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Rupert Hargreaves
Rupert Hargreaves
Articles (325)  | Author's Website |

How to Invest the Buffett Way

Some tips from Buffett on how to value companies and make sure you're on the money

October 12, 2017 | About:

Many people view Warren Buffett (Trades, Portfolio) as the world’s greatest value investor. But while he may have started out as a value investor during the early years of his investment career, over the last few decades his strategy has morphed away from value to more of a quality bias.

The Oracle of Omaha changed his strategy because the results started to disappear. Buying high-quality cheap stocks used to be easy, but as the financial markets have opened up, the number of high-quality stocks trading at deep value multiples has dwindled. Today, the market is littered with cheap stocks that are cheap for a reason. Few, if any, of these will make investors money.

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The lack of cheap, good quality stocks started to impact Buffett several decades ago. He described why in his 1992 letter to investors of Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B):

“In my early days as a manager I, too, dated a few toads. They were cheap dates – I've never been much of a sport – but my results matched those of acquirers who courted higher-priced toads. I kissed, and they croaked.

“After several failures of this type, I finally remembered some useful advice I once got from a golf pro (who, like all pros who have had anything to do with my game, wishes to remain anonymous). Said the pro: 'Practice doesn't make perfect; practice makes permanent.' And thereafter I revised my strategy and tried to buy good businesses at fair prices rather than fair businesses at good prices.” – Berkshire Hathaway 1992 letter.

Buffett goes on in the letter to try and define what value investing is. He argues that the traditional metrics of value such as low price-earnings (P/E) and price-book (P/B) ratios “are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics a high ratio of P/B value, a high P/E ratio and a low dividend yield are in no way inconsistent with a "value" purchase.

Instead of using the traditional value metrics, Buffett suggests the following from "The Theory of Investment Value," written before the 1950s:

The value of any stock, bond or business today is determined by the cash inflows and outflows discounted at an appropriate interest rate that can be expected to occur during the remaining life of the asset. Note that the formula is the same for stocks as for bonds.”

Cash flows are king, and that’s the case whether the business is growing or not:

“The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase irrespective of whether the business grows or doesn't, displays volatility or smoothness in its earnings or carries a high price or low in relation to its current earnings and book value.”

The best companies to own are the ones that produce the best returns with the least capital:

“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite that is, consistently employ ever-greater amounts of capital at very low rates of return.”

The most significant drawback to using DCF calculations, and investing in companies where the returns are high, is that it is impossible to accurately predict future cash flows and profits. This is why so many Wall Street DCF price targets generally make little sense or are ever hit (there’s also the inspiration to issue overly optimistic forecasts). Berkshire Hathaway overcomes 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.

“Second, and equally important, 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.”

The second method, the margin of safety principle, is firmly ingrained in value investing. But the first, understanding businesses, is something that many investors fail to comprehend.

The power of focus is something I’ve covered several times before. Buffett is famous for the level of diligence he does on his investments (he read 100 years of annual reports before buying Coca-Cola [KO]), but he’s one of only a handful of investors that do the same. Focus and understanding a business is key if you want to be able to predict its future potential accurately, risks to the business model and cash flow forecasts.

Overall, if you want to be as successful as Buffett the key is not buying stocks trading at 0.5 of book; it’s buying stocks that look cheap compared to their future cash flows. There’s no shortcut for estimating cash flows either. If you want to achieve the best results, you need to do the legwork yourself, calculate the value and invest. There’s no shortcut for focus, diligence and understanding.

Disclosure: The author owns no stock mentioned.

About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. Prior to his investing and writing career, Rupert was as a proprietary currency trader. Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

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