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Why Should You Invest Only in High-Quality Companies?

June 13, 2012 | About:

How did Warren Buffett make most of his money? For those of us who have followed Warren Buffett for years, the answer is simple. Warren Buffett made most of his money by buying good companies at fair prices.

We have published tons of articles about different aspects of investing. But is investing really that complex philosophically? Actually no. Philosophically, value investing ought to be simple.

Seth Klarman divides value investing into three categories:

1. Buying “cigar butts” at good prices

2. Buying great companies at great prices

3. Buying great companies at so-so prices.

Mr. Klarman said that he is still in the first stage. We can clearly see that from his recent purchase of Taracept (TRGT) and PDL Biopharma (NASDAQ:PDLI). Most of the stocks in our Ben Graham Net-Net screener are cigar butts.

The problems with investing in cigar butts are:

1. You need to require a very large margin of safety with them. Therefore the risk premium must be high enough.

2. The timing of both buying and selling is important.

3. It is much more stressful.

Warren Buffett was once a cigar-butt investor. Under the influence of Phil Fisher and Charlie Munger, he invests more in high-quality companies. He made most of his money by buying companies like See’s Candy, Geico, American Express (NYSE:AXP), Coca-Cola (NYSE:KO) and Procter & Gamble (NYSE:PG). The advantages with buying great companies are:

1. The entry point is not that important. Warren Buffett buys great companies at great prices and fair prices. Time is on your side with growing high-quality companies. If you did not do a good job with the valuation and the margin of safety is not enough, the growth of the company will gradually compensate for the premium you have paid.

2. You don’t have to make a sell decision. Buy and hold works well in this case.

3. You sleep well.

As pointed out by Charlie Munger is his speech, Art of Stock Picking:

There are huge advantages for an individual to get into a position where you make a few great investments and just sit back and wait: You're paying less to brokers. You're listening to less nonsense. And if it works, the governmental tax system gives you an extra 1, 2 or 3 percentage points per annum compounded.

If you can find some fairly-priced great company and buy it and sit, that tends to work out very, very well indeed especially for an individual…

The idea of buying high-quality companies at fair prices is at work in the universe of GuruFocus Value Strategies. The Buffett-Munger Model Portfolio is our live proof that buying great companies at fair prices works. Since inception in January 2009, this model portfolio consisting of 25 high-quality companies has outperformed the market EVERY year. We only rebalance it once a year at the beginning of each year. The current list of the stocks is in the Buffett-Munger screener (Premium Access only).

It is worth noting that the quality of companies tends to be quite lasting. You don’t need to worry too much about the deterioration of business quality. Those who have made a lot of money for a long time tend to continue that way, as pointed out by the research of GMO in Profits for the Long Run: Affirming the Case for Quality.

Considering this, GuruFocus will publish a Quality Rank of businesses. We will also calculate the risk premium of low-quality companies vs. high-quality companies. The rank of quality will be based on these factors:

1. Profitability

a. Operating margin

b. The consistency of operating margin

c. The stability of operating margin

2. Financial Strength

a. Debt to equity ratio

b. Interest coverage

3. F-score

4. Z-score

We will create several model portfolios to track the performances of stocks with different quality ranks. In the meantime, we believe that the stocks in Buffett-Munger screener are a subset of high-quality companies that are traded at reasonable prices.

If you are not a Premium Member, we invite you for a 7-day Free Trial.

Rating: 4.0/5 (25 votes)


Drclark - 5 years ago    Report SPAM
What Warren says and what he does are two different things.

For every good company like Coca-Cola, that he's bought in his career, there are heaps more that we don't hear about that aren't anywhere near as good. These are the ones that count, as investing is a game of statistics, not stock picking. As proved time and time again.

Unless of course you own a large enough stake to influence management.

Warren's never really released how he picks the smaller ones, which is the backbone to his performance, he just says value and good companies. This is a huge generalisation and means nothing.
LwC - 5 years ago    Report SPAM
Drclark, I disagree. Buffett has clearly stated over and over again for decades that he does it the way Ben Graham taught him to do it. Since Graham published his methods, they are available to anyone who takes the time to read and understand it.

"[Graham and Dodd] laid out a roadmap for investing that I have now been following for 57 years. There's been no reason to look for another." - Warren Buffett (2009)

"Graham himself once said that his books: ' have probably been read and disregarded by more people than any book on finance that I know of '." William Ruane

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