Warren Buffett's 4 Rules for Stock Market Success

Want to invest like Warren Buffett? Just follow these 4 simple rules!

Jul 6, 2014 at 4:01PM

"We get excited enough to commit a big percentage of insurance company net worth to equities only when we find (1) businesses we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) priced very attractively." -- Warren Buffett, 1978 Berkshire Hathaway letter to shareholders

Do you wish you could invest like Warren Buffett? Luckily for you, the Oracle of Omaha laid out his 4 big rules for investing success in a Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) shareholder letter more than three decades ago.


In 1988, Coca-Cola fit Warren Buffett's 4 criteria for a great investment

Buffett put his 4 rules into practice a decade later, when he invested in Coca-Cola (NYSE:KO). Not surprisingly, the investment was a smashing success. Within 10 years, Coca-Cola was a 10-bagger for Buffett. Despite a pair of recessions since 1999, Coca-Cola stock has maintained its value in Berkshire Hathaway's portfolio while generating billions of dollars in dividends.

Buffett's 4 rules
Buffett's first rule is simple enough. Buy stock in businesses that you can understand. There are surely tech start-ups you could invest in today that will crush the market in the next 10 years. But if you're not a technology expert, how will you find them? (Remember, if you're buying a stock, someone else is selling because he/she sees better opportunities elsewhere.)

Buffett's point is: why bother? There are businesses out there with good prospects that you can understand -- if you're willing to do some homework. Sticking with what you understand already gives you a leg up on a lot of investors.

Buffett's second rule is to stick to businesses with good long-term prospects. There are plenty of companies that have a good year from time-to-time -- but many of them don't have sustainable businesses. If you have any doubts that a company's products will still be sought-after in 10 years, that's a big warning sign.


Warren Buffett's 4 rules for investing success have served him well over the last 50 years

The third rule is to buy companies with honest, competent managers. In many businesses, good management is the difference between generating steady profit growth and lurching from crisis to crisis. A management team with a long track record of success is likely to continue posting strong results.

Buffett's final rule is to look for attractively priced stocks. You should be able to find plenty of companies with good long-term prospects and talented management in businesses you can understand. If you overpay, you can still wind up with a poor result despite following the first 3 rules. If a business fitting the first 3 rules is really pricey, wait until you find another one that's cheaper!

Buffett's love affair with Coke
In 1988, Coca-Cola fit all 4 of Buffett's criteria for a great investment. First, it's really easy to understand the business of selling sugary drinks backed by one of the strongest brands in the world. In his 1989 shareholder letter, Buffett remarked that he became a loyal Coca-Cola customer more than 50 years earlier.

Second, Coca-Cola's brand name (and secret recipe) had kept the company on an upward trajectory for a century before Buffett first invested in the company. With international markets representing a huge additional growth opportunity, Buffett could feel fairly confident in Coke's long-term prospects.

Third, Buffett had great admiration for Coca-Cola CEO Roberto Goizueta, who led the company from 1980 until his death in 1997. While Buffett wished that he had bought Coca-Cola shares long before 1988, Goizueta's strong leadership during the 1980s was a key factor motivating Buffett's investment. Coca-Cola had posted solid earnings growth in the few years prior to 1988.

KO EPS Diluted (TTM) Chart

KO EPS Diluted (TTM), data by YCharts

Equally important, Coca-Cola shares were very reasonably priced when Buffett made his purchase. Despite the recent record of earnings growth, Coca-Cola shares traded for around 15 times earnings for most of 1988.

KO PE Ratio (TTM) Chart

KO P/E Ratio (TTM), data by YCharts

By the end of 1994, when Buffett stopped buying, he had put $1.3 billion to work in Coca-Cola stock, and that investment was already worth more than $5 billion. Once he had identified the opportunity, Buffett could relax and let Goizueta and his employees do the hard work. Two decades later, Berkshire Hathaway has not sold a single share. Its stake is now worth more than $16 billion, and produces nearly $500 million in dividends annually.

Foolish final thoughts
Buffett's first 3 rules of investing -- buy what you know, and stick to companies with good long-term prospects and good management teams -- are well-known by most Warren Buffett fans.

However, some Buffett admirers may be surprised by his focus on attractive prices. After all, Buffett also famously stated, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

The two aren't really contradictory, though. Buffett always believed that the key to investing successfully was finding high-quality businesses. As long as you have a long-term mentality, it's possible to get a good return even if you pay a "fair" price -- not a great price. That said, the real home runs are when you find a great business at a bargain price. That is exactly what Coca-Cola was for Warren Buffett and his fellow Berkshire Hathaway investors.

Warren Buffett just bought nearly 9 million shares of this company
Imagine a company that rents a very specific and valuable piece of machinery for $41,000 per hour (That's almost as much as the average American makes in a year!). And Warren Buffett is so confident in this company's can't-live-without-it business model, he just loaded up on 8.8 million shares. An exclusive, brand-new Motley Fool report details this company that already has over 50% market share. Just click HERE to discover more about this industry-leading stock... and join Buffett in his quest for a veritable landslide of profits!

Adam Levine-Weinberg has no position in any stocks mentioned. The Motley Fool recommends Berkshire Hathaway and Coca-Cola. The Motley Fool owns shares of Berkshire Hathaway and has the following options: long January 2016 $37 calls on Coca-Cola and short January 2016 $37 puts on Coca-Cola. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

4 in 5 Americans Are Ignoring Buffett's Warning

Don't be one of them.

Jun 12, 2015 at 5:01PM

Admitting fear is difficult.

So you can imagine how shocked I was to find out Warren Buffett recently told a select number of investors about the cutting-edge technology that's keeping him awake at night.

This past May, The Motley Fool sent 8 of its best stock analysts to Omaha, Nebraska to attend the Berkshire Hathaway annual shareholder meeting. CEO Warren Buffett and Vice Chairman Charlie Munger fielded questions for nearly 6 hours.
The catch was: Attendees weren't allowed to record any of it. No audio. No video. 

Our team of analysts wrote down every single word Buffett and Munger uttered. Over 16,000 words. But only two words stood out to me as I read the detailed transcript of the event: "Real threat."

That's how Buffett responded when asked about this emerging market that is already expected to be worth more than $2 trillion in the U.S. alone. Google has already put some of its best engineers behind the technology powering this trend. 

The amazing thing is, while Buffett may be nervous, the rest of us can invest in this new industry BEFORE the old money realizes what hit them.

KPMG advises we're "on the cusp of revolutionary change" coming much "sooner than you think."

Even one legendary MIT professor had to recant his position that the technology was "beyond the capability of computer science." (He recently confessed to The Wall Street Journal that he's now a believer and amazed "how quickly this technology caught on.")

Yet according to one J.D. Power and Associates survey, only 1 in 5 Americans are even interested in this technology, much less ready to invest in it. Needless to say, you haven't missed your window of opportunity. 

Think about how many amazing technologies you've watched soar to new heights while you kick yourself thinking, "I knew about that technology before everyone was talking about it, but I just sat on my hands." 

Don't let that happen again. This time, it should be your family telling you, "I can't believe you knew about and invested in that technology so early on."

That's why I hope you take just a few minutes to access the exclusive research our team of analysts has put together on this industry and the one stock positioned to capitalize on this major shift.

Click here to learn about this incredible technology before Buffett stops being scared and starts buying!

David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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