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Warren Buffett: Select and Sit

by Margaret Baldock

Margaret Baldock, the Co-founder of Conscious Investing wrote an article for the Australian Women's Money magazine. Below is a transcript of the part of the article. (Autumn 2004, Page 66-7)

MARGARET BALDOCK looks at the philosophy behind one of the world's best known investors.

Warren Buffett is undisputedly the world’s greatest investor. He is the second richest man, behind Bill Gates' with a personal wealth of US$30 billion

As Chairman and CEO of the diversified investment company Berkshire Hathaway, Buffett's success in the sharemarket is unmatched.

Suppose someone invested US $10,000 in one of Buffett's original investment partnerships back in 1956, then today that person would have seen a return of over US$280 million after all taxes and expenses.

What is most fascinating about Buffett's success is that he created his fortune entirely through investing, and mostly through investing in well known listed companies available to any investor.

He simply bought shares in ordinary businesses, such as Gillette, Walt Disney and Coca Cola.

Buffett didn't amass his $30 billion fortune by "hitting the jackpot" with one or two great picks or by trading in and out of stocks seeking the maximum, short term returns.


Instead Buffett selects outstanding companies that he can hold year in, year out, thereby allowing his returns to compound over time. Using this simple strategy, Buffett's wealth has grown at an exponential pace. Isn't this what all investors aspire to?

Despite Buffett's unmatched and undisputed track record, almost no investment professionals attempt to follow his approach. Most investment professionals focus instead on the futile exercise of predicting general market movements.

In fact, the average managed fund turns over 40 per cent of its entire portfolio each year trying to emulate movements in the general market, incurring costly taxes and commissions along the way. This is the key reason why more than 80 per cent of fund managers consistently fail to deliver even average returns (as measured by market indices such as the S&P500 in the United States and the All Ordinaries Index in Australia).

This obsession with the greatest short term gains seriously erodes wealth over the long term.

Over a 47 year period, Buffett's investment company, Berkshire Hathaway has achieved returns of 194,936 per cent versus the Wall Street market index (S&P500) returns of 4,742 per cent.


There are just three key steps to investing like Warren Buffett:

STEP 1 - Ignore the "sharemarket": The first point in understanding Buffett’s investment methods is to recognize that he does not think about the "sharemarket".

After all, the wonderful world of shares really has nothing to do with "shares". It has to do with businesses. Every share is tied to a company an actual enterprise run by managers, employing people and offering products or services to customers.

"We look at individual businesses," Buffett says. "And we don't think of stocks as little items that wiggle around in the paper. We think of them as parts of businesses." Buffett's sole focus is on businesses, not share symbols!

STEP 2 - Don't worry about the economy: For Buffett, economic conditions are irrelevant. Instead he seeks good businesses at fair value regardless of economic conditions. In any case, if economists can't reliably predict the economy, then what chance do you and I have?

STEP 3 - Buy businesses, not shares: Buffett is only interested in buying outstanding or "great" companies, as determined by a set of rational investment guidelines. These are companies that have done well in the past and have all the hallmarks of doing well in the future.


- Is the business simple and understandable? Buffett doesn't invest in tech stocks as he says that he doesn't understand them. Instead he focuses on businesses within his "circle of competence" which includes consumer goods, food, newspapers and insurance. Similarly you should only invest in businesses that you can understand.

- Does it have a consistent operating history? That is, are its sales and earnings growing consistently over time? (In the following table we look at Sales Per Share (SPS) and Earnings Per Share (EPS) to evaluate operating history).

- Does management have a successful track record of delivering outstanding returns to shareholders? 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 (ROE) is low. Look for companies that have 15 per cent or more return on equity and return on capital (ROC).

- Does the company have minimal or no debt? If debt is too high, then the company is vulnerable to credit squeezes and may have difficulty in raising money for expansion.

- Does the company have favorable long term characteristics (or what we refer to as an "economic moat")? An economic moat provides protection against competitors. This could be geographical (eg Westfield), patents (eg CSL), brand name (eg RM Williams), entry costs, and so on.

The following table is a sample of five great Australian companies that have many of the characteristics described in steps 1 to 3, that is: high return on equity and return on capital, low debt, and stable strongly growing earnings and sales.

These are quality businesses that are potentially great investments so long as they can be purchased at a reasonable price. The price that you pay for a quality company will ultimately determine how profitable your investment will be.

The target price that you establish should factor in a "margin of safety" that allows you to protect your capital, in the event that the company's future performance is not as strong as you would like. In doing so, you also allow yourself to enjoy unlimited upside potential on your investments. Buffett has often said that he is willing to wait indefinitely to buy stock at the right price.

*Current Price as at 12th December 2003 # Stock return is based upon buying the stock at the "Current Price" and holding the stock for 5 years (note: a margin of safety has been built into these calculations) A The Target Price is the price that you would need to pay to achieve your required return (or profitability, given a reasonable margin of safety). Setting the target price allows you to protect the downside of your investment while leaving you with unlimited upside potential.

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