Buffettology: Value Investing Strategy

Buffettology: Warren Buffett Quotes & Value Investment Strategy for Stock Picks

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While it may be tempting to throw yourself into the dramatic highs and lows of investing in the stock market in search of instant gratification, it’s not necessarily the most profitable choice. Warren Buffet has spent his career watching investors pounce on “hot” companies, only to flounder when the market takes a plunge. All the while, he’s been steadily accumulating wealth by taking an entirely different approach.

You may be thinking, “OK, the guy’s successful, why should I care?” Well, in 2008, Warren Buffett was the richest man in the world with an estimated worth of over 62 billion dollars. This kind of wealth is not a result of sheer luck. He’s gained his enormous fortune using a very specific investment strategy, developed on a basis of long term investing. The great news is that, by learning a little about the way Warren Buffett thinks, you too can enjoy greater success in the stock market.

So what exactly is Warren Buffett’s investment strategy and how can you emulate him? Read on and find out.

Secrets to Investing Success

Since Warren Buffett has never personally penned an investment book for the masses, how does one go about learning his secrets? Luckily, many of his letters to shareholders, books that compile such letters, and insights from those close to him are readily available to the public.

There’s a lot to be gained from his quotes alone. Here are a few sayings that have been attributed to him.

Warren Buffett Quotes on Investing

• “Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.”
• “Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”
• “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
• “Investors making purchases in an overheated market need to recognize that it may often take an extended period for the value of even an outstanding company to catch up with the price they paid.”
• “If a business does well, the stock eventually follows.”
• “Price is what you pay. Value is what you get.”
• “Time is the friend of the wonderful company, the enemy of the mediocre.”

Clearly, Warren Buffet is a value investor. He looks for great companies, or “wonderful” ones as he puts it. He is not looking at hot sectors or stocks that may shoot up now, only to cool and fall later. He wants an efficient running business that has favorable long-term prospects.

Additionally, although he wants great stocks, he does not want to pay a premium price. Warren uses a specific calculation to arrive at a fair valuation, then waits until a market correction or crash puts those prices on his doorstep.

Now that you know a little about his basic investing philosophy, let’s take a more in-depth look at how he makes investment choices.

Buffettology and Stock Selection

The book, Buffettology, is a fantastic resource, primarily written by Warren Buffett’s former daughter-in-law, Mary Buffett. The co-author, David Clark, is a long-time friend of the Buffett family. Since these authors probably have some special insight into how Warren Buffet privately analyzes stocks, it’s worth hearing what they have to say. Here are a few of the major points they focus on:

Best Stock Industries

The authors of Buffettology recommend looking for promising companies in 3 broad categories:

1. Consumables
Buffett’s choice businesses include those that make products which are consumed or quickly wear out such as:

• Snacks
• Pop
• Gum
• Toothpaste
• Pens
• Razor blades

Why? Because higher product turnover implies more revenue for the company. If you can also find a leading name brand that people gravitate towards, you have a good starting point.

2. Communications
Another major category of companies that Warren likes is communications. Advertising agencies are a major part of this group as they expand into new platforms like cell phones and tablet computers, in addition to the old standbys of TV, radio, and newspapers.

This is an area where you will need to be careful because what is new today can be discarded as waste tomorrow. Be aware that advertising may go down with the economy as businesses prune costs during tough times. Also, as people turn from print to web, some forms of advertising will increase at the expense of others.

3. Boring Services
The last category is for repetitive and boring services. A few examples of these highly profitable companies doing the same job over and over might be:

• Lawn care companies
• Janitorial services
• Basic tax filing services

“Boring” itself is not enough to warrant an investment. However, if something is both boring and essential, there’s a good chance it’s a stable, efficient, easy-to-operate business that will have a long-lasting life.

What Characteristics in a Company to Look For

Once you know where to look, it’s important to know who you should turn your attention to. The book cites the following factors for determining which companies to watch closely.

1. Existence and Value
Warren Buffett analyzes considerable historical financial data on a stock. In general, this would exclude new companies where only a few years of financial data exist. He picks stocks based on their intrinsic value and the ability of the company to continually increase that value, often wanting a minimum of 15% annually over many years. This kind of regular increase can be considered a High Annual Rate of Return.

2. Market EdgeThis includes companies that have a monopoly, where no other alternative exists. Think of a toll-bridge as one example. Other market edges could include companies that sell a unique product. Buffett is not as keen on commodity-based companies where the price is set by the market, competition is stiff, and the company has no ability to freely adjust for inflation.

3. Finances
Warren looks for these financial traits in companies:

• Increasing Earnings. It is especially important that a large amount of this money is being retained and used for further growth. Sitting on a big pile of cash, or giving earnings back as dividends, is not viewed as desirable since extra tax may need to be paid on dividends, and the burden of re-investing is placed on the shareholder.
• Reasonable Financing. The financing for the company should be reasonable, without a high debt-load.
• Simple Business Model. The company model should be simple with few moving parts, and not a lot of money needed to maintain the business model. It should be a lean, mean, and profitable operation.

But when you find such a wonderful company, how will you know if it is a good buy? For that we need to learn how to value a stock the Buffett way.

Valuing a Company Buffett-style

Buffettology also outlines a few different methods to determine the value of a stock and whether or not it is a good buy. Two of the most popular methods revolve around “Earnings Yield” and “Future Price Based on Past Growth.”

1. Earnings Yield

The concept behind this is elementary and rooted firmly in the price-to-earnings ratio, or more correctly, the opposite, which is called the earnings yield. When you divide the annual earnings by the current share price, you find your rate of return. Therefore, the lower the stock price is in relation to its earnings, the higher the earnings yield. Here are three examples for comparison:

• Aeropostale Inc. (NYSE: ARO) has a share price of around $25 and an annual earnings of $2.59. If you divide $2.59 by $25 you get the earnings yield of 10.36%.
• Hansen Natural Corporation (NASDAQ:HANS) has a share price of $56 and an annual earnings per share of $2.39 and only 4.2% of the share price is annual earnings.
• McDonald’s is trading at a $75 with annual earnings of  $4.62 per share, which gives us an earnings yield 6.2%.

Warren would use this formula to compare similar stocks with steady earnings to see which would provide a higher earnings yield based on share price. Based on these examples, Aeropostale has the most attractive earnings yield.

Keep in mind, this is only to be used as a very quick and crude method of comparing similar stocks, or to compare yields to bond rates. As you will see in the next two valuation methods, the earnings yield is far from accurate in giving us a long-term growth rate.

2. Future Price Based on Past Growth

For this, Buffett would analyze the long-term growth trend to determine how it might perform over the next 10 years. Depending on the company and the industry, it may make sense to use any of a variety of metrics, including both the PE ratio and the Enterprise Value/Revenue multiple.

Let’s use the PE ratio to illustrate how this strategy works. To guess what growth might be like over the next 10 years, you first need to determine what the average earnings growth rate has been on the stock over the past 5 to 10 years.

I will use McDonald’s as an example. They are a big name brand, they aggressively opened up in new markets, and McDonald’s provides a consumable product that has a loyal following. Let’s say the EPS growth over the past 5 years averages 17.6%. Using an EPS of$4.62 EPS in year 0, and a growth rate of 17.6% per year, will yield the following 10-year forecast:

• Year 0, EPS: 4.62
• Year 1, EPS: 5.43
• Year 2, EPS: 6.39
• Year 3, EPS: 7.51
• Year 4, EPS: 8.84
• Year 5, EPS: 10.39
• Year 6, EPS: 12.22
• Year 7, EPS: 14.37
• Year 8, EPS: 16.90
• Year 9, EPS: 19.88
• Year 10, EPS: 23.37

Now you have an estimated total earnings per share by the end of year 10. Today, the EPS is $4.62 and in a decade that should appreciate to $23.37.

Now, you must determine what this means for the share price. To do this, you simply look to a long-term average of P/E, or the price-to-earnings ratio. The 5 year P/E average in this example is 17.7. Multiply this by the future expected earnings rate of $23.37, and you get an estimated price of $413.65.

If the price right now is $75, what is the rate of return over the next 10 years?

You can simply use an online rate-of-return calculator to calculate annual profits of 18.62%. Remember, this is a basic estimate that doesn’t include dividends, which can boost your yield by 3% every year, or almost 22% when using capital gains and dividend yield together. Moreover, it is based on the assumption that the PE ratio will remain constant, which is unlikely, but still serves as a good example

For those of you who find all of this a little overwhelming, that doesn’t mean that Buffett-style investing isn’t for you. There is a simpler option.

Berkshire Hathaway

If you want to utilize his strategies without actually having to learn them, you can buy shares in Warren Buffett’s company. He is the Chairman and CEO of the publicly owned investment managing company, Berkshire Hathaway. Take advantage of his success by choosing from the following:

• Class A Shares with a current sticker price of $127,630 each.
• Class B Shares which currently sell for $85.04 each.

As you can probably tell from the price discrepancy, it takes 1,500 Class B shares to have equivalent ownership of one Class A share. They are similar except that Class A shares have proportionally more voting rights per dollar of worth.

How have the shares of Berkshire Hathaway performed over the past 46 years? The cumulative gain is 490,409% which works out to an average of 20.2% per year. This is an average annual 10.8% excess of the market as tracked by the S&P 500 index (including dividends). If in 1965, you invested a whopping $1,900 with Warren Buffett, this would be worth $9,545,300 by the end of 2010.

Effects Of Success

With those numbers, you may be wondering why anyone would choose to attempt Warren’s strategy on their own. Unfortunately, this kind of incredible growth is becoming harder for Berkshire Hathaway to attain. When a company has hundreds of billions of dollars in revenue, achieving significant growth is far more difficult.

Buying up smaller companies did not impact Warren Buffett’s Berkshire’s financials as much as when his company was smaller. He has become an elephant stomping around the market in search of increasingly elusive good buys.

Final Word

The simplest way to invest Warren Buffet style is to buy shares of Berkshire Hathaway and forget about them for the next 10 or 20 years. But, as his company has reached astronomical heights, this strategy has become less and less valuable.

Thus, many people who love the “Warren Buffett investing style” choose to invest on their own. If you are excited by due diligence, scanning thousands of stocks for that highly profitable (and oftentimes mundane) business, forecasting company earnings, and monitoring the company’s progress, then the “Warren Buffett investment method” may be a perfect fit for you. Remember, perhaps above all else, to have guts of steel when the market drops so that you can buy undervalued and profitable stocks.

What are your thoughts on Warren Buffett and his investing style? Do you try to replicate his strategies and success? Share your experiences in the comments below.

http://www.moneycrashers.com/buffettology-warren-buffet-quotes-investment-strategy-stock-picks/

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Here is a detailed and comprehensive summary of the key principles and strategies of Buffettology, the value investing philosophy of Warren Buffett.

Core Investment Philosophy

Warren Buffett's strategy is the antithesis of short-term, speculative trading. It is a disciplined, long-term value investing approach focused on buying outstanding businesses at fair prices and holding them indefinitely. Success comes from patience, fundamental analysis, and emotional fortitude to buy when others are fearful.

Key Buffett Quotes & Principles

The article emphasizes several foundational quotes that distill his mindset:

• Contrarian Mindset: "The time to get interested is when no one else is."

• Long-Term Ownership: Buy companies you'd be happy to hold if the market closed for a decade.

• Quality over Cheapness: "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

• Business Drives Stock Price: "If a business does well, the stock eventually follows."

• The Role of Time: "Time is the friend of the wonderful company, the enemy of the mediocre."

Buffettology Stock Selection Criteria

As detailed in the book Buffettology, the strategy involves a two-step process: identifying promising industries and then selecting the best companies within them.

1. Preferred Industries (The "Where to Look"):

• Consumables: Companies with high product turnover (e.g., snacks, razors, toothpaste). Strong brand loyalty is a plus.

• Communications: Particularly advertising agencies, especially those adapting to new media. Caution is advised due to economic sensitivity and technological disruption.

• Boring Services: Essential, repetitive services (e.g., lawn care, janitorial) that represent stable, easy-to-operate business models.

2. Company Characteristics (The "Who to Buy"):

• Proven Track Record & Value: Requires extensive historical financial data (usually 5-10 years). Seeks a consistent, high annual rate of return on equity.

• Sustainable Competitive Advantage ("Moat"): Looks for monopolies, unique products, or powerful brands. Avoids commodity businesses where competition is based solely on price.

• Strong Financials:

  • Consistently Increasing Earnings, with profits retained for reinvestment and growth (high retained earnings).

  • Low Debt Load (reasonable financing).

  • Simple, Efficient Business Model that doesn't require constant heavy capital investment to maintain operations.

Valuation Methods

The article outlines two primary methods for determining if a wonderful company is trading at a "fair price."

1. Earnings Yield (Quick Comparison):

• This is the inverse of the P/E ratio: Earnings per Share / Current Share Price.

• It shows the rate of return based on current earnings. A higher yield is better. Used to quickly compare similar companies or against bond yields.

2. Future Price Based on Past Growth (10-Year Forecast):

• This is a more detailed, long-term intrinsic value calculation:

  • Step 1: Determine the company's average annual EPS growth rate over the past 5-10 years.

  • Step 2: Project that growth rate forward 10 years to calculate future EPS.

  • Step 3: Multiply the future EPS by the company's long-term average Price-to-Earnings (P/E) ratio.

  • Step 4: This gives an estimated future stock price. Compare it to the current price to calculate the potential annualized rate of return.

• Note: This method assumes past growth and P/E ratios will persist, which is a simplification. It also ignores dividends, which would enhance total return.

The Simpler Alternative: Invest Alongside Buffett

For those who don't wish to perform individual stock analysis, the article suggests buying shares in Buffett's conglomerate, Berkshire Hathaway (BRK.A or BRK.B). Historically, it has vastly outperformed the S&P 500. However, the article notes a significant caveat: due to its enormous size, replicating its historical growth rates is now much more difficult ("the elephant problem").

Final Conclusions & Requirements for Success

• Direct Replication: Successfully employing Buffett's strategy requires significant due diligence, patience, analytical work (forecasting, monitoring), and emotional discipline to buy during market downturns.

• Proxy Strategy: Investing in Berkshire Hathaway offers a simpler, though potentially less explosive, path to mirror his approach.

• Ultimate Takeaway: Buffett's success is not accidental but the result of a rigorous, business-owner-oriented philosophy that prioritizes long-term intrinsic value over short-term market sentiment.

In essence, Buffettology is a systematic approach to investing that combines the search for high-quality, understandable businesses with durable advantages, a strict valuation discipline to ensure a margin of safety, and the patience to let compounding work over decades.

Interesting to Note that this is a development that hurts Berkshire Hathaway during 2011

-  Three large and very attractive fixed-income investments were called away from us by their issuers in 2011. Swiss Re, Goldman Sachs and General Electric paid us an aggregate of $12.8 billion to redeem securities that were producing about $1.2 billion of pre-tax earnings for Berkshire. That’s a lot of income to replace, though our Lubrizol purchase did offset most of it.

http://www.berkshirehathaway.com/letters/2011ltr.pdf


Comment:  Buffett emphasizes increasing the aggregate pre-tax earnings and incomes.  He reinvests into or replaces companies, to achieve growth in aggregate pre-tax earnings and incomes.   This is very sound strategy to follow.

WARREN BUFFETT'S INVESTMENT PRINCIPLES

Warren Buffett does not readily disclose the investments he makes on behalf of himself or Berkshire Hathaway. He does, every year, report on the substantial holdings of his company in other corporations. These provide only tiny clues however to why, when and where he invests.


He is prepared, however, and does so regularly, to outline general principles of sound investment. These have a consistent theme and can be summed up like this.


Stock investments should be looked at in the same way as buying a business. The stock investor is really buying a tiny share or partnership and should apply the same principles that they would in buying a business – the Benjamin Graham approach:


1. The company should be soundly managed. Tests of good management include:

• Share buybacks
• Good use of retained earnings
• Sticking to what you know

2. The company has demonstrated earning capacity with a likelihood that this will continue. Tests of earning capacity include:

• Company growth
• Dealing with inflation
• Capital expenditure
• Look through earnings
• Brand names

3. The company should have consistently high returns. Warren Buffett would look at both:

• Returns on equity
• Returns on capital

4. The company should have a prudent approach to debt.

5. The businesses of the company should be simple and the investor should have an understanding of the company.  See case studies

6. Assuming that all these thresholds are satisfied, the investment should only be made at areasonable price, with a margin of safety. This is always a matter for independent judgment by the investor but it is relevant to consider:

• Price/earnings ratios
• Earnings and Dividend yields
• Book value
• Comparative rates of return

7. Investors need to take a long term approach.

http://www.buffettsecrets.com/buffett-investment-principles.htm

Ignore shares and get poorer.

Diary of a private investor: ignore shares and get poorer
Our private investor is back - and he says that savers who are prepared to take some risk will prosper.

Despite the Gulf of Mexico oil spill last year, BP shares are doing well Photo: PA

By James Batholomew

10:51AM BST 06 Jun 2011

After the glorious year of 2010 - for the stock market anyway - this year has, so far, been a damp squib. First it was up, then it relapsed, then it rose once more before retreating again. As I write, it is within 2pc of where it started.

As Lady Bracknell said in The Importance of Being Earnest, "this shilly-shallying is absurd". Which is it to be? Will shares finally rise or fall?

On the bearish side, I'm told, by people who ought to know, that Greece is bust, whatever the politicians say. Another well-placed individual has the same opinion about Ireland.

If either is right, shares could fall heavily on the day the default is announced. Some people say "it is already in the price", but I doubt it.

On the other hand, shares still look good value. I own some in BP which, at 458p, stands at a mere 6.8 times forecast earnings for 2011.

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Its adventures in Russia do worry me a bit and, of course, the shadow of the disaster in the Gulf of Mexico still hangs over it. But rarely in its history have the shares been treated with such disdain.

Professional and lifelong investors are now generally back in the stock market. But many private individuals are still holding back.

Over the past few years, I've talked to quite a few people about their investments and found they can be divided into four sorts.

The first thinks shares are too risky. They remain almost entirely in cash. In some cases they have good reason. Some have a limited amount of money and a very specific thing - such as school fees - which they want to be sure they can pay.

Others argue that shares are unpredictable and they don't know anything about them. Better to keep the money safe in the bank. These people have their reasons. But over the long term, I've seen so many of this sort, who were once well off, become very gradually much less so. I knew the daughter of a Seventies multi-millionaire who inherited her fair share. She kept the money in a building society and is now, frankly, just getting by. It's frustrating. She could have stayed rich.

The second group consists of those who have made quite a bit of money but have not had much time or interest in managing it. They were then persuaded by persistent, charming salesmen to invest in certain funds. For these salesmen, nothing was too much trouble. They visited them in their homes. They brought wonderful, sophisticated brochures and "personalised" recommendations.

The untold story which the salesmen never quite got around to explaining in detail was the full extent of the commissions and expenses involved. The people in this group have generally had a pretty thin time of it over the past dozen years.

The FTSE 100 is still rather lower than it was in January 2000, and all those commissions have eaten a substantial hole in the dividend income.

The third sort are thrill-seekers. To be honest, I know only one person in this group. There was a time when he got very excited about shares and was dealing on an hourly basis, following recommendations from a broker. After initial success, he lost a bundle and decided to give it all up.

Long-term, persistent portfolio investors are the fourth group. They have built up experience and understanding. They tend to have done best.

But where does that leave the sort of person who has other things to do and does not want to spend time building up experience in shares?

My flippant answer would be "poorer". You make your choices and live with the consequences. Trying to be more helpful, let me suggest this: how about putting, say, 15pc of free cash in a selection of lowest-possible-cost tracker funds? And then increasing the amount each year up to a level with which you are comfortable?

This way, you will not give away a fortune in commission. You will keep most of the dividends. You will not have to worry about selecting individual shares. And you are likely - though not guaranteed - to be richer in 10 years than otherwise. You could go for a mixture of, say, half of the invested amount in a FTSE 250 shares fund, a fifth in a Far East fund, another fifth in a US fund and a 10th in an emerging markets fund.

http://www.telegraph.co.uk/finance/personalfinance/investing/shares/8558975/Diary-of-a-private-investor-ignore-shares-and-get-poorer.html