Saturday, February 26, 2011

Investing Like Buffett: 5 Ways to Achieve Legendary Returns - Seeking Alpha

Investing Like Buffett: 5 Ways to Achieve Legendary Returns - Seeking Alpha

People are always interested to hear what Warren Buffett has to say about the current state of the economy, but what everyone actually cares about is how he continues to achieve such amazing returns after all this time. Of course he’s always willing to impart pieces of his wisdom to the public, but sometimes they sound like cryptic messages from the future, while others are crystal clear to understand. Unfortunately, a conceptual understanding of what he says is very different than turning his thoughts into sound investment principles and actions. This is why we have pinpointed five easy Buffett investment principles, which build upon each other, that hopefully will help the everyday investor to achieve better returns.

1. Be a Bear Market Investor

Buffett is, in our opinion, a bear market investor; he has historically made some of his most successful investments and deployed the greatest amount of capital specifically during bear markets. Think for one moment about how well a portfolio would do if a good chunk of its assets were consistently invested only during bear market periods, and that during bull markets capital was deployed much more sparingly. It’s not hard to understand that it would probably do much better over the long term with this general mindset. This is due to the fact that investments would be made more often when stocks are trading at depressed prices. Below is an example of Buffett being a bear market investor:

Investment: PetroChina (PTR)

Investment Date: 2002-2003 (Dot.com crash/recession period)

Total Capital Invested: $488 Million

Holding Period: 6 Years (Sold in 2008)

Capital Received from Sale: $4 Billion

Total Return: 819.67%

Annualized Return on PTR: 136.66%

Most investors were obviously not looking at investing in a Chinese state-owned oil company after the dot.com crash -- or anything else, for that matter. Still, this simple investment principle is no different than if a person only bought clothes when they were on sale at a department store. He bought a great company when it was on “sale” because he realized that the intrinsic value of the company never changed; just the price tag on it. Remember, a great company generally only goes on “sale” during a bear market -- so when there is fear in the streets, it’s time to go shopping.

2. Invest in What the World Needs

During the last recession, investors hated Goldman Sachs (GS), Burlington Santa Fe Rail (BNI), and General Electric (GE) equally. Investors crushed their respective stock prices based on illogical fears, emotional hatred, and very little analysis. Putting personal opinions aside, GE, BNI, and GS are all marble pillars of the U.S. economy. Buffett always invests with objectivity, and that’s why he bought shares in each of these firms. In particular, he bought the remaining shares of Burlington Santa Fe and folded them into Berkshire Hathaway (BRK.A). One man’s “trash” was definitely Buffett’s treasure. The takeaway point here is that Buffett went into heavily distressed industries that were crucial to the U.S. economy recovering and then bought the best in breed.

3. Fundamental Analysis and Due Diligence

The Oracle of Omaha is constantly quoted for saying “I only invest in what I understand.” As simple as this sounds, it actually goes over the heads of about 80% of investors. What he means here is that he spends a good portion of time educating/doing due diligence for himself about industries that he is interested in but potentially unfamiliar with. This includes taking time to understand the industry as a whole, how it fits into the world economy, and the company itself. We doubt he was a chocolate connoisseur before or after he bought See’s Candy, but either way, he knew what he was buying because he did his due diligence.

As an investor, he is probably one of the few who still directly requests the financial statements from firms he has an interest in. Everyone can call Buffett a “value investor” till they’re blue in the face, but he is a fundamental analysis investor at the end of the day. We have little doubt he goes through every number and checks every financial statement ratio in the book to find potential “hidden value.” He is even known to go through the granular footnote details for assumptions and/or additional information about inventory classification.

Doesn’t doing all this due diligence and research take time though? Yes, of course it does. Still, this is what he does in order to beat the market. He realizes and understands that most investors won’t take the time to do this consistently. Imagine how successful anyone could be at anything if they knew exactly how much effort they needed to give in order to outperform the competition. When it comes to investing, Buffett knows exactly how much effort he has to put forward.

This may all sound boring so far, but becoming the third-richest billionaire in the world by investing in names like Coca-Cola (KO) is not. He may like the taste of a Coca-Cola soda, but we doubt he would have invested in the company if it were short on cash, up to the eyeballs in red, and leveraged to the hilt with debt and with no hope of being able to pay it back. When he invests in a company, he knows it and its industry inside out. The time involved with principle three is substantial -- but so is the potential payoff.

4. Pricing Power beats Sound Management

The pricing power of a firm generally holds more value than does sound management, plain and simple. Further, it reduces the risk that a firm will underperform longterm should key personnel leave. Do you agree? Well, Buffett certainly does; he was quoted saying the following in two separate, recent interviews:

  • "The single most important decision in evaluating a business is pricing power …. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.” (For more, see here.)
  • “The extraordinary business does not require good management.” (For more, see here.)

His argument here makes sense and we are happy to follow this principle without question.

5. Patience

It’s true that Rome wasn’t built in a day, but sometimes it’s tough to remember that. Buffett understands the power of patience, and that is why he remains bullish over the long term. The rules are no different for anyone else, in that if an investor follows all the other principles then all that is left for him to do is be patient enough to wait and watch hard work pay off.

Conclusion

The Oracle of Omaha will always be bullish long term because he follows these principles without fail, in our opinion. With these five simple principles he has consistently outperformed the market and continues to see the investment landscape differently than almost everyone else.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Comments (34)
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  • Thanks for the good article, these 'rules' cannot be repeated enough.

    I understand Buffet's principle's for picking the right stocks/business but my biggest question remains, when is it time to sell?

    Even buffet doesn't hold on to a lot of his picks forever. Perhaps you can dig a litter deeper in this question in your next Buffet article.

    Suggestions in the comments are also more than welcome!
    Feb 23 10:54 AMReply! Report abuse+3-1
  • I agree, if you want to invest like Buffett, you should not invest in Cisco (CSCO). You should instead invest in Sisqo...even Buffett can't handle that! Oww!
    Feb 24 12:08 AMReply! Report abuse0-2
  • Buffett's favorite holding period is "forever." He doesn't like to sell his long term holdings, even when he should. He admitted as much in his 2004 annual report.

    He DOES sell some of his "smaller" positions, particularly when he doesn't understand them well. (And some of the selling attributed to him is actually done by Lou Simpson or others on his staff.) The most likely time is a year or two after they were bought, before they become "permanent" parts of the portfolio.

    Buffett wants to buy stocks that he feels he can be "sure" of, so that he never has to sell. The one major "permanent" position I can think of that he has divested in recent years is Freddie Mac. At other times, he "divests" (e.g.Salomon, Capital Cities/ABC, or Gillette) by having the companies taken over. Then he will sell the stock of the acquirer (e.g. Disney or Citigroup), if he doesn't like it, since he's starting with a fresh slate. (But he kept P&G.)
    Feb 25 05:39 PMReply! Report abuse0-1
  • Having been a Buffett watcher for many years, including having been the first analyst to initiate regular research coverage of Berkshire when I was at Value Line, a situation that gave me opportunities to talk regularly with Buffett, I've come to the conclusion that he is every bit as brilliant as people think he is (actually, more so) but that when it comes to his public persona, he's got something of a playful streak and that you have to be careful about how you react to the things he says. If you ignore what he says and look only at what he does, you're apt to see a very different sort of "investor."

    We know, for example, his famous one-liner to the effect that derivatives are financial weapons of mass destruction. Yet he invests in them when he finds instruments priced such that he thinks he can make money. (His affinity for and admiration of Goldman Sachs goes deeper than a well-timed, well-priced investment opportunity.)

    We know, for example, his statements about investing in businesses he understands. Less obvious, however, is his willingness to roll up his sleeves, study up, and do what it takes to make darn sure he's able to understand businesses that intrigue him, such as insurance, and especially the more exotic reinsurance aspect of the business. You actually acknowledge this tendency in Part 3 of your article using a different example. Many say he avoids tech because he doesn't understand it. Actually, he understands the dynamics of tech (hefty investment needs, ever--shorter product cycles, etc.) well enough to know it doesn't appeal to him meaning he often has no motive to bother learning the particulars of the companies.

    We definitely know his recent quotes, the ones you reiterate, about pricing power trumping good management (which sounds like a tortured way of talking about economic moats, a term that has become vastly overused today to the point where it's easy to see why he'd prefer to dodge a cliche). Yet he has made many other statements over the years expressing the importance of good management, even to the point of often bragging about how he won't acquire a company outright unless it has a management team that can and will remain in place. (He hasn't always been right, but I can't think of a time when he went in on day one knowing he was buying into managerial mediocrity.) Those who watch what he does, as opposed to what he says, likewise cannot help but notice a that he has over the years invested in companies in brutally competitive areas that do, indeed, have to sweat every time they try to raise a price.

    We know, for example, how he says he values fundamentals. We also know he values speculative trading opportunities, as evidenced by his inclination toward speculation in silver.

    Ultimately, Buffett has done a magnificent job crafting a homespun folksy image -- the Norman Rockwell of investing -- that investors love and revere (hence the frequent presence of Buffett-inspired articles on Seeking Alpha). If I were the dean of a business school, I'd probably want to add to the curriculum a course in public relations that focuses entirely on Warren Buffett.

    The reality, though, is that much of Buffett's success comes from just plain raw genius, as opposed to particular set of rules, or principals or guidelines. Perhaps the most poignant thing I ever heard him say about himself was about how lucky he was to be alive at time when the only skill he had, allocating capital, could be valuable. Had he been born with that skill at other times, he said, he might have just become lunch for a wild animal.

    The guidelines so many of us associate with Buffett are fine and many investors would improve their lot if they were to use them. (Actually, looking at the 100%-owned Berkshire businesses may teach us a lot more than looking at the equity portion of the insurance unit's portfolio, which is what so many Buffett watchers obsess on.) But nobody should assume they are actually investing like Buffett, unless they own Berkshire stock.
    Feb 23 11:13 AMReply! Report abuse+18-1
  • I have been told that if you adjust for risk, his returns are no better than a chimpanzee.
    Feb 23 02:09 PMReply! Report abuse+1-4
  • apropos of buffet's preference for pricing power over good management,i think he meant it as either or choice ie that's what he woud do if he were forced??? to invest.but if he were left to his own devices he would NEVER take one without the other.
    Feb 23 02:14 PMReply! Report abuse0-1
  • "...looking at the 100%-owned Berkshire businesses may teach us a lot more than looking at the equity portion.."

    That is so true--he made most of his money from the businesses he owned outright.
    Feb 24 01:10 AMReply! Report abuse0-1
  • Marc
    That was an outstanding post.
    My personal opinion is that small investors like us have a huge advantage over Buffett right now. With the right temperament and sound financial foundation, many are beating Buffett right now. It is extremely unlikely that Buffett can find a 5 bagger that will have meaningful effect on his total return.
    Feb 24 04:06 PMReply! Report abuse+1-1
  • excellent comment; however i would like to emphasize this about the environment when warren made most of his money: "how lucky he was to be alive at time when the only skill he had, allocating capital, could be valuable"--it is much more challenging to achieve his returns in the past 20 years because frankly, the industry is crowded and manipulated. he did perform exceptionally through the 50s-80s, when it was less crowded and less manipulated. BRK.A and B have performed very poorly in the past 20 years returning 125%; shouldn't money double every 7 implying a 300% return? if i get 125% in the next 20 i will not be capable of retirement.
    Feb 25 11:47 AMReply! Report abuse0-1
  • 1991 BRK.A I see in the $7,000 - $8,000 price range. Today its $127,000. He doubled his money 4 times in that period. Thats a tad more then 125% growth and % wise I could only wish I had his very poor performance.
    Feb 25 12:03 PMReply! Report abuse0-1
  • Kwm. Thanks for your comment.
    I think Buffett did well earlier in his career because he had small amount of money to work with. His biggest enemy is size, not the current market conditions in my opinion. The only thing that has changed is the availability of instant information. But markets, at the end of the day, ultimately involve human emotions...fear...greed. Buying below intrinsic price will never be displaced as the cornerstone of investing ( not trading). With the availbility of instant financial information, the only change i see is increase volitility and wide price swings from intrinsic value. As a long term investor, this is actually good news because the price can drop very signficantly from intrinsic value....much more so than in the past.
    If Buffett just came out of graduate school with 100,000 dollars to work with, there is no doubt in my mind he can compound his money at 20%/year for the next 30 years.
    Just my opinion
    Feb 25 12:13 PMReply! Report abuse+1-1
  • Intriguing question.

    I think a lot of the It's-different-for-Buf... sentiment stems from undue attention to the superficial aspects of Buffett; the rules, etc. writers think he bequeaths to us. If we get past that stuff and look at the full range of what Buffett is about, being a world-class capital allocator, I think you'll see that such accomplishments would be do-able today, too, if the capital allocation talent is there.

    I don't know that it's harder to make money today than in the 50s-80s. Global growth, technological advance, etc. provide different themes (and contrary to those who get apoplectic about use of the words Buffett and technology in the same sentence, I think he'd be fine in figuring out how to play it if he were 20-30 years younger; we already see him edging a bit in this direction with his 100%-owned acquisitions, and we also seem him straying beyond the U.S. borders). He'd have to be different. I don't know if he'd be so excited by American Express or newspapers or Dairy Queen or Nebraska Furniture Mart as in the past. But there's always been more to him than that sort of thing.

    So if Berkshire Hathaway were to get off the ground today, it would undoubtedly look a lot different (including the name, which he got from the first business he actually bought). And instead of writing about how Buffett avoids tech, the Buffettology cottage industry would be likely writing about how he finds tech opportunities others ignore. Generally, everything I've seen of him suggests he's as good as anybody at working within whatever investment arena he finds himself. All he really needs is a world where successful capital allocators do better than unsuccessful capital allocators.

    The real challenge for him today is, in fact, size, and he openly says so.
    Feb 25 12:17 PMReply! Report abuse+1-1
  • From my Instablog

    With utmost respect, Buffett's ideas may not be valid to us, today's common retail investors. First, we do not make big bets like buying most of a company. Second, in many cases, his bets require him or his company to run the company. Third, he has connections and sweetheart deals that most of us do not have access to. Fourth, we can dump losers and sellers any time we want without public opinions. Fifth, most of his bets require him to pay extra to get in and get out.

    There are exceptions. If you follow him to buy Chinese Petro. (I did) and the Chinese auto company (I could not find any US exchange), you do good.

    Contrary to Mr. Buffett's philosophy, I believe after 2000 buy-and-hold is dead. I will buy the company whose technology I do not know - but try to find time to understand it. I believe some companies will die eventually like Washington Post he owns unless they move out from the paper product.

    I may beat his performance during 2000 to 2010 by a good margin, but I am a nobody and will remain so. I moved out most of my tech holdings in April, 2000. I had a 85% return for my largest trade account I owned in 2009. If Buffett only handled a portfolio of $5 millions or so, he would beat me year after year. No one including Peter Lynch can make a decent return with that size of his current portfolio.
    Feb 23 11:34 AMReply! Report abuse+5-2
  • I respectfully disagree with you TonyP4.
    During the dotcom bubble many people said the same thing of Buffet that his ideas and strategies are no longer valid. I think they are now and will continue to be so for quite some time.

    He wasnt always in a position to where he could buy companies outright. He had to start out where your average investor is. True we cannot get the same % growth and the overall billion $ deals but we dont need to really as retail investors.

    Buy-hold-ignore may be dead but not buy-hold-monitor.
    Feb 23 02:56 PMReply! Report abuse+2-2
  • Hi Rhianni32,

    It is more based on my personal experience, so it is one's opinion.

    * I moved all tech sector funds out (being employed by a mutual fund I could not trade stocks that easily) on the first week of April, 2000, Hence I did quite well than Buffett that year as I had a lot of profits on high tech funds. Most likely it is luck in acting according to what I read.

    * For non-retirement accounts I only trade the stocks once a year to take advantage of the lower long term capital gain tax rate. For retirement accounts, it is about an average of 4 months. The more I trade, the better improvement is my portfolio. It compares favorable to some accounts I did not trade that frequently. Again, it is based on my experience only.

    Any one has Buffett's performance for the last 3 years. I bet he does not beat the SPY. It is not his fault, as his portfolio is just too big.
    Feb 23 04:24 PMReply! Report abuse0-1
  • Buy and hold will work.....but it requires ALOT of homework.
    Feb 25 12:15 AMReply! Report abuse0-2
  • I agree, citing Buffett's supposed techniques to retail investors not only gives people a false perception of how he acquired his wealth, but also puts a formulaic approach on his investing standards.

    Buffett started his company buy buying unloved undervalued companies and squeezing out the last of its profits, as well as merger & abritrage. Buying private companies is much cheaper than buying public companies, so buying a private company at an 8 P/E ratio when your stock trades at a 15 P/E is a very easy way to grow the share price.
    Feb 23 06:23 PMReply! Report abuse+1-1
  • Excellent comments.

    He also moves in and out of the stock market but the moves out tend to garner less press.
    Feb 24 01:12 AMReply! Report abuse0-1
  • So do we just brush aside the fact that his "investments" were bailed out by the U.S. Taxpayers?

    I am sure he does have a deep love for GS, however would he have committed all those billions if he did not have some kind of knowledge GS would be getting access to TARP, discount window, AIG back door bailouts, etc?
    Feb 23 11:50 AMReply! Report abuse+2-2
  • "I am sure he does have a deep love for GS, however would he have committed all those billions if he did not have some kind of knowledge GS would be getting access to TARP, discount window, AIG back door bailouts, etc? "

    YES . . . that is the point of Warren Buffett.

    He didn't jump into GS because of economic moats, fundamentals, etc. that Buffett watchers go on and on about. I wouldn't go so far as to say he actually knew there would be a bailout (I have no clue what he knew or didn't know), but at the very least, I think we can assume he was prescient enough to recognize that something would be done. He saw an opportunity and pounced without regard to any sort of checklist of Buffettology-type rules laid out by Robert Hagstrom, etc.

    And as to the fact that through his efforts over the years, he raised himself to the level where he can get sweetheart deals, good for him. If I had enough skill to get myself up to that level, you can be darn sure I'd take advantage of whatever perks might be available. Too bad for me that I'm not that good. :-(
    Feb 23 12:54 PMReply! Report abuse+5-2
  • He knew that GS was in a business that wasn't going away any time soon. So the highly insulated convertible preferred stock he bought was a no brainer.

    GS just wanted his stamp of approval for the world to see, so they overpaid for liquidity from Buffett versus acquiring it cheaper from other sources.
    Feb 23 06:29 PMReply! Report abuse+2-1
  • "Everyone can call Buffett a “value investor” till they’re blue in the face, but he is a fundamental analysis investor at the end of the day" i dont pretend to be a brilliant investor but isnt fundamental analysis the basis of value investing?how can anyone evaluate value in a company without knowing its fundamentals?unless i'm missing something in the definition of either value investing or fundamental analysis.
    Feb 23 02:08 PMReply! Report abuse+3-1
  • You are correct. The reason an investor examines fundamentals is to find value.
    Feb 25 08:52 AMReply! Report abuse+1-1
  • Tech stocks can give you tons of money if timed properly, they have the easiest life cycle of all industries, you just don't have to fall in love with the stock.

    I've heard a lot about buffet what i believe that makes him great is that he doesn't follow other people he makes his path and takes de risk / profit of it.

    Regards
    Feb 23 05:18 PMReply! Report abuse0-2
  • "Tech stocks can give you tons of money if timed properly"

    Any stock can be profitable if timed properly
    Feb 23 06:30 PMReply! Report abuse+2-1
  • luck, prudence and skepticism
    Feb 23 09:51 PMReply! Report abuse0-2
  • Excellent article, thanks!
    Feb 23 10:31 PMReply! Report abuse+10
  • The trouble with Buffett's style is that it fits few people other than rich ones. And, few are willing to wait 40 or more years for full investment fruition, as by that time they are old and nothing in old age is seen or felt the same as when young. Trust me. 40 years looks like nothing when you are 20, but when you are 60 you wonder.... "why did I do that? I am old now and all my interests and tastes have changed to the point where nothing I thought then makes any sense now."

    You'll see. The biggest change in anyone's life is.....aging. Nothing else even comes close. If you can, live your life big when you are young and don't deny yourself by skrimping along until retirement, as nothing felt then is even close to the same as when young. Even Buffett would agree with that.
    Feb 24 12:31 PMReply! Report abuse+4-3
  • Better yet don't center your life around material things at any age, then you'll have enduring happiness.
    Feb 24 11:27 PMReply! Report abuse+10
  • You know what? We are living in a material world, and I am a material girl.
    Feb 24 11:30 PMReply! Report abuse0-2
  • i learn from buffet...its old school wise investment advise..simple principles but not easy...the take away point from him is there is no get rich quick scheme. i am a businessman and it take a business a good 10 years to find its footing in the market..

    its good to always fall back and read buffet because all the brokers are always trying to sell the new get rich stocks and investment schemes..
    do your homework read up on smart people and you will see a lot of similarities and few differences that can be attributed to their personal style or personalities..
    Feb 25 12:41 AMReply! Report abuse+2-1
  • * If you read the books/articles praising buy-and-hold, you would find they all based on data before 2000.

    * I agree money is just a vehicle to buy us more material but not happiness. I'm a kind of sad that my tax bill is more than all my social security, pension... due to huge capital gain tax. Losing money could make me more sad. Either way, money makes me sad (and sick).

    * Making money in a business and in trading stocks have different discipline and strategy and you should not mix the two.
    Feb 25 09:29 AMReply! Report abuse00
  • "Making money in a business and in trading stocks have different discipline and strategy and you should not mix the two. "

    That's a very important concept that often gets short shrift from gurus. Running a business involves having full information, not just that which conforms to Wall Street disclosure protocols, and more important, control. Trading stocks (even investing for the so-called long term) is a very different thing with, as TonyP4 says, a different discipline and also different ways to measure success.

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