How to Invest Like Warren Buffett

Ask any small investor who his idol is, and the odds are they'll say Warren Buffett.

But can he invest like Warren Buffett?  Sure; or least he can try to invest like Buffett. But to be successful, you have to learn to think like Buffett, and that may take a little time.

To think and invest like Buffett requires four attributes:

  • An appreciation of time as an important creator of great value.
  • The willingness to research and develop investment opportunities that may not be glamorous but are solidly profitable.
  • The willingness and courage to ignore the short-term vagaries of the stock market.
  • The discipline to invest in what you know and stay away from the risks of ignorance.

That's the essence of Buffett -- who, with his partner Charlie Munger, has built Berkshire Hathaway BRK into the world's fifth most valuable company. Its market capitalization as of Friday was around $280 billion, behind only Apple, at $503.9 billion; Exxon Mobil, $417.9 billion; Google, with $357.4 billion; and Microsoft, at $320.2 billion.

Buffett's achievement has resulted in a conglomerate with 288,500 employees. That's bigger than Lowe's but smaller than Home Depot.

Berkshire's holdings include the BNSF Railway, See's Chocolates, Geico Insurance, General Re and Munich Re, the Buffalo News and Omaha World-Herald newspapers, wholesale distributor McLane Co., MidAmerican Energy, paint-maker Benjamin Moore, Ben Bridge Jeweler, the Nebraska  Furniture Mart, Fruit of the Loom and The Pampered Chef.

(If you're curious about what Berkshire Hathaway owns, check this list.)

Berkshire also has a massive securities portfolio that includes holdings in Goldman Sachs, Visa, Exxon Mobil, Costco Wholesale, US Bancorp and Wells Fargo.

There's nothing fancy about these companies. No flashy tech firms. That's suited Buffett, Munger and Berkshire investors just fine. The companies they own and the companies they invest in have strong managers. They generate enough profits and cash flow to give Berkshire the opportunity to look constantly for new acquisitions, and the stock continues to grow.

Since the end of 1990, the Class A shares are up 2,509 percent, or roughly 15 percent a year.

Buffett measures the company's success by the growth in per-share book value of the company.

By that measure, Berkshire had grown 586,817 percent between the end of 1964, when he took control of Berkshire Hathaway, then a struggling textile company, and the end of 2012. That works out to 19.7 percent a year.

That compares with 9.4 percent a year in total return (including dividends) for the Standard & Poor's 500 Index.

Only twice has Berkshire's book value declined: in 2001, when it declined 6.2 percent, and in  2008, when it declined 9.6 percent. The S&P 500 has suffered 10 years of negative total returns in the same time period.

The philosophy Buffett uses to buy companies or invest in them is built around six questions:

  • Has the company consistently performed well? Buffett will want to look a five-to-10 years of performance, paying attention to return on assets, return on equity, return on capital and the like.
  • Has the company avoided excess debt? Buffett wants debt to be low compared with equity.
  • How strong are profit margins? Buffett would look at the net margin (net income divided by net sales) for five-to-10 year years. Rising profit margins are very important.
  • How long has the company been public? Again, Buffett looks for companies that have been public for 10 years or so. He also will buy privately-held companies, but they have decent records.
  • Is a company's fortunes tied closely to the price of a specific commodity? Buffett doesn't like companies whose fortunes can be crushed by commodity prices -- so you don't see mining companies in his portfolio.
  • Is the stock selling at a 25 percent discount to its real value?

The last point is critical, Investopedia notes. Buffett wants to know a company's intrinsic value, which includes liquidation value plus the value of intangible assets, such as the value of a company's brand and the quality of the management. This is probably the hardest measure to come up with, and many Buffett watchers write that they don't know the methodology he uses. Buffett himself is always a bit vague, but however Berkshire comes up with a value, it works.

(Here's one way of determining intrinsic value. And here's a more detailed method.)

Buffett's investment philosophy is value-oriented.

He studied with Benjamin Graham, the Columbia University finance professor who developed the value theory of investing in the 1930s. Graham's thinking was meant to find a way to come up with real values for securities after the mayhem of the Depression. Buffett even worked for Graham in the 1950s.

Buffett professes to not spending a lot of time thinking about a company's stock price. The key is that he sees an investment as an investment in the entire business.  There are times when he thinks stock prices are too high.

And he was clear in the aftermath of the 2008.

Related: Warren Buffett: U.S. Is Better With Detroit Than Without

The big problem he has these days is finding investments large enough to benefit Berkshire investors. He owns 39 percent of the Class A shares (the ones that trade at around $174,000) and 0.3 pecent of the Class B shares.
In 2009, Berkshire bought the BNSF Railway for $26 billion. Buffett admitted, in his 2013 letter to shareholders, that he and Munger failed to make a big deal in 2012 -- but, early this year, they did take a 50 percent position in a holding company that bought H.J. Heinz, the big food company.
Buffett has a big advantage over small investors. His big insurance operations generate lots of float. It includes the cash that auto, life and health policy holders have paid in but have yet to make a claim on. That's provided lots of cheap financing to do deals. Berkshire's float was about $77 billion at the end of the third quarter.

The insurance holdings -- both wholly owned and simple investments -- offer a clue about how Buffett thinks.

He likes insurance, banks, finance companies, credit-card companies. And that's where he often spends a lot of time.

Insurance operations generated 23 percent of revenue in the third quarter. Financial companies generated an additional 3.2 percent. In addition, Berkshire's domestic stock portfolio is 40 percent financial stocks, with Wells Fargo the largest holding, followed by American Express.

During the worst of the financial crisis in 2008, he invested $5 billion in Goldman Sachs. His $5 billion investment included $5 billion in preferred shares paying a 10 percent dividend, plus warrants to buy 43.5 million Goldman Sachs shares at $115 a share.

Ultimately, Goldman bought the preferred stock back. It then agreed to simply give Berkshire Hathaway shares for his warrants. All told, by Stephen Gandel's calculations in Fortune, Buffett walked away with a 64 percent gain.

So if you're going to invest like Warren Buffett, it means you're going to be extremely patient.

You might very well ignore today's big momentum stocks, like Tesla, Netflix and maybe the Apple.

You're going to look for companies with long, long histories of consistent profits and modest debt levels. You're going to look for companies you can live with for a long time. And you're not going to pay a premium.

With Warren Buffett, cheap is a good thing.

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