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Keys to Warren Buffett's Methods

By John Price, PhD

The following are what I consider are the five main keys to Buffett's methods of investing.

1. Businesses that you understand: Focus on areas that you have the most background in or the most interest in. Often this will mean from a consumer's perspective. Buffett, for example, does not invest in tech companies because he says that he does not understand the market for their products or services. He focuses on "consumer" foods (Coca Cola, Dairy Queen, etc), newspapers (Washington Post, Buffalo News), insurance companies (GEICO) and retail furniture stores (Nebraska Furniture Market, Star Furniture).

2. Strong economic moat: Look for companies that have a protection against their competitors. This could be geographical, patents, brand name, entry costs, and so on. When companies have a strong economic moat, then financial forecasts can be more reliable. USA examples of such companies are Coca Cola and Intel. An Australian example is Westfield Holdings and ARB Corporation Ltd.

After teaming up with Charlie Munger, Warren Buffett has often talked about the importance of an economic moat for companies that he would consider investing in. Just as a moat around a medieval castle kept the castle safe from intruders, an economic moat around a company keeps the company safe from competitors and other profit-draining forces.

The following are some of the remarks that Warren Buffett had made about economic moats over the years.

If you own See's Candy, and you look in the mirror and say, 'mirror, mirror on the wall, how much do I charge for candy this fall?' and it says 'more', that's a good business. (Omaha World Herald, 1994; See's Candy is fully owned by Berkshire Hathaway.)

Wonderful castles, surrounded by deep, dangerous moats where the leader inside is an honest and decent person. Preferably, the castle gets its strength from the genius inside; the moat is permanent and acts as a powerful deterrent to those considering an attack; and inside, the leader makes gold but doesn't keep it all for himself. Roughly translated, we like great companies with dominant positions, whose franchise is hard to duplicate and has tremendous staying power or some permanence to it. (Berkshire Hathaway Annual meeting, 1995)

You need a moat in business to protect you from the guy who is going to come along and offer (your product) for a penny cheaper. (Warren Buffett Talks Business, 1995)

The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products and services that have wide, sustainable moats around them are the ones that deliver rewards to investors. (Fortune, 1998)

3. Sales and earnings growth: You can still get good returns from companies that have poor growth figures if they pay out most of their earnings as dividends or use them for share buybacks. Nevertheless, at least a reasonable level of growth is often important for the management and employees to have a sense of achievement which then translates into higher productivity and less unrest. I also look for companies with earnings that have a high STAEGR® or stability of earnings growth. (STAEGR® is a trademark of Dr. John Price.)

4. Return on equity: If you think of equity as your money, then return on equity is a measure of how well management is doing with your money. It is virtually impossible for a medium to long-term investment to be satisfactory if the return on equity is low. Each year in the annual report of Berkshire Hathaway Buffett stresses the importance of finding companies with a high return on equity. I look for companies that have 15 percent or more return on equity and return on capital.

5. Not too much debt: If debt is too high, then the company is vulnerable to credit squeezes and may have difficulty in raising money for expansion. Look at the debt to equity ratio, the current ratio and the quick ratio.

Each year in the annual report of Berkshire Hathaway, Buffett writes that one of the criteria he looks for is "businesses earning good returns on equity while employing little or no debt".

Of course, even with the best of companies you can still pay too much. But as a general rule, Buffett says that he would rather pay a fair price for a great company than great price for a fair company.

The next step is to determine what is a fair price to pay for individual companies. Conscious Investor has proprietary tools that allow you to determine the "target price" to pay for companies under a margin of safety set by the user.

Once all this is done, Buffett says that he is willing to wait indefinitely to but the stock he wants at the price he is willing to pay.

Other criteria for Buffett's methods

6. Investment period Buffett buys stocks as if he will be holding them for the rest of his life. I think it is a little like getting married. When you pop the question, your intention is that it is going to be a marriage for the rest of your life. It might not end up that way, but this is what guided your decision.

On a number of occasions Buffett has referred to himself as a "Rip Van Winkle" investor, an investor whose "favorite time frame for holding a stock is forever."

In the 1986 Berkshire Hathaway Annual Report, Buffett wrote that "we expect to keep permanently our primary holdings, Capital Cities/ABC, Inc., GEICO Corporation, and The Washington Post. Even if these securities were to appear significantly overpriced, we would not anticipate selling them, just as we would not sell See's or Buffalo Evening News [companies fully owned by Berkshire Hathaway] if someone were to offer us a price far above what we believe those businesses are worth… Despite the enthusiasm for activity that has swept business and financial America, we will stick with our 'til-death-do-us-part policy."

A few years later he added Coca Cola to his list of permanent stock holdings.

7. Management Buffett never interferes with the management of any company that he invests in or buys. He once said, "If they need my help to manage the enerprise, we're probably both in trouble." He likes to buy companies with owners whose passion about their business far exceeds their passion about making money.

8. The Big Picture Buffett says that he enjoys work so much that he feels like tap dancing each day he comes to work. He explains that he does not begrudge paying taxes because he would much rather be on the paying side than on the receiving side. Also he recognizes that it is only in the USA that he could have made the profits that he has. He also explained the importance of working with people he likes.

The following quote is a good way to end this brief look at the investing methods of Warren Buffett which, I believe, are relevant in all regulated stock markets and, in particular, the Australian market.

We're not pure economic creatures, and that policy penalizes our results somewhat, but we prefer to operate that way in life. What's the point of becoming rich if you're going to have a pattern of operations where you continually discard associations with people you like, admire, and find interesting in order to earn a slightly bigger figure?

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