Buffett's Equity Investment Strategy: Part 2

In the first article in this series, we began looking at Warren Buffett and Charlie Munger's equity investment strategies, in their own words. Today, I'd like to continue that overview, and I'll pick it back up by examining Buffett's belief in the folly of dividing value investing and growth investing into two distinct categories.

In his 1992 Berkshire Hathaway (NYSE: BRK-A) annual report, Buffett explains the misconceptions that can occur when using the terms "value" or "growth" in seeking out attractively priced companies. Referring to the prevalent use of the term "value investing," he said:

Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price earnings ratio, or high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments.

Back in the early '50s and '60s, Buffett would not have been able to make such a statement, since he was focused back then on Ben Graham-style pure value stocks. Later in his career, Buffett, thanks in part to Munger, realized the inherent value of buying a spectacular business at a fair price.

Correspondingly, opposite characteristics -- a high ratio of price to book value, a high price-to-earnings ratio, and a low dividend yield -- are in no way inconsistent with a "value" purchase.

Indeed, value is what happens when a business can deploy a dollar to finance growth that creates more than a dollar in long-term market value.

Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.

It's this characteristic that has attracted Buffett to simple yet highly profitable businesses such as American Express (NYSE: AXP) and GEICO, and now to the railroad industry, which, for the first time in more than 20 years, is earning rates of return exceeding its cost of capital. It also explains why oil-and-gas company XTO (NYSE: XTO), owned by Buffett disciple Bruce Berkowitz of Fairholme Capital, has generated more than 20% annualized returns for more than a decade. XTO has been able to grow its net reserves year over year, and its finding costs are lower than just about anybody else's.

Although Buffett's universe for potential investments has gotten bigger, his approach and discipline remain firmly grounded in Graham's teachings.

At Berkshire ... we try to stick to businesses we believe we understand. That means they must be relatively simple and stable in character. What counts for most people in investing is not how much they know, but rather how realistically they define what they don't know. An investor needs to do very few things right as long as he or she avoids big mistakes. Second, and equally important, we insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying.

There are certain approaches in investing that should always be followed, and having a margin of safety is one of them. Every company is undervalued, fairly valued, or overvalued at a particular price. It's important to remember that there's a paramount difference between a good business and a good investment -- that distinction being the price you pay.

I'll let Buffett have the last word:

We believe this margin of safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of the investment success.

For Further Related Foolishness:

• Buffett's Words of Wisdom
• Meet the World's Richest Man
• Buffett's Words of Wisdom: Part 2