Price is what you pay. Value is what you get.

Warren Buffett's investment principles

How did Warren Buffett become the most successful investor of his generation? Here I give you more information about his life and investment strategy.

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Buffett's words are enough to move the financial markets. The mere rumour that he is buying a particular stock causes its price to skyrocket. The latter is not surprising. He has amassed his enormous fortune of around USD 103.1 billion (2021) simply by selecting the right stocks. In addition, he does so on the basis of simple and clear investment principles. For more than five decades, Warren Buffett was able to beat the market with his investment strategy. Nevertheless, some academics and somewhat envious colleagues often dismiss his success as a form of extreme luck. But investors who are a little less biased and take the trouble to look into his fascinating life story and investment principles generally come to a different conclusion.

Simple framework

One passage from the foreword that Warren Buffett wrote for The Intelligent Investor by Benjamin Graham is particularly memorable: To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What is needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework. If you want to understand the framework of investment guru Warren Buffett, then the large number of publications that have appeared about him over the years are very helpful. Both from this work of third parties and from Buffett's own writings, the same elements always emerge. The investment framework that then becomes clear is of an astonishing simplicity. Below, I explain each of the building blocks of his investment strategy.

Invest in companies, not in pieces of paper

The foundation of the Buffett method is to see shares for what they are: a share in the ownership of a company. As such, it is fundamentally different from the speculative piece of paper it is usually mistaken for. Based on this insight, Warren Buffett is able to simplify the investment process into two essential questions. The first question is: what type of companies do I want to hold for the long term? The second question is: what price am I willing to pay for those companies? The advantage of this approach is that Buffett excludes distracting noise, and focuses only on questions he can answer with a reasonable degree of certainty. Note, for example, that considerations such as 'how much has the share price risen in the past week?' and impossible-to-answer questions such as 'what will the stock market do in the next month' play no role at all.

In my article - Value Investors invest in businesses, not just stocks – you will learn more about this topic!

Find strong companies

Buffett is only interested in high-quality companies. He looks for companies that create value for their shareholders over longer periods of time. Buffett knows that if he selects a company whose intrinsic value grows year after year, the share price will eventually grow accordingly. Warren Buffett is therefore not concerned with trend analysis, stock market graphs or short-term predictions. Criteria such as the financial position, the competitive position and the skills of the management present are much more relevant with a view to value creation. In this light, one can clearly explain his predilection for strong brands such as Coca-Cola and Gillette. These brand names function as figurative moats and thus keep the competition at bay. Buffett often uses razor blade manufacturer Gillette (now taken over by Procter & Gamble) as an example. During a speech to students at the University of North Carolina in 1995, the CEO of Berkshire Hathaway said, for example: 'Worldwide, 20 to 21 billion razor blades are consumed each year. Of that, 30% is Gillette, but in terms of value, it is 60%. They have 90% market share in some places like Scandinavia and Mexico. So you see something that has been around for as long as shaving, and a company that innovates so much in terms of developing better and better blades. Add to that the dominance in distribution, along with the place they have in people's minds. Moreover, here you have something that men do every day - at least I hope you do it every day - and for USD 20 a year, you have a fantastic shaving experience. When men are in a situation like that, they are not easily tempted to switch... You sleep very peacefully at night when you know that 2½ billion men have to shave the next morning.'

Only do things you understand

According to Warren Buffett, success is highly dependent on the extent to which the investor understands his investments. He has demarcated the area of companies in which he himself invests to only those, which he can understand. Buffett refers to this demarcation as his 'circle of competence': his area of expertise. Buffett believes that a correct definition of the parameters is more important than the size of this circle. In other words: know your limits, avoid making big mistakes and apply yourself with above-average dedication to the remaining things you can easily grasp.

Starting your research is very difficult. It takes a few tries and quite a while to find good companies. However, the Three Circles Exercise by Phil Town will help you to find good companies that you understand.

Welcoming low prices

Unlike most investors, Warren Buffett welcomes periodic price falls. He is surprised that other investors often look at stocks with an unnatural attitude. I will continue to buy hamburgers for the rest of my life, to quote a personal preference of mine. When the price of hamburgers falls, the Buffett household chants "Hallelujah." When the price of hamburgers goes up, we burst into tears. For most people, the same applies to everything they buy in their lives: except stocks. When stocks fall, and you can get more for your money, suddenly people don't find them attractive anymore.'

When Warren Buffett has a strong company in his sights, he waits until the price of the share drops to an attractive level. Sometimes this can take years. Buffett knows that the price he pays for a strong company determines his ultimate return. If he estimates the value per share of company ABC to be USD 100 in 10 years' time, it makes a big difference whether he buys it at USD 18 or USD 12 per share. In the first case, the annual return is 18.71%; in the second case, the annual return is 23.62%. That translates into serious money after 10 years at the end of the horizon. An example: If you invest USD 100,000 now with an annual return of 18.71%, this investment grows to USD 555,742 after 10 years. If, on the other hand, you invest USD 100,000 now with an annual return of 23.62%, that same investment will grow to USD 833,465. That means a difference of no less than USD 277,723, or almost three times the investment!

Think independently

Buffett is renowned for his contrary approach. In his opinion, achieving a high return does not go hand in hand with following fashions. One simply cannot expect that buying what is popular will lead to financial success. Buffett knows that really favourable prices on stock exchanges only arise when nobody else wants a specific share. In doing so, he makes clever use of the prevailing culture among institutional investors, whom he likes to compare to lemmings, where blind imitation is the order of the day. In his 1984 annual letter to shareholders, Buffett says: 'the ratio of profit to loss for the managers personally is clear: if an unconventional decision works, they get a pat on the back, but if it goes wrong, they get a letter of dismissal. Conventional failure is the route: as a group, lemmings may have a lousy image, but no individual lemming has ever gotten bad press.'

Do you want to learn more about behavioural finance? Here you will find more about the topic!

Invest for the long term

Warren Buffett put his investment strategy and horizon in Forbes magazine in 1990 as follows: Shares are simple. All you do is buy stakes in a wonderful company with highly integer managers for less than the company is intrinsically worth. Then you hold those shares forever. Buffett knows that price and value can diverge periodically, but that in the longer term the stock market works reasonably well. Over short periods of time, the price of a specific share is often depressed due to the overreaction of investors, but in the long run, reason always wins over emotion. Buffett estimates the value development of a company in the long term because he never knows exactly when the price will rise. Adopting a long horizon allows him to focus on what really matters: the business.

In 1992, the CEO of Berkshire Hathaway illustrated this idea at the shareholders' meeting as follows: 'In every industry there are all kinds of things that will happen the next week, the next month, or the next year. But the most important thing is to be in the right business. The classic example is Coca-Cola, which was listed in 1919. Initially, the price was USD 40 a share. The next year it dropped to USD 19: the price of sugar changed dramatically after the First World War. So if you had bought shares at the IPO, you had lost half your money a year later. But if you owned that stock today - and you had reinvested all the dividends - it would be worth about USD 1.8 million. We have had a depression. We have had wars. Sugar prices have gone up and down. In short, a million things have happened. How much more fruitful is it to think about the shelf life and the economics of the product, than to wonder whether you should jump in or out of the stock?'

A long investment horizon takes advantage of the fact that strong companies are usually able to reinvest their profits profitably: a mechanism that leads to growth in earnings per share and thus works like the interest-on-interest effect. Basically, one can consider the price of a share as the product of two things: (1) the earnings per share that the company realises, and (2) the valuation of investors. This valuation translates into a price/earnings ratio, the number of times the profit the investor is willing to pay. Buffett knows that a healthy growth in earnings per share will ultimately lead to a higher share price, and so he focuses his attention on the company, not the share price. Buffett has listened carefully to Philip Fisher who believed that it is not possible to always buy shares at the low point and sell at the high point: 'If when buying a share the task has been done correctly, then the right time to sell is: practically never.'

Mr. Market or the true meaning of the market

Warren Buffett often uses the metaphor of Mr. Market, a figure of speech that Benjamin Graham often used to teach his students the right mental attitude towards the stock market. Mr. Market stands on investors' doorsteps every day to make them an offer: on the basis of this offer, investors can either buy pieces from him, or sell pieces to him. However, there is a catch: Mr. Market is manic-depressive. Sometimes he has one of his optimistic moods and sees nothing but positive developments. At such times, he will only sell at a very high premium. On the other hand, when he is in one of his pessimistic moods, he sees nothing but dark clouds. At such times, he is prepared to sell his shares at a soft price.

Investors, Buffett teaches in his 1987 letter to shareholders, have a fundamental advantage over Mr. Market: 'Mr. Market has another sympathetic trait: He does not mind being ignored. If you do not find his bid today interesting, he will come back tomorrow with a new bid. Transactions are purely optional for you. Under these circumstances, the more manic-depressive his behaviour, the better it is for you.'

'Mr Market is there to serve you, not to guide you. His wallet, not his wisdom, is useful. If one day he appears in a particularly foolhardy mood, you can ignore him or make use of him, but it is disastrous if you fall under his influence. In fact, you should not play the game if you are not sure that you can appreciate a business much better than Mr. Market. As they say in poker, "if you've been at the table for thirty minutes and you don't know who the klutz is, that klutz is you.''

Price versus value

Buffett was already fascinated by investing before he discovered Benjamin Graham, but until then, he says he was a fan of all winds. He did technical analysis, read all kinds of magazines and listened to tips from others. So he lacked a specific basic idea and clearly needed a handle on making investment decisions. In short, Buffett started his career as a speculator, but realised that he had to develop into an investor. Everything changed once, under Graham's influence, he became aware of the distinction between price and value. That idea was like a revelation to him: 'Price is what you pay. Value is what you get.' In The Super Investors of Graham-and-Doddsville, he summarises the essence of this thinking in a few lines: 'The common intellectual theme of the Graham-and-Doddsville investors is as follows: they look for discrepancies between the value of a company and the price of small portions of that company on the stock market. In essence, they exploit those discrepancies without caring whether it is Monday or Thursday, whether it is January or July and so on. That is something for an efficient market theorist.'

Margin of Safety

The margin of safety is Benjamin Graham's idea of protected investment. Investors obtain a margin of safety by demanding the highest possible discount on the real value of a stock or other asset. Warren Buffett compares this idea to buying a dollar for 60 cents: 'Buying a dollar note for 60 cents is riskier than buying a dollar note for 40 cents, but the profit expectation is higher in the latter case. The greater the profit potential in a portfolio of securities, the less risk there is.' The safety margin offers Buffett protection when a transaction ultimately turns out to be less promising than he estimated, or when a stock takes a long time to reach its intrinsic value. In The Super Investors of Graham-and-Doddsville he writes: 'But you don't do anything at the cutting edge. That is what Benjamin Graham meant by having a margin of safety. You do not try to buy companies that are worth USD 83 million for USD 80 million. You make sure you have a huge margin. If you build a bridge, you insist that it can handle 30 tonnes, even though you only drive 10-tonne trucks over it. The same principle works in investing.

Summary

Warren Buffett is one of the best investors all time. I think that is a good opportunity to learn from him and his letters. If we study his letters and the lecture from Graham and Fisher, it will make us to a good investor, too.

What do you think about Warren Buffett investment strategy? Did you learn something from it? Tell me in the comments below.

About Alexander Kelm

Alexander Kelm is a passionate value investor and runs the website Wall St. Nerd. Here, the passionate value investor writes in-depth articles on the topic of Value Investing. Value Investing involves analyzing a company's fundamentals and can be characterized by an intense focus on a stock's price, its intrinsic value and the relationship between the two.

Alexander Kelm offers online courses on stock investing.

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