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John Reese,
I follow a pretty straightforward investment strategy. My belief is that you don't need to reinvent the wheel to be successful in the stock market.
Fortunately for me (and you), a few legendary investors have shared their wisdom and their stock-picking principles through books, academic papers and articles. When one of these stock market gurus speaks up, I listen.
So when Warren Buffett, CEO of Berkshire Hathaway (BRK.A, news, msgs) and arguably the most successful investor of all time, recently released his annual letter to shareholders in Berkshire's 2007 report, I took notice. (I encourage you to read the letter using this link .)
In an astute, witty and yet humble way, Buffett outlines many insightful ideas. Everyone who reads the first 20 or so pages will walk away with something different, but I wanted to share with you what I gleaned from this year's letter.
Buffett's 'enduring moat' indicator
Unlike many of the gurus I follow, Buffett has never fully disclosed, criteria by criteria, his investment methodology. (I based my Buffett strategy on the book "Buffettology," which was written by his ex-daughter-in-law Mary Buffett.) Throughout the years, however, he has given many hints in interviews, articles and his annual letters, and this year is no different.On Page 6 of the report, Buffett talks about the type of companies he looks for, and while his methods, in general, are nothing new to those who are intimate with his investment approach, I think this deserves some attention.
Buffett writes, "Charlie (Munger, Berkshire's vice chairman) and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag."
Buffett goes on to say that he wants to see a high return on capital and an "enduring moat" that protects this profitability from competitors. An enduring moat could be a strong brand name or the ability to produce a quality product at a lower cost than rivals. Both of these are long-term competitive advantages that can lead to sustained success.
Coca-Cola (KO, news, msgs), one of Buffett's big holdings, has, for example, a brand name that is known throughout the world and ingrained in our everyday life. We sometimes refer to colas as "Coke" when they're made by a different company. That kind of name recognition is hard for new competitors to overcome -- no matter how much money they have to spend promoting their product.
There are, however, situations in which a "moat" isn't enough. In Berkshire's letter this year, Buffett explains a few reasons why, even if a company has an "enduring moat," he might not consider it for an investment.
One reason would be if the firm is in an industry that is rapidly changing and evolving (think high-technology businesses), because that constant change can quickly lead to the erosion of a company's moat. As Buffett says, "A moat that must be continuously rebuilt will eventually be no moat at all." In addition, he also shuns businesses that are dependent on a superstar CEO to produce results. Buffett wants to invest in companies that have strong management and bench strength, and ones that wouldn't be hurt by a departing executive.
4 more key principles
Turning back to the four investment principles -- "a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag" -- all of these are ways to reduce risk and variability. Buffett wants to understand the company, how it makes money, what its competitive position is, whether it has a unusual advantage that leads to high returns on capital, whether the management is strong and displays good principles, and, lastly, whether the stock is trading at a value that gives a good chance for a reasonable return.Also inherent in this four-pronged approach is disciplined investment strategy and framework that he has consistently followed for years. Buffett never gets caught up in the hype around a hot stock, and he's never dissuaded from investing in a company simply because others think little of it. He focuses on numbers -- the real value of the firm, and the price for which he can get its stock. In part, it's this approach that has enabled Buffett to increase Berkshire's book value by an astonishing 400,863% since 1965 (see Page 2 of the report for the annual and total gains in the per-share book value of the firm). By following this discipline Buffett is able to override emotions and stick with an approach that has been successful.
Learn from your mistakes
Buffett is the first to tell you that his path to 400,000%-plus gains wasn't mistake free. He's not infallible, and he is quick to mention that more mistakes are likely to happen in the future (if you want to read about those mishaps, check Page 8 of his letter). But what I find fascinating are not the mistakes he outlines but his ability to look back and understand those mistakes so that he can avoid them in the future.As investors, we'll all make mistakes. A good investor learns and grows from those mistakes. Maybe you buy a stock because you get caught up in the hype surrounding it, only to watch it tumble after you own it. Maybe you hang on too long to the stock of a company whose financial situation is worsening, because you'd rather hope against hope that it will rebound than admit you made a mistake buying it.
Whatever the case, all investors -- even Buffett -- make mistakes. The important part is to make sure you don't keep making the same mistakes again and again.
Dow 2.4 million? Not likely, but be bullish
Buffett goes on to discuss the expectations for the market over the long, long term. In discussing the underlying assumptions of pension funds, he concludes that these funds have baked in a 9.2% net return assumption on their equity investments.Buffet says the Dow has gained 5.3% annually over the last century. If the Dow rose 5.3% per annum over the next 92 years, the index would hit roughly 2 million, whereas a 10% annual gain puts it at 2.4 million by the year 2,100. So Buffett asks a good question, "While anything is possible, does anyone really believe this is the most likely outcome?"
My read on this is that though stocks have offered, and will continue to offer, the best chance for long-term wealth creation, Buffett is implying that returns in the next century may not be as strong as the returns we've realized over the past century.
Still, while Buffett questions whether past returns will continue at the same rate, his actions indicate a more positive near-term to midterm outlook. On Page 17, he discloses that Berkshire has sold put-option contracts on four U.S. market indexes, including the S&P 500 ($INX). By selling put options on the indexes, he is making a bet that when the contracts expire between 2019 and 2027, those markets will be higher than the level they were when the contracts were written. He then goes on to say that "these contracts, in aggregate, will be profitable and that we will, in addition, receive substantial income from our investment of the premiums we hold during the 15- or 20-year period."
Buy the business, not the stock
Right at the beginning of the report, on Page 2, Buffett displays Berkshire's increase in per-share book value by year. He has increased per-share book value by 21.1% annually over 42 years. Buffett doesn't calculate the stock price performance, which is what tends to get more attention in the financial press.When evaluating Berkshire and the businesses he invests in, he looks at two tests. According to Buffett, the first test is improvement in earnings, while making due allowance for industry conditions. The second test, which is more subjective, is whether their "moats" have widened during the year.
Like Buffett, I don't buy and sell stocks based on the stock's price trend. Instead, my decisions are based on a strict set of fundamental criteria -- financials, profitability, valuation, cash flow and more. As an investor, you should periodically review your equity investments and ask yourself, just like Buffett does, if the reasons for the purchase of the stock are still in place or have they deteriorated. If you're seeing cracks in the investment thesis, you should consider this a reason to sell the stock and invest the funds in a better opportunity.
Over the short term, stocks will fluctuate unpredictably, but history has proved that in the long run, the stocks of solid companies with good fundamentals do well.
While Strategy Lab is a six-month stock-picking competition, investing is a long-term discipline. And to me, the best way to succeed in the long run is to learn from those who have had the most success.
It's not just learning what they think about individual stocks. Part of the reason great investors like Buffett have succeeded is their broader understanding of how the market -- and the mind and emotions of the investor -- works. If you take the time to listen, their broader musings and ponderings on those and other investing-approach issues can be just as helpful as any "buy" or "sell" recommendations you'll come across.
If you have a question or comment, please don't hesitate to send me an e-mail at johnreese@validea.com.
Guru Investor
John Reese
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Round 17
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