Rule No. 1: It's OK to Lose Money

Rule No. 1: It's OK to Lose Money
By Rich Greifner
March 5, 2009 Comments (2)

For such a brilliant investor, Warren Buffett sure lives by a stupid set of rules.

I'm referring, of course, to Buffett's famous first (and second) rule of investing: Never Lose Money. That's certainly an admirable goal, and it's one that we analysts at The Motley Fool strive for -- to be right about every stock, every time. However, there's a small problem with Buffett's rule. It's impossible.

Mission impossible

It seems like everything the man touches turns to gold, but even Buffett has been wrong on occasion. His investment in Pier One didn't pan out, nor did his purchases of H.H. Brown Shoe Co. or Dexter Shoes (perhaps Rule No. 3 should be "Never Invest in Shoe Companies").
His recent purchases haven't all been moneymakers, either. In his latest letter to Berkshire Hathaway shareholders, Buffett lamented that purchasing ConocoPhillips too soon had cost Berkshire "several billion dollars," and he referred to his investments in two Irish banks as "unforced errors."

Given his stated M.O., how could Buffett be so cavalier about these losses? It's simple. For starters, the man has more money than God. And secondly, his famous advice may not mean what you think it does.

Do as he does, not as he says

When Buffett says "never lose money," he doesn't actually mean that investors should never lose money. Instead, he means that investors should strive to limit their downside risk by purchasing shares in businesses with significant competitive advantages when those businesses trade at a large discount to their intrinsic value.

If you concentrate on buying such companies, it's less likely you will lose money on each of your investments and highly unlikely that you will lose money over the long run. That's the real meaning of Buffett's famous rule -- and it's the secret to his sustained success.

Rule No. 3: Buy great businesses at good prices

A great business is often easy to spot. In fact, Buffett has even given us a handy framework. In Berkshire's just-released 2008 annual report, Buffett outlined six key traits that he looks for in any acquisition candidate:

• At least $75 million in pre-tax earnings.
  
• Demonstrated consistent earnings power.
  
• Good return on equity with little or no debt.
  
• Strong, committed management.
  
• A simple business model.
  
• A fair price.
  

Scores of companies meet these criteria. As you'll see in the table below, I've identified six popular companies that appear to fit Buffett's bill. The trick, however, is buying these businesses at a significant margin of safety.

To calculate a company's intrinsic value, Buffett usually forecasts future cash flows, and discounts those amounts to a present value as one would when pricing a bond. For the purposes of this article, I'll substitute the price-to-earnings ratio, which is admittedly a crude approximation of a company's value:

Company
5-Year Average P/E Ratio
Current P/E Ratio

AutoZone (NYSE: AZO)
13.9
13.9
Boeing (NYSE: BA)
28.6
8.6
Colgate-Palmolive (NYSE: CL)
23.6
16.1
Honeywell (NYSE: HON)
19.4
9.4
Microsoft (Nasdaq: MSFT)
24.2
10.0
Yum! Brands (NYSE: YUM)
23.1
15.5

Data from Capital IQ, a division of Standard & Poor's.

Would Buffett buy these stocks?

Doubtful. Although he is chummy with Bill Gates, Buffett's deep aversion to technology will likely keep Microsoft out of Berkshire's portfolio. Boeing is too cyclical, AutoZone too pricey, Yum! Brands' interest coverage too low, and Honeywell he's already bought -- and sold. And while Colgate-Palmolive looks attractive at today's prices, Buffett already owns a large stake in competitor Procter & Gamble (NYSE: PG).
And that brings us to rule No. 4:

Rule No. 4: Pick your stocks wisely

Buffett doesn't purchase stocks because he saw them mentioned on CNBC or he received a hot tip from a friend in the know. He takes his time, studies the company and its industry, and buys only when he is confident that he understands the company and it meets his aforementioned criteria. His famous thought experiment below nicely sums up his feelings about stock selection:

If you thought of yourself as having a card with only twenty punches in a lifetime, and every financial decision used up one punch, you'd resist the temptation to dabble. You'd make more good decisions and you'd make more big decisions. ... You'd get very rich.

Buffett's point is not that investors should limit themselves to a predetermined number of trades. Rather, you should carefully study a company and make sure you fully understand it before you buy shares. With greater understanding comes greater confidence -- and greater returns as well.

At Motley Fool Inside Value, advisors Philip Durell and Ron Gross don't recommend stocks based on short-term trends or market movements. Like Buffett, they study superior businesses -- and they wait patiently for these businesses to fall to attractive price levels.

Rich Greifner wishes he had held a few of his punches last year. He does not own any of the stocks mentioned in this article. The Motley Fool owns shares of Berkshire Hathaway and Procter & Gamble. Berkshire is an Inside Value and Stock Advisor recommendation. Microsoft is an Inside Value selection. The Fool has a disclosure policy.
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