Stock market trends keep changing. But Buffett's investment principles remain the same. "Warren Buffet is content. He loves everything he does, dealing with people and reading mass quantities of annual reports. As an investor he has discipline, patience, flexibility, courage, confidence and decisiveness. He is always in search for investments where risk is minimal. He can determine the key elements of a company with speed and precision. He can take a decision not to invest in a company in two minutes and make major purchase decisions after just a few days of research," writes renowned investor Peter Lynch.
These lines reveal some shades of the enigmatic 'Oracle of Omaha'. In The Warren Buffett Way, Robert G Hagstrom goes a little further - he analyses Buffett's actions, words and decisions for common threads. The book weaves those threads into timeless investment principles.
Buffett never invests in businesses he cannot understand or that are outside his 'circle of competence'. "All we want is to be in businesses that we understand, run by people whom we like, and priced attractively relative to their future prospects," he says.
Investors must feel convinced that the business they are buying will perform well over time. They must have some confidence in their estimate of its future earnings, and that has a great deal to do with how well they understand its business fundamentals.
Buffett believes that risk can be reduced by concentrating on a few holdings if it forces investors to be more careful and thorough in their research.
More than 75 per cent of Berkshire Hathaway's (Buffett's investment company) common stock holdings are represented by five securities.
Buffett is keen on buying great businesses when they have temporary problems or when the stock market declines and creates bargain prices for outstanding franchises.
"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price," he reasons.
The most distinguishing trait of Buffett's philosophy is the understanding that by owning shares he owns businesses, not pieces of paper.
For him, buying stocks without understanding the company's operating functions - its products and services, labour relations, raw material expenses, plant and equipment, capital reinvestment requirements, inventories, receivables and needs for working capital - is meaningless.
This mentality reflects the attitude of a business owner as opposed to a stock owner, and is the only mentality an investor should have.
Benjamin Graham wrote in The Intelligent Investor, "Investing is most intelligent when it is most businesslike". Those are, says Buffett, "the nine most important words ever written about investing."
Buffett cares little about stocks that are 'hot' at any given moment. He is far more interested in buying into companies that he believes will be successful and profitable in the long term. While predicting future success is not foolproof, a steady record is a relatively reliable indicator.
According to Buffett, the economic world is divided into a small group of franchises and a larger group of commodities. He defines a franchise as a company whose product or service is needed or desired and has no close substitute.
These create what he calls a 'moat' - something that gives the company a clear advantage over others and protects it from competition. The bigger the moat, the better he likes it.
"The key to investing," he says, "is determining the competitive advantage of any company and the durability of that advantage. The products and services that have wide sustainable moats around them are the ones that deliver rewards to investors".
The most important management act, Buffett believes, is allocation of the company's capital. It is important because allocation of capital over time determines shareholder value.
Deciding what to do with the company's earnings - reinvest in the business or return money to shareholders - is a rational act. Buffett finds most corporates lacking in rationality.
He believes that certain management values will make a company's operations transparent. He respects managers who report their companies' financial performance fully and genuinely, admit mistakes and share success, and are candid with shareholders.
Unlike market analysts, Buffett doesn't take yearly results too seriously - he focuses on four- or five- year averages.
Instead of accounting trickeries that produce impressive year-end numbers, Buffett prefers to (a) focus on return on equity, not earnings per share, (b) calculate 'owner earnings' to get a true reflection of value, and (c) look for companies with high profit margins.
Buffett selects companies in which each dollar of retained earnings is translated into at least one dollar of market value. This test identifies companies whose managers have been able to optimally invest their company's capital.
If retained earnings are invested in the company and produce above-average return, the result will be a proportionally greater rise in the company's market value.
Customarily, analysts measure a company's performance by looking at its earnings per share. But Buffett thinks earnings per share are a smoke screen.
Since most companies retain a portion of their previous year's earnings to increase their equity base, he sees no reason to be excited about record earnings per share. The test of economic performance, he believes, is whether a company achieves a high earning rate on equity capital.
"The basic ideas of investing are to look at stocks as businesses, use market fluctuations to your advantage, and seek a margin of safety. That's what Ben Graham taught us. A hundred years from now, they will still be the cornerstones of investing," says Buffett.
In the last 50 years the trends of the stock market changed several times over. But Buffett's approach remained the same - think of buying stocks as buying fractional interests in whole businesses, construct a focused low-turnover portfolio and demand a margin of safety between the purchase price and the company's long-term value.
Use this book to learn. Don't use this to be like Buffett. If you try, you may suffer.
The Warren Buffett Way
Author: Robert G Hagstrom
Publisher: John Wiley and Sons
Edition: 2005, hardcover
Price: Rs 1,055
Book courtesy: Crossword
| HARD QUESTIONS Answer the following questions - as Buffett does - before investing in a company: Business
- Is the business simple and understandable?
- Does the business have a consistent operating history?
- Does the business have favourable long-term prospects?
Management
- Is the management rational?
- Is the management candid with its shareholders?
- Does the management resist the 'institutional imperative'?
Financials
- What is the return on equity?
- What are the company's 'owner earnings'?
- What are the profit margins?
- Has the company created at least one rupee of market value for every rupee retained?
Value
- What is the value of the company?
- Can it be purchased at a significant discount to its value?
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