire that he will hold the purchased companies forever even if profitability declines.
Why is this important? It builds trust and security in the seller’s mind about the future of the company, especially if the seller wants to be sure his business will prosper. As Buffett writes, “We have a decided advantage, therefore, when we encounter sellers who truly care about the future of their businesses.”
In essence, growth is accomplished through good management.
The main message from value investing strategies is to invest with low downside risk. If a stock satisfies this criterion, then it is necessary to consider its growth in earnings to implement a value-plus-growth strategy that can be called Buffett-style investing or simply Buffett investing.
The focus in value investing is on the past, the focus in growth investing is on the future, and the focus in Buffett investing is on both the past and the future.
Management quality is also an essential element, because high-quality management is the source of growth in Buffett-style investing. To implement this strategy, compute the stock’s intrinsic value and compare it with the stock’s price. As a rule of thumb, if the price is about half the intrinsic value, it is worth investing in that stock.
It must be noticed that not all investments will turn out to be wonderful growth stocks. However, a low downside risk means the loss will not be much. The gains can still be very high, particularly if a few investments turned out to be truly successful. Even if only one out of every five of the stock investments does well, the overall return can be high.
Let's take Berkshire's (BRK.A, Financial)(BRK.B, Financial) example. From 1987 to 1991, Berkshire invested a total of about $2 billion in five convertible preferred stocks: Champion International, First Empire State, Gillette, Salomon Inc. and U.S. Air. All these investments could be characterized as value investments because the downside risk was low. Out of these five, only Gillette turned out to be a good growth stock. In 1990, Berkshire invested $600 million in Gillette, which was taken over in 2005 by Procter and Gamble (PG), with Berkshire receiving about $5 billion in Procter and Gamble stock in exchange. Over the 15-year period, Berkshire earned about 16 percent per year, which was twice the rate on the S&P 500 index for the same period. The other four investments essentially generated normal returns.
Buffett's example is very clear and following his practices, there is a two-step process worth looking at. First, consider his practice of investing only in his circle of competence. In the two-step process, it is necessary to compute a stock’s intrinsic value, which requires reliable earnings forecasts for several years in the future. Forecasts can be made well only when there is understanding of the company or when it is in the circle of competence. Second, Buffett rarely invests in high-tech or fast-growing industries. He usually invests in traditional industries.
If Buffett has never invested in fast-growing industries, how could he have earned so much money? The answer is quality of management. He acquires a company only if the current management comes with the acquisition. This is rather unique because most acquirers replace the incumbent management with a new team of their own. Why? To start with, it is obvious that if the acquired business was successful under the existing managers, they should not be replaced. If the acquired company was a private company, as is frequently the case, the CEO was probably also the owner. In economic parlance, this reduces the principal-agent, or conflict of interests, problem. Buffett also promises those who sell their firms to Berkshire that he will hold the purchased companies forever even if profitability declines.
Why is this important? It builds trust and security in the seller’s mind about the future of the company, especially if the seller wants to be sure his business will prosper. As Buffett writes, “We have a decided advantage, therefore, when we encounter sellers who truly care about the future of their businesses.”
In essence, growth is accomplished through good management.
The main message from value investing strategies is to invest with low downside risk. If a stock satisfies this criterion, then it is necessary to consider its growth in earnings to implement a value-plus-growth strategy that can be called Buffett-style investing or simply Buffett investing.
The focus in value investing is on the past, the focus in growth investing is on the future, and the focus in Buffett investing is on both the past and the future.
Management quality is also an essential element, because high-quality management is the source of growth in Buffett-style investing. To implement this strategy, compute the stock’s intrinsic value and compare it with the stock’s price. As a rule of thumb, if the price is about half the intrinsic value, it is worth investing in that stock.
