Warren Buffett's Priceless Investment Advice

"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 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. From 1980 to 2003, the stock portfolio of Berkshire Hathaway (NYSE: BRK-B  ) 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 that 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 Iron Mountain (NYSE: IRM  ) . Over the years, Berkshire has owned household names such as UPS (NYSE: UPS  ) and Wal-Mart (NYSE: WMT  ) .

Although not every pick worked out, Buffett and Berkshire have, for the most part, made a mint. Indeed, Buffett's 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.

Do-it-yourself outperformance
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, Berkshire opened a position in CarMax (NYSE: KMX  ) late last year, and added to an existing stake in US Bancorp (NYSE: USB  ) . So far both of those picks are in the red, which may signal a buying opportunity -- after all, getting a lower cost basis than the Oracle of Omaha has been a sound strategy in the past.

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 Buffett's. 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 can't remember the last time he used a razor made by someone other than Gillette and wishes he'd owned shares in that company before P&G acquired it. John does not own shares of any company mentioned in this article. The Motley Fool owns shares of Berkshire, which is an Inside Value and Stock Advisor recommendation. CarMax and Wal-Mart are also Inside Value selections. UPS and US Bancorp are Income Investor picks. The Motley Fool has a disclosure policy.


Read/Post Comments (15) | Recommend This Article (115)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 02, 2008, at 10:48 AM, sean1964 wrote:

    Warren Buffets major coup in the ninties was buying a ton of stock while it was way undervalued and then instating a chap called Jim Kilts at the helm. Jim tossed aside the bloated inventories and then sold the company for a song. Perhaps the Gillette company is doing better (Share price wise) but the people who work there are not.

  • Report this Comment On March 07, 2009, at 1:18 AM, skirtchaser456 wrote:

    as to buffet and COP, i have been dollarcost avgg'ing into this equity for about nine months. the comment that "it's not the company, it's the price paid" is very r5elevant, as my cost basis is about $55.00 a share.

  • Report this Comment On October 29, 2009, at 9:43 AM, Jtweez19 wrote:

    Warren's advice hasn't changed in years, and it won't change anytime soon. Warren is a true value-investor, he buys great companies at low prices. He keeps investing extremely simple.

  • Report this Comment On November 19, 2010, at 2:17 PM, RENNOTA wrote:

    I'm a big fan of value investing from Ben Graham all the way to today's great practitioners. Value investing provides an intellectual framework for investors that works, outperforming other investment strategies over the long-term. By insisting on a margin of safety, it's also the only investment strategy that explicitly espouses risk management as one of its core tenets. Buffett's #1 rule: "Dont lose money." Buffett's #2 rule: "Don't forget the first rule." Thanks for the article.

  • Report this Comment On May 25, 2011, at 11:26 PM, Boscalis wrote:

    Can't argue with these facts. Now, making the time...

    That's a value investment too.

  • Report this Comment On October 21, 2011, at 1:48 AM, NycityInvested wrote:

    how many people practice value investing? this is interesting way to analyze stocks.

  • Report this Comment On February 04, 2013, at 6:42 AM, pankajjain wrote:

    Well, no words to talk about Buffett from this foolish reader. Just that my fello readers may also enjoy reading this compilation of Buffett advice, here - http://www.equitymaster.com/outlook/warren-buffett/warren-bu...

    Cheers

  • Report this Comment On August 07, 2013, at 8:03 AM, cledrag wrote:

    On November 20, 2008, Alice Schrooder, author of “The Snowball: Warren Buffett and the Business of Life”, spoke at the Value Investing Conference at the Darden School of Business. She gave some fascinating insights into how Buffett invests that are not in the book. I hope you find them useful.

    Refer to youtube: http://www.youtube.com/watch?v=PnTm2F6kiRQ

    Much of Buffett’s success has come from training himself to practice good habits. His first and most important habit is to work hard. He dug up SEC documents long before they were online. He went to the state insurance commission to dig up facts. He was visiting companies long before he was known and persisting in the face of rejection.

    He was always thinking what more he could do to get an edge on the other guy.

    Schroeder rejects those who argue that working harder will not give you an edge today because so much is available online.

    Buffett is a “learning machine”. This learning has been cumulative over his entire life covering thousands of businesses and many different industries. This storehouse of knowledge allows Buffett to make decisions quickly.

    Schroeder uses a case study on Mid-Continent Tab Card Company in which Buffett invested privately to illustrate how Buffett invests.

    In the 1950′s, IBM was forced to divest itself of the computer tab card business as part of an anti-trust settlement with the Justice Department. The computer tab card business was IBM’s most profitable business with profit margins of 50%.

    Buffett was approached by some friends to invest in Mid-Continent Tab Card Company which was a start-up setup to compete in the tab card business. Buffett declined because of the real risk that the start-up could fail.

    This illustrates a fundamental principle of how Buffett invests: first focus on what you can loose and then, and only then, think about return. Once Buffett concluded he could lose money, he quit thinking and said “no”. This is his first filter.

    Schroder argues that most investors do just the opposite: they first focus on the upside and then give passing thought to risk.

    Later, after the start-up was successfully established and competing, Buffett was again approached to invest capital to grow the business. The company needed money to purchase additional machines to make the tab cards. The business now had 40% profit margins and was making enough that a new machine could pay for itself in a year.

    Schroeder points out that already in 1959, long before Buffett had established himself as an expert stock picker, people were coming to him with special deals, just like they do now with Goldman Sachs and GE. The reason is that having started so young in business he already had both capital and business knowledge/acumen.

    Unlike most investors, Buffett did not create a model of the business. In fact, based on going through pretty much all of Buffett’s files, Schroder never saw that Buffett had created a model of a business.

    Instead, Buffett thought like a horse handicapper. He isolated the one or two factors upon which the success of Mid American hinged. In this case, sales growth and cost advantage.

    He then laid out the quarterly data for these factors for all of Mid Continent’s factories and those of its competitors, as best he could determine it, on sheets of a legal pad and intently studied the data.

    He established his hurdle of a 15% return and asked himself if he could get it based on the company’s 36% profit margins and 70% growth. It was a simple yes or no decision and he determined that he could get the 15% return so he invested.

    According to Schroder, 15% is what Buffett wants from day 1 on an investment and then for it to compound from there.

    This is how Buffett does a discounted cash flow. There are no discounted cash flow models. Buffett simply looks at detailed long-term historical data and determines, based on the price he has to pay, if he can get at least a 15% return. (This is why Charlie Munger has said he has never seen Buffett do a discounted cash flow model.)

    There was a big margin of safety in the numbers of Mid Continent.

    Buffett invested $60,000 of personal money or about 20% of his net worth. It was an easy decision for him. No projections – only historical data.

    He held the investment for 18 years and put another $1 million into the business over time. The investment earned 33% over the 18 years.

    It was a vivid example of a Phil Fisher investment at a Ben Graham price.

    Buffett is very risk averse and follows Firestone’s Law of forecasting: “Chicken Little only has to be right once.” This is why Berkshire Hathaway is not dealing with a lot of the problems other companies are dealing with because he avoids the risk of catastrophe.

    He is very realistic and never tries to talk himself out of a decision if he sees that it has cat risk.

    Buffett said he thought the market was attractive in the fall of 2008 because it was at 70%-80% of GDP. This gave him a margin of safety based on historical data. He is handicapping. He doesn’t care if it goes up or down in the short term. Buying at these levels stacks the odds in his favor over time.

    Buffett has never advocated the concept of dollar cost averaging because it involves buying the market at regular intervals – regardless of how overvalued the market may be. This is something Buffett would never support.

  • Report this Comment On August 07, 2013, at 9:10 AM, cledrag wrote:

    Just a reminder, althought John Burr Williams talked about estimating dividends of the stock and discounting that to find the value of the security, that has been debunked. To value the security, value the entire business first. We should first find out and then estimate conservatively the future free cash generated by the whole business, value it, and then see if we are paying a reasonable price relative to value.

    Mr Charlie Munger once mentioned in an annual meeting that Buffett does not use the discounted cash flows approach either. According to Whitney Tilson's website which I highly recommend for your readings on Buffett and Munger:

    "If the future were predictable with any degree of precision, then valuation would be easy. But the future is inherently unpredictable, so valuation is hard -- and it's ambiguous. Good thinking about valuation is less about plugging numbers into a spreadsheet than weighing many competing factors and determining probabilities. It's neither art nor science -- it's roughly equal amounts of both.The lack of precision around valuation makes a lot of people uncomfortable. To deal with this discomfort, some people wrap themselves in the security blanket of complex discounted cash flow analyses. My view of these things is best summarized by this brief exchange at the 1996 Berkshire Hathaway annual meeting:

    Charlie Munger (Berkshire Hathaway's vice chairman) said, "Warren talks about these discounted cash flows. I've never seen him do one."

    "It's true," replied Buffett. "If (the value of a company) doesn't just scream out at you, it's too close."

    Marty Whitman, Mr Fan Jiang and Mr Seth Klarman approach valuation from the book value. Mr Bill Nygren approaches valuation from a more P/E approach. Mr Warren Buffett also, from the articles I have read and the feel I get from his letter to shareholders has an earnings approach as well. However, everyone has different methods. What is important is the margin of safety - which to me means, don't pay a price that requires everything to go right before the price paid is justified.

    e.g. If you project a revenue growth rate for the next 5 years of a company that ran into some earnings trouble in the short term at say 25%, which is very aggressive, and the value you calculated is about market price, I'll say there is no margin of safety because the probability of that happening is not very high and if it does not materialize, you didn't make a value buy.

  • Report this Comment On October 03, 2013, at 2:00 PM, 14202 wrote:

    no time

  • Report this Comment On January 15, 2014, at 9:48 AM, jmaranhao wrote:

    Invest like Warren Buffett and beat the S&P 500 is the ultimate goal. Another good article writes about this: http://www.big5roireports.com/1/post/2014/01/how-to-beat-the...

  • Report this Comment On January 15, 2014, at 9:53 AM, Mathman6577 wrote:

    I have been happy beating the SP500 by 1% a year over the last 30 years. I feel inferior now :)

  • Report this Comment On April 13, 2014, at 8:59 AM, borneofan wrote:

    I recently read his biography. Buffett gets no credit as a turnaround artist, yet a number of his bigger company purchases, especially insurance, had serious management and corruption problems. Unlike the hedge funds that serve as "fixers" for poorly managed companies, Buffett tends to fix them and keep them, not flip them. And of course he does not fix them, load them with debt, and then dump them in an IPO.

    It does not seem to be common knowledge that some of the reason that prices were low was that the goods were damaged. His connections to the business world gave him a pool of talent to draw from when he needed a corporate mechanic.

    The biography has several examples. I was familiar with his horse handicapping approach to value, but the corruption was new information for me.

  • Report this Comment On July 14, 2014, at 9:00 AM, DavidDavis wrote:

    It's time to make a choice by your own

  • Report this Comment On July 17, 2014, at 1:25 PM, DavidDavis wrote:

    Oldie Buffet rules the investment world how he wants

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