7 Quotes That Sum Up Buffett's Entire Strategy

Warren Buffett (Trades, Portfolio) is the world’s greatest and most prominent value investor.Unlike other highly successful value investors, such as Seth Klarman (Trades, Portfolio), Buffett spends a large amount of time doing interviews. There have also been thousands of articles written about him and possibly hundreds of books.

Not only is Buffett the world's most successful investor, he is also the investing world’s biggest celebrity. In some ways, this success has been a doubled-edged sword.

Since Buffett is a larger-than-life celebrity, his interviews stray away from the topic of investing. At the same time, he has produced so many sound bites on the topic of investing, many have lost their true meaning. For instance, almost all investors know Buffett’s first two rules -- "Rule No.1: Never lose money. Rule No.2: Never forget rule No.1." More often than not, however, I have seen this interpreted as “If I don’t sell, I don’t lose money” -- clearly not the right viewpoint at all.

So considering all of the above, in this article I have tried to pull together seven quotes I believe best describe Buffett’s investment process and give essential insight into how the average investor should look for value and high-quality investments. These are not one-liners, they are specifically picked to give as much detail as possible.

How to pick the best businesses:

"I like businesses I can understand. We’ll start with that. That narrows it down about 90%. There are all kinds of things I don’t understand, but fortunately, there’s enough I do understand. You got this big, wide world out there. Almost every company is publicly owned. You got all American business, practically, available to you. Now, to start with, it doesn’t make sense to go with things you think you can[‘t] understand. But you can understand some things. I can understand this (picks up can of Coca-Cola (KO, Financial)). I mean you can understand this. Anybody can understand this. I mean this is a product that basically hasn’t been changed much since 1886, and it’s a simple business. It’s not an easy business. I don’t want a business that’s easy for competitors. I want a business with a moat around it with a very valuable castle in the middle. And then I want the duke who’s in charge of that castle to be honest and hard-working and able. And then I want a big moat around the castle, and that moat can be various things.

The moat in a business like our auto insurance business at GEICO is low cost. I mean people have to buy auto insurance so everybody’s going to have one auto insurance policy per car, basically, or per driver. And I can’t sell them 20, but they have to buy one. What are they going to buy it on? They’re going to buy it based on service and cost. Most people will assume the service is fairly identical among companies, or close enough, so they’re going to do it on cost, so I gotta be the low-cost producer. That’s my moat. To the extent my costs get further lower than the other guy, I’ve thrown a couple of sharks into the moat."

Stock prices are random, but fair value is not:

“It is difficult at the time of purchase to know any specific reason why they should appreciate in price. However, because of this lack of glamour or anything pending which might create immediate favorable market action, they are available at very cheap prices. A lot of value can be obtained for the price paid. This substantial excess of value creates a comfortable margin of safety in each transaction. This individual margin of safety, coupled with a diversity of commitments, creates a most attractive package of safety and appreciation potential. Over the years our timing of quotes from Buffett’s letter between 1960 and 1965 purchases has been considerably better than our timing of sales. We do not go into these generals with the idea of getting the last nickel but are usually quite content selling out at some intermediate level between our purchase price and what we regard as fair value to a private owner.”

You do not need to be a genius to be a successful investor, master the basics and the rest will fall into place:

"To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these. That, of course, is not the prevailing view at most business schools, whose finance curriculum tends to be dominated by such subjects. In our view, though, investment students need only two well-taught courses - How to Value a Business, and How to Think About Market Prices."

On the fine line between investment and speculation:

"The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities — that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future — will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands."

How to invest well:

“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 joys of compounding and the difference 50 basis points makes over the long term:

“One story stands out. This, of course, is the saga of trading acumen etched into history by the Manhattan Indians when they unloaded their island to that notorious spendthrift, Peter Minuit, in 1626. My understanding is that they received $24 net. For this, Minuit received 22.3 square miles, which works out to about 621,688,320 square feet. While on the basis of comparable sales, it is difficult to arrive at a precise appraisal, a $20 per square foot estimate seems reasonable giving a current land value for the island of $12,433,766,400 ($12.5 billion). To the novice, perhaps this sounds like a decent deal. However, the Indians have only had to achieve a 6.5% return (The tribal mutual fund representative would have promised them this.) to obtain the last laugh on Minuit. At 6.5%, $24 becomes $42,105,772,800 ($42 billion) in 338 years, and if they just managed to squeeze out an extra half point to get to 7%, the present value becomes $205 billion.”

The difference between risk and volatility:

“The measurement of volatility: it’s nice, it’s mathematical and wrong. Volatility is not risk. Those who have written about risk don’t know how to measure risk. Past volatility does not measure risk. When farm prices crashed, [farm price] volatility went up, but a farm priced at $600 per acre that was formerly $2,000 per acre isn’t riskier because it’s more volatile. [Measures like] beta let people who teach finance use the math they’ve learned. That’s nonsense. Risk comes from not knowing what you’re doing. Dexter Shoes was a terrible mistake-I was wrong about the business, but not because shoe prices were volatile. If you understand the business you own, you’re not taking risk. Volatility is useful for people who want a career in teaching. I cannot recall a case where we lost a lot of money due to volatility. The whole concept of volatility as a measure of risk has developed in my lifetime and isn’t any use to us.”

Disclosure: The author owns no stocks mentioned.