Warren Buffett is the most consistently successful investor in the world, and there are several ways that we as commoners can attempt to catch a draft from his success. For $90,000, we could buy a single share in his company, Berkshire Hathaway (NYSE: BRKa ) , but that represents a significant chunk of some investors' reserves. Or, for a fraction of that amount, we could buy a "B" share of Berkshire Hathaway (NYSE: BRKb ) . For those seeking a more challenging option, though, we can spend some time understanding the principles behind Buffett's investment philosophy. Let's begin by taking a look at the stories behind the man.
A brief history of Buffett
Warren Buffett was born on Aug. 30, 1930, in Omaha, Neb. Using savings from his paper-delivery route, Buffett invested in a series of entrepreneurial ventures, like buying pinball machines and installing them in local barber shops. By the time he went to study at the University of Nebraska in 1946, he had saved $6,000. During his days at the university, Buffett read The IntelligentInvestor, Benjamin Graham's classic work on quantitative value investing. Graham would become one of the main influences on Buffett's investing philosophy. He even studied under Graham at New York City's Columbia Business School, which he attended after graduating from Nebraska.
After his studies, Buffett briefly returned to Omaha to work with his father's brokerage business, but he soon returned to New York to work with his mentor at the Graham-Newman Corporation. Then in 1956, Graham retired. Armed with Graham's value-based investing philosophy, Buffett returned to Omaha and started his own investment company. He was 25.
Buffett invested in a number of companies, including a leading textile manufacturer called Berkshire Hathaway. In 1969, he was having difficulty finding reasonable investments in the stock market, so he liquidated his partnership. His initial investors received $30 for every dollar they invested in 1956 -- a compounded annual return of almost 30%. Buffett invested his share of the partnership profits in Berkshire Hathaway.
A brief history of Berkshire
Buffett's partnership had taken control of Berkshire in 1965. In 1967, Buffett began diversifying Berkshire's business interests by purchasing two insurance companies: National Indemnity and National Fire and Marine. Over the next decade, he added several more insurance companies to his arsenal. In fact, in 1985, bowing to the realities of international competition, Buffett closed the doors on Berkshire's textile business completely.
Buffett liked insurance companies for two main reasons: The insurance business was profitable, and policyholder premiums provided insurance companies with a steady stream of money.
Essentially, Buffett became the investment manager for the insurance companies' premium-based capital (or "float"). But instead of returning the profits from his investments to his partners, he reinvested them in his company. Over the next 35 years, he took positions in The Washington Post (NYSE: WPO ) , Gillette (NYSE: G ) , Coca-Cola (NYSE: KO ) , Wells Fargo (NYSE: WFC ) , General Dynamics (NYSE: GD ) , and a number of other distinctive businesses. In so doing, he built one of the most successful and respected companies in the world.
The Benjamin Graham contribution
The concept of a "margin of safety" was Benjamin Graham's most important contribution to Buffett. Graham suggested that since no one can know the future, investors should protect themselves by looking for companies that are trading at a discount to their net asset value (total assets minus total liabilities). This discount -- or margin of safety -- protects the investor against unforeseeable risks.
Graham believed that companies experienced discounts in their share prices mainly because of investor greed and fear. In other words, when a company is the subject of bad news or poor forecasts, investors flee the stock, and a company's price can get driven down below the value of its net assets as a result. Graham recognized that the best investment opportunities often occurred when the public was most fearful. Likewise, the best selling opportunities often came about when the public was most euphoric.
Because bad news could come at any time, investment opportunities occurred regardless of macroeconomic market conditions. Month to month, and even year to year, market fluctuations were of no importance to Graham. If he bought enough companies at enough of a discount, he reasoned that they would, on the whole, eventually return handsome profits.
The margin of safety became the key tenet of Buffett's philosophy. But he also realized that there might be more to a good investment than just a discounted share price. He began to look more at the health of a company and the products it generated. Eventually, his search led him to the writings of Philip Fisher, who would provide the other key component of Buffett's investing philosophy: research.
The Philip Fisher contribution
Shortly after the 1929 stock market crash, Fisher started his own investment firm. Whereas Graham was most concerned with a quantitative measure of value, Fisher focused on qualitative metrics. He interviewed company officers, employees, suppliers, customers, and competitors to find companies with significant competitive advantages and management teams that could effectively exploit these advantages. Because each investment required so much time, Fisher's portfolio was very small.
Like Fisher, Buffett does not invest in a company unless he has a good handle on its products, its competitive advantages, its weaknesses, and, most importantly, the competence of its management. Also like Fisher, Buffett is willing to invest in a small number of good companies, rather than diversify across a large number of companies he doesn't understand as well.
The Buffett touch
Buffett's philosophy is a marriage of Graham's quantitative valuation and Fisher's qualitative research. He looks for well-run companies at discounted prices. By satisfying both conditions, Buffett reduces his risk and increases his upside.
In the next several articles, we will look at each of Buffett's key investing concepts. We will examine their meaning, identify what information we need to analyze them, and look at how we can quantify their value to evaluate companies. Please join me then to learn more about Buffett and his investment approach.
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Fool contributor Jim Schoettler does not own any of the companies mentioned in this article. If you are interested in reading more about the man and his methods (and just can't wait for my next series installment), there is no shortage of books on Buffett's investing philosophies. I recommend reading The Warren Buffett Way by Robert Hagstrom. The Motley Fool is investors writing for investors.