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Sunday, 1 June 2008

4 Secrets of Warren Buffett's Investment Success

1) Economic Moats
Buffett requires a company to have a sustainable competitive advantage, or what he calls an "economic moat."

This means he looks for companies that are virtually certain to have earnings that are higher in five or 10 years than they are today.

There are few companies that meet this "virtually certain" criterion. Thus, you won't find stocks like Amazon.com (NasdaqNM:AMZN - News), Yahoo (NasdaqNM:YHOO - News), or EMC (NYSE:EMC - News) in Buffett's portfolio. These companies may have moats around them today. But no one--not even Buffett--can predict if they'll still have that moat in five or 10 years. So he avoids them.

What he tries to do is think about the company's business as a whole, not just the financial aspect of it, to determine whether it will survive indefinitely. He asks questions such as "Am I fairly certain that this company's existing products will be around in 10 or 20 years?" and "Does this company have a unique advantage over others in its industry?" and "Will the health of this industry remain strong in coming decades?"

If the answer to those questions is yes, he'll consider the stock. If the answer to any of those questions is no, he moves on to evaluating another company.

Note that there are two components to an economic moat: The competitive position of an individual company within an industry, and the long-term viability of the industry itself. For this reason, it's very difficult for an airline or chemical or auto company to develop a wide moat--these industries are probably going to get weaker over time, not stronger.

2) Margin of Safety
Finding great companies is just the first step. Buffett realizes the difference between a great company and a great investment is the price you pay. He also realizes that he's human and is prone to making valuation mistakes. To account for this, Buffett uses a technique he calls "margin of safety," which he defines (following his mentor Graham) as buying a stock well below his calculation of its fair value. He does this so that, even if he makes a mistake in analyzing a company, he can sell the stock at a higher price than he paid for it.

Look at it this way: Investing is like gambling, in that they both rely on playing the odds. However, there's one big difference between gambling and Buffett-style investing: Gambling requires you to make bets in which the odds of winning are less than 50%. When Buffett makes an investment, the odds of winning are always greater than 50% or he won't invest. He won't always be right, but the odds will always be on his side. If you insist on a margin of safety, the odds will always be on your side, so there's a much higher probability that a stock will do well after you buy it.

Of course, just because a stock's cheap doesn't mean Buffett will buy it. He typically avoids "cigar-butt" stocks that are cheap for a good reason: They only have one or two puffs left in them. Lately, he has loosened that criterion a bit by purchasing the debt and equity of companies in bankruptcy, but for most of his career, this was not the case.

3) Patience Is a Virtue Buffett figures that as long as he buys companies that meet the first two criteria, their stock prices are almost certain to be higher five or 10 years later. And he doesn't mind waiting that long for one of his picks to pan out, provided the company still meets his investment criteria. This has to do with his nontraditional definition of risk.

Most investors, especially professional investors, define risk as volatility. As Buffett sees it, if you're willing to hold a stock for many years, volatility doesn't matter. The only risk is that the stock price will underperform a "hurdle rate" over the next five or 10 years.

Buffett defines this hurdle rate as a 10% pretax return, and defines risk as the probability of earning less than this on an investment.

Permanent underperformance can occur in two ways: by paying too much for a stock, or by buying a company that suffers a long-term decline in its economic moat and its earnings. Because Buffett is very picky about which companies he assigns wide moats, and buys them only at prices below fair value, he comes close to eliminating the risk of permanent underperformance.

4) Never deviate from your strategy, despite what others around you are doing. So why can't just anyone copy Buffett and beat the S&P 500 Index year in and year out? Although many people have the ability to understand Buffett's investment philosophy, very few have the discipline to execute it. Buffett shows an almost superhuman ability to stick with his investment strategy no matter what's going on around him.

This ability to think independently and keep emotion out of the investment process is the variable that Buffett copycats have a hard time mastering. The ability to think and act with complete independence may be something that can't be taught, and thus, can't be duplicated by many people.

Conclusion: In a nutshell, these four principles are what separate Warren Buffett from everyone else: Invest in companies with wide economic moats, insist on a margin of safety, hold on to them for long periods of time, and think independently by ignoring what other investors are doing.

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