At last count, Warren Buffett's net worth exceeded $71 billion. Accumulating that kind of wealth doesn't happen by accident.
Fortunately for those of us still dreaming of having a six-, seven-, or 11-digit net worth, Buffett hasn't been shy about discussing his investing approach publicly. Better yet, the fundamentals of it are as simple as they are powerful.
So simple, in fact, that you can boil it down into just eight words.
Word 1: Understanding
Buffett invests in businesses that he understands. Buffett is a value investor at his core. He wants to pay $0.50 to buy $1. The only way to successfully and repeatedly do that is to deeply understand the business, what makes it tick, and how to value it.
Take a glance at the Berkshire Hathaway (BRK.A 0.64%) (BRK.B 0.54%) investment portfolio. The vast majority of his investments are in financial and consumer-goods companies. There's Geico, Wells Fargo, and American Express (AXP -0.08%), alongside Coca-Cola (KO 0.68%) and Wal-Mart Stores (WMT -0.65%).
There aren't any high-flying tech stocks or sophisticated healthcare companies. For that matter, the Berkshire Hathaway portfolio isn't really diversified at all by conventional standards. Why? Because the Oracle of Omaha invests in companies and industries that he understands. If he doesn't understand it, he doesn't invest in it.
In your investing, if you already have a strong knowledge base in an industry, start there. If not, start building that foundation by choosing a company you're interested in and reading their most recent annual report. Then read the annual report of their closest competitors. That's how Buffett started out, and before you know it, you'll be strong expert in your own right.
Words 2 and 3: Competitive Advantage
Once Buffett understands an industry or a company, he then seeks to find the companies in that space with a competitive advantage that competitors can't easily overcome. Buffett likes to call this advantage a company's moat. Over the long term, the moat protects the business from competitors edging in on profits and market share.
How to spot competitive advantage? Again, we can start by doing it the same way Buffett does.
First, he looks to find the specific companies that are able to win as the low cost provider. Think about Wal-Mart's "rolling back prices." Or the GEICO lizard who is so confident that "in 15 minutes you could save 15% or more on auto insurance."
Second, he looks to industries that are highly regulated or very capital intensive. It's ridiculously hard to start a bank because of the regulatory hurdles. Good luck starting your own railroad, like Berkshire's BNSF, given the massive amount of capital you'd need to just get started.
Words 4 and 5: Strong Management
With few exceptions, Buffett is a hands-off shareholder. When he buys a company, he has no intention of showing up on Monday to shake things up. By being so hands-off, Buffett must instead rely on the management teams already running the business.
It's not just about being a hands-off business owner, though. It's also about buying high-quality businesses.
A business is essentially an organization of people working toward a goal. A business is not the numbers we review on the financial statements; the financial statements are merely a report card for the performance of the people that make up the company. When you invest in a business, you're investing in those people. It only makes sense to seek out the best people to be the stewards of your shares.
This is without question the most challenging part of implementing a Buffett-like investment strategy. Evaluating management is as much art as it is science. In my view, the best tactic to do this is twofold. First, take the time to read the annual reports and quarterly filings closely. Tune in to the conference call. Listen to what management has to say, evaluate it critically, and listen to your gut.
Second, I would look to past performance. Those financial statements are a report card, remember. Find the companies with the strongest financial statements, and odds are a strong management team is driving it.
Words 6, 7, and 8: Margin of Safety
Last, and definitely not least, are the three most critical words to investing like Buffett. I mentioned that Buffett is a value investor, seeking to buy companies that are worth more than their price. The difference between the actual value and the price is called the margin of safety, and it's absolutely critical.
A margin of safety accomplishes two objectives. First, it defines the upside of your investment. Eventually, the market will recognize that a stock is undervalued, and when that happens, the price will rise. That's your profit.
Second, a sufficient margin of safety protects your risk to the downside. If a stock is trading at a significant discount to its intrinsic value, the downward movement is already taken into account. If it wasn't, the stock wouldn't be trading so cheaply!
The best way to put this into practice is to spend some time familiarizing yourself with some common valuation metrics. The price to earnings ratio (P/E ratio) is a good place to start; it works across most all industries. Start comparing P/E ratios among various companies and try to understand why one company is more expensive than another. Soon, the dirt cheap prices will be obvious to you.
Now that you're armed with Buffett's fundamental investing philosophy, your next step is to put it into practice. Start reading those annual reports, tune in to quarterly conference calls, and hone your analytical skill set to find those diamonds in the rough. With this approach and the hard work to put it into practice, you're sure to improve your investing skills.
