When it comes to good investing, I like simple strategies. Recently, I was reading a case study by University of Virginia professor Robert Bruner, in which he discussed Motley Fool Stock Advisor selection Berkshire Hathaway's (NYSE: BRK-A ) (NYSE: BRK-B ) acquisition of auto insurer GEICO. Bruner's quick explanation of Warren Buffett's investment process struck me as brilliant in its simplicity.
Before making an investment, I think all investors needs to ask themselves the following three questions:
1. How simple is this business?
Simple means different things to different people. To Michael Jordan, scoring a basket with 10 seconds left, a playoff series on the line, 20,000 fans yelling at the tops of their lungs, and five extremely tall, world-class athletes trying to stop him is relatively simple. However, Jordan struggled to hit pitches thrown by minor-league pitchers.
Similarly, investors need to stick to industries that they understand. I cannot count the number of times I've gotten burned on companies that are extremely complex to me; instead of walking away, I squinted my eyes and leaned a little to the left to come up with an investment thesis.
2. How consistent is the firm's operating history?
It's no surprise that many of Berkshire's core investments -- including Wells Fargo (NYSE: WFC ) , American Express (NYSE: AXP ) , and Inside Value pick Coca-Cola (NYSE: KO ) -- exhibit some of the longest strings of growth and profitability in the entire business world.
Buffett isn't interested in paying full price for something and hoping it pays off tomorrow. He's interested in getting a big discount on something he's sure is worth a lot more right now -- and will hold its value in the future. Thus, he sticks to companies and industries where it requires little or no foresight to predict their futures.
Buffett once remarked, "Is Spearmint or Juicy Fruit going to evaporate? It isn't going to happen. You could give me a billion dollars and tell me to go into the chewing-gum business and try to make a real dent in Wrigley (NYSE: WWY ) . I can't do it."
Clearly, Fools should think about investing primarily in companies with extremely stable businesses.
3. How attractive are long-term prospects?
While it's nice to invest in companies that have virtually guaranteed profits, it's even nicer to have both guaranteed profits and growth. GEICO's a great example of a company that has its cake and can eat it, too. Its lower expense ratios mean that it can charge customers lower premium rates and spend much more money on advertising.
Customers see GEICO ads everywhere. If they pick up the phone and call, or check it out on the Internet, GEICO can usually offer them a lower rate than their existing auto insurer can. In that situation, it'd be extremely difficult for GEICO not to grow.
On the other hand, GEICO's excellent management team also means that not only will the company stay disciplined by maintaining its underwriting quality and earning profits, but it also will have superstar portfolio manager Lou Simpson putting its capital to work at high rates of return. Put it all together, and GEICO's like an indestructible golden goose. In short, on a scale of 1-10, the attractiveness of GEICO's long-term prospects gives it a solid 10.
Before making your next investment, quickly go through each of these questions. It might help stop you dead in your tracks before investing in companies like Enron, with its ultra-complicated corporate structure, or New Century Financial with its extremely volatile operating results.