Could someone today do what Warren Buffett did and parlay a $105,000 investment into more than $50 billion?
In considering the things Buffett did to become the world’s wealthiest man, the answer is yes. But comprehending the things he did takes a measure of study. Not to mention the commitment needed to execute it.
Much has changed since Buffett began his career in the 1950s. But the American economic system is largely run by the same rules and principles.
Early Money Making Secrets
Buffett discovered two of his lifelong money making secrets early in life: reinvesting profits and being willing to be different, according to warrenbuffett.com. These are principles that would certainly be useful today.
In high school, Buffett and a friend purchased a pinball machine and put it in a barbershop. They used the proceeds to buy more machines until they had eight in different shops. When they sold the venture, they used the proceeds to buy stocks and start another business.
In 1956, Buffett began managing money with $100,000 he received from a handful of investors while working in Omaha, Nebraska. When he ended the partnership 14 years later, it was worth more than $100 million from investing in undervalued companies.
He is often characterized as advocating a “buy and hold” strategy, but further examination indicates this is an oversimplification of his strategy.
Buffett’s Investment Strategy
There are several aspects to Buffett’s approach to investing. The most basic aspects have to do with his assessment of stock value, known as value investing. Early in his career, he said he is 85% Benjamin Graham, known as the godfather of value investing.
Value investing determines the underlying fair value of a stock based on it is future earnings ability, according to Investopedia.
To guide his decisions, Buffett considers the business, the management, financial measures and value. While these considerations seem easy to understand, they can be hard to execute.
A key Buffett tenet is to ask if management is candid with shareholders. This is not an easy question for many companies to answer.
There are also concepts Buffett follows that seem complex but are actually easy to execute, like economic value added (EVA). The concept is not easy to grasp, but in fact it is a laundry list of adjustments. It is an easy way to calculate EVA for a company.
Buffett’s ideas are also open to adaptation. Traders often require adherence to a formula to control emotions, but investors can adapt their models to current environments.
Another Buffett tenet is to restrict his activity to his area of competence – businesses he understands. Robert Hagstrom, the author of “The Essential Buffett: Timeless Principles for the New Economy,” wrote investment success is not a matter of how much one knows, but how realistically one defines what they don’t know.
Buffett regards a deep understanding of the operating business as a prerequisite for forecasting future business performance. He first analyzes the business, not the market, the economy or the investor sentiment. Then he looks for a consistent operating history. Lastly, he uses the data to determine whether the business has good long-term prospects.
Focus On Management
Another Buffett tenet is to evaluate management quality. This is one of the most difficult tasks for an investor. Buffett focuses on the degree to which the management is rational. He considers management’s approach to reinvesting, retaining earnings or returning profits to shareholders as dividends.
Research indicates that historically, management tends to be greedy and retains too much profit. It is naturally inclined to seek scale rather than utilize cash flow to maximize shareholder value.
Another tenet considers management’s honesty with shareholders. Does it admit mistakes? Does management resist the “institutional imperative”?
Buffett seeks out management that resists a “lust for activity” and the duplication of competitor strategies.
Buffett focuses on return on equity (ROE) as opposed to earnings per share. ROE can be distorted by leverage (a debt-to-equity ratio) and therefore be less reliable than the return-on-capital metric. Buffett recognizes this, but he examines leverage separately, preferring low-leverage companies. He also looks for high profit margins.
Buffett also looks at what he calls “owner’s earnings” – the cash flow available to shareholders. He defines it as net income plus depreciation and amortization minus capital expenditures (CAPX) minus additional working capital needs.
With owner’s earnings, Buffett pays attention to a company’s ability to create cash for shareholders.
He also has a “one-dollar premise;” the market value of a dollar assigned to each dollar of retained earnings. This metric resembles market value added, the ratio of market value to invested capital.
Focus On Value
Buffett tries to estimate a company’s intrinsic value. He projects the future owner’s earnings, then discounts them back to the present. The projection of future earnings is easier to do if Buffett’s other tenets have been followed since consistent historical earnings are easier to forecast.
Buffett also coined the term “moat,” the “something that gives a company a clear advantage over others and protects it against incursions from the competition.”
The Bottom Line
Buffett’s tenets create a foundation in value investing that is open to adaptation. It is an open question which tenets require modification in consideration of a future where consistent operating histories are more difficult to determine, where intangibles play a bigger role in franchise value, and the blurring of industries’ boundaries makes business analysis harder.
Focus On Staples
Many Buffett observers have noticed he has made a lot of money over decades buying stocks in goods used every day, according to CNBC. He is known for being reluctant to invest in technology — an area that may not fall within his comfort zone.
Many consumer goods companies have beat broader market averages in recent years, such as Coca Cola and Wal-Mart.
Buffett’s Ownership Role
Kiara Ashanti, a financial adviser and securities trader writing in Money Crashers, noted that Buffett has taken an ownership role in many of his investments. He buys enough stock to gain seats on companies’ boards. As a board member, it is possible to influence a company’s direction and its management decisions.
The key point is that to gain wealth, ownership is imperative.
Ashanti observed that Buffett is often mischaracterized as following the “buy and hold” model, holding a stock through good times and bad. Buffett buys for specific reasons. When such reasons end, he sells.
Ashanti agreed Buffett looks for good prices, good management and a competitive advantage. In 1996, he cited General Motors, IBM and Sears as great companies that could not stay competitive in their markets.
Buffett does not pay attention to daily stock prices or what the press has to say about companies. He sticks to his tenets, asking if the company is properly valued and if it is making money.
While there is more to Buffet’s strategy than “buy and hold,” it bears noting that he has gone on record as saying successful investing takes time, discipline and patience.
According to the website, warrenbuffett.com, Buffett offered the following 10 money making secrets.
1) Reinvest your profits.
2) Be willing to be different. Don’t base decisions on what others say or do. The average is what everyone else does. To be above average, judge yourself by your own standards.
3) Never suck your thumb. Make decisions fast. Gather any information in advance to make a decision, but make sure you stick to a deadline.
4) Spell out the deal before you begin. Bargain leverage is greatest before the job begins.
5) Watch small expenses. Buffett looks for businesses with managers who obsess over the smallest costs.
6) Limit your borrowing.
7) Be persistent. Tenacity and ingenuity will enable you to win against a better established competitor.
8) Know when to quit. Know when to walk away from a loss and don’t let anxiety cause you to keep trying.
9) Assess the risk. Asking “and then what?” will help you see the possible outcomes when struggling with a decision.
10) Know what success really means. Buffett does not measure success in dollars. At his present age, he said a person measures success by how many people you want to have love you actually do.
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