"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
If you can grasp this simple advice from Warren Buffett, you should do well as an investor. Sure, there are other investment strategies out there, but Buffett's approach is both easy to follow and demonstrably successful over a period of more than 50 years. Why try anything else?
Two words for the efficient market hypothesis: Warren Buffett
An interesting academic study (link opens PDF file) illustrates Buffett's amazing investment genius. During the period from 1980 to 2003, the stock portfolio of Berkshire Hathaway beat the S&P 500 index in 20 out of 24 years. During that same period, Berkshire's average annual return from its stock portfolio outperformed the index by 12 percentage points. The efficient market theory predicts this is impossible, but the theory is clearly wrong in this case -- and, as Casey Stengel said, "You can look it up."
Buffett has delivered these outstanding returns by buying undervalued shares in great companies such as Gillette (now owned by Procter & Gamble) and M&T Bank (NYSE: MTB ) . Over the years, Berkshire has owned household names such as Nike (NYSE: NKE ) , Cadbury Schweppes (NYSE: CSG ) , and Pier 1 Imports (NYSE: PIR ) . While not every pick worked out, Buffett and Berkshire have for the most part made a mint. Indeed, his investment in Gillette increased threefold during the 1990s. Who'd have guessed you could get such stratospheric returns from razors?
The devil is in the details
So buying great companies at reasonable prices can deliver solid returns for long-term investors. The challenge, of course, is identifying great companies and determining what constitutes a reasonable price. Buffett recommends that investors look for companies that deliver outstanding return on capital and produce substantial cash profits. He also suggests that you look for companies with a huge economic moat to protect them from competitors. You can identify companies with moats by looking for strong brands alongside consistent or improving profit margins and returns on capital.
How do you determine the right buy price for shares in such companies? Buffett advises that you wait patiently for opportunities to purchase stocks at a significant discount to their intrinsic values -- as calculated by taking the present value of all future cash flows. Ultimately, he believes that "value will in time always be reflected in market price." When the market finally recognizes the true worth of your undervalued shares, you begin to earn solid returns.
Beginning investors will need to develop their skills in identifying profitable companies and determining intrinsic values before they'll be able to capture Buffett-like returns. In the meantime, one place to look for stock ideas is among Berkshire's own holdings.
For example, Buffett took advantage of valuations in the building sector in late 2006, when Berkshire boosted its stakes in Lowe's (NYSE: LOW ) and wallboard manufacturer USG (NYSE: USG ) . Those bets haven't paid off yet, but that just means you can buy shares of these fine companies at a discount to Berkshire's purchase price.
Another place to find great value stock ideas is Motley Fool Inside Value. Philip Durell, the lead analyst for the service, follows an investment strategy very similar to that of Buffett. He looks for undervalued companies that also have strong financials and competitive positions. This approach has allowed Philip to outperform the market since Inside Value's inception in 2004. To see his most recent stock picks, as well as the entire archive of past selections, sign up for a free 30-day trial today.
If investing in wonderful companies at fair prices is good enough for Warren Buffett -- arguably the finest investor on the planet -- it should be good enough for the rest of us.
This article was originally published on April 7, 2007. It has been updated.
John Reeves owns shares of Berkshire Hathaway. The Motley Fool also owns shares of Berkshire. John can't remember the last time he used a razor made by someone other than Gillette and wishes he owned shares in that company before it was acquired by P&G. Berkshire, Cadbury Schweppes, and USG are Inside Value recommendations. Berkshire is also a Stock Advisor selection. The Motley Fool has a disclosure policy.