May 30: The Warren Buffet Investing Strategy

by David Jenyns on May 30, 2007

Even those who are not very familiar with the world of the stock market have probably heard of Warren Buffet. He has been called the most successful investor of all time. He netted over $42 billion personally with an investment partnership he started with only $100.

While he has been sometimes categorized as a “value stock investor” his method was actual a bit different. He focused on the quality of stock as well as the value. Robert Hagstrom, a senior vice president with Legg Mason Capital Management, presented Buffet’s method in the book “The Warren Buffet Method” over 10 years ago. Hagstrom wrote the book because he believed that the average investor could learn from Buffet’s method.

Buffet’s incredible story begins with a small investment partnership established in 1956. In the mid-1960s, this partnership acquired a failing textile company. Buffet was able to bring this company’s net worth from $22 million to $69 billion.

The Buffet method is broken down into 12 tenants that form the basis for evaluating any investment, from stocks to entire companies. One of the key points in the method is that it is necessary to do some hard work (like research and projections) in order to know the investments thoroughly before any money exchanges hands.

The twelve tenets are really questions to ask yourself before making an investment. According to Buffet via Hagstrom, the first consideration is “Is this business simple and understandable?” Buffet did not invest in any technology stocks for the simple reason that he did not understand them. If you understand the business you are investing in (or outright purchasing) you will be in position to see the problems and possibilities as they arise. Secondly, ask yourself “Does the company have a consistent operating history?” Viewing the viability of the business in its previous operation can forecast future trends.

The third tenant is “Does the business have favorable long-term prospects?” This question is a gentle reminder that wise investors hold stock in good companies for the long term. Looking to the future of the companies reveals the true value of the investment.

Next, “Is the management rational?” Buffet places a great deal of importance on evaluating the management of the company. He pays attention to how the excess profits of a company are used. Additionally, he asks “Is the management candid with shareholders?” He believes that many company executives hide behind the company and do not fully disclose information to their shareholders. A manager who readily admits any mistakes made is more honorable and trustworthy. Following the theme of management related questions is “Does the management resist the institutional imperative?” Essentially this question evaluates the manager’s ability to act with character rather than cave-in to the peer pressure to do what other managers are doing.

The next question for evaluation is “What is the return on equity?” Buffet focuses on return on equity rather than the more popular ratios. This is because he feels earnings figures can be manipulated. The long term return on equity will have a more powerful effect than simple earnings.

The 8th tenant is “What are the company’s owner earnings?” His calculations of owner’s earnings include estimates of future capital expenditures. The 9th tenant is “What are the profit margins?” If a company makes sales but does not profit, then the company is a failure. Buffet avoids companies with large expenses because in his eyes it reflects a lack of discipline in the management of the company.

The 10th tenant is “Has the company created at least one dollar of market value for every dollar retained?” This is a test of correct capital allocation. If the company is holding onto cash but is not helping its shareholders than something is wrong with the management strategy.

The final two questions are “What is the value of the company?” and “Can it be purchased at a significant discount to its value?” Buffet calculates the value of a company as the total of the net cash flow expected to occur in the life of the business. By buying at discount, an investor will assure that any discrepancies in his calculations will be covered.

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