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 (PDF file) illustrates Buffett's amazing investment genius. 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 that this is impossible, but the theory is clearly wrong in this case.

Buffett has delivered these outstanding returns by buying undervalued shares in great companies such as Gillette, now owned by Procter & Gamble. Over the years, Berkshire has owned household names such as Nike (NYSE: NKE  ) , Home Depot (NYSE: HD  ) , and The Washington Post (NYSE: WPO  ) .

Although not every pick worked out, for the most part Buffett and Berkshire have 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
Before they can capture Buffett-like returns, beginning investors will need to develop their skills in identifying profitable companies and determining intrinsic values. In the meantime, consider looking for stock ideas among Berkshire's own holdings.

Lately, Buffett has been investing in energy and infrastructure plays. Late last year, he tried to acquire Constellation Energy (NYSE: CEG  ) , and he added a big slug of NRG Energy (NYSE: NRG  ) as well. He also picked up shares of tiny Nalco Holding (NYSE: NLC  ) , a water treatment company that has been growing at a torrid pace (for a water treatment company).

We’ll have to wait for Berkshire to file a Form 13F before we know what Buffett’s buying today – although as my Foolish colleague Alex Dumortier pointed out, he certainly does seem to like banks like BB&T (NYSE: BBT  ) .

In the meantime, 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 he wishes he'd owned shares in that company before P&G acquired it. John does not own shares of any companies mentioned. The Motley Fool owns shares of Berkshire Hathaway and Procter & Gamble. Berkshire Hathaway is an Inside Value and Stock Advisor recommendation. Home Depot is an Inside Value selection. BB&T is an Income Investor pick. The Fool has a disclosure policy.


Read/Post Comments (8) | Recommend This Article (24)

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 March 13, 2009, at 5:31 PM, ATI2DE wrote:

    "intrinsic values -- as calculated by taking the present value of all future cash flows"

    How is this calculated?

  • Report this Comment On March 13, 2009, at 10:00 PM, SkepticalOx wrote:

    Wow... Did you even read up on the put options before you made this comment?

    The only way these option exposures would destroy Berkshire would be if ALL 3 indexes he bet on fall to 0, and he basically made no or negative returns on the premium he received. Inflation is also on his side, as these puts are NOT inflation-adjusted. Never mind the whole point that if the indexes were at zero, we'd probably have more to worry about then our stock portfolio.

    And at least spell his name correctly.

  • Report this Comment On March 14, 2009, at 11:12 AM, rajeevsingh111 wrote:

    Warren Buffett is undoubtedly the smartest investor the world has seen till now.. so things he says makes sense.

    he always beleived in the power of compounding,ways of investing to avoid paying tax on your returns,buying good copanies at a fair value andmost importantly companies which had consumer monopoly and was run by great management team. his all time favorite is offcourse Coca Cola.

  • Report this Comment On March 14, 2009, at 11:14 AM, rajeevsingh111 wrote:

    Please also visit http://moneyforinvestment.blogspot.com to find out the biggest worry on dollar crisis.

  • Report this Comment On March 14, 2009, at 11:34 AM, EggplantWizard wrote:

    There's no question that Buffett is a very good investor, but the time-frame of a single human life is too short to presume that the efficient market theory is wrong, and that much of Buffett's outperformance isn't due to luck.

  • Report this Comment On March 15, 2009, at 8:28 PM, cityhunter66 wrote:

    @Eggplantwizard: So what's the time frame for efficient market theory? 100 yrs? That's not very efficient is it?

    I wish i have luck like his though, beating the market the way he has for such a long time.

  • Report this Comment On March 16, 2009, at 3:34 PM, brettrich9 wrote:

    Report this Comment On March 14, 2009, at 11:34 AM, EggplantWizard wrote:

    There's no question that Buffett is a very good investor, but the time-frame of a single human life is too short to presume that the efficient market theory is wrong, and that much of Buffett's outperformance isn't due to luck.

    The smartest post on this page and even smarter than the article written by Mr. Reeves.

    7. (5 points) Ted and Regina are both doing a valuation of XYZ Corporation common stock. Ted believes XYZ's cost of equity capital is 8.5%, while Regina believes it is 8.7%. Ted expects next year's earnings per share to be $2.30, but Regina only expects $2.00. They both expect XYZ to pay half of next year's earnings as a dividend. Ted expects dividends to grow at a constant rate of 6.2% into the future, and Regina expects dividend growth to be 6.0%. Both investors use the dividend discount model. What values will Ted and Regina place on XYZ? If the current bid and ask prices are $40.25 and $41.00, what actions will Ted and Regina likely take based on their valuations?

    This is a question from one of my old exams for the Introduction to Investments class at University of Florida. I reproduce it here to make a point about placing values on common stocks. Before I make my point, we have to do some arithmetic. The dividend discount model of stock prices says that the current value of a stock is equal to the present value of expected future dividends, discounted back to the present at the firm's cost of equity capital. In the special case where dividends are expected to grow from now on at a constant rate, the model reduces to the following convenient form:

    Today's price = next year's expected dividend / (cost of equity — constant growth rate)

    For Ted, today's value is 1.15/(0.085 — 0.062) = $50.00. Regina's estimates yield a price of 1.00/(0.087 — 0.06) = $37.04. Ted would be willing to pay about 35% more for XYZ than Regina would. What are they likely to do, based on the current market quotes? Since Ted believes XYZ to be undervalued by nearly one-fifth, he would probably be willing to buy, depending on what is already in his portfolio. Since Regina believes the company to be overvalued by about 10%, she might be interested in shorting the stock. However, the 75-cent bid-ask spread suggests that we are dealing with an illiquid stock that may be difficult to sell short. Since Regina may or may not be the type of investor that is comfortable with short positions, and since the stock may be difficult to sell short, there is a reasonable probability that she will do nothing.

    Now I can make my point. Ted and Regina have very different opinions about the value of XYZ Corp., in spite of the fact that they agree about a lot of things. Consider the following:

    They agree that the dividend discount model is a valid way to price stocks.They agree that the constant growth assumption is reasonable for XYZ Corp.They agree on the 50% dividend payout rate.Their expected growth rates differ by only 20 basis points.Their estimates of XYZ's cost of equity differ by only 20 basis points.Their estimates of next year's dividend differ by just 15 cents.

    In spite of their like-mindedness on so many issues, they have very different opinions about the value of XYZ stock. This is one of the most frustrating aspects of active portfolio management; the estimated value of a company can be highly sensitive to small changes in the underlying projections. In another one of my classes, we used free cash flows instead of dividends to value the firm, but the valuations were still sometimes highly sensitive to small changes in certain variables. Sensitivity analyses revealed that seemingly inconsequential changes to variables like gross margin or fixed-asset turnover could have an astonishing effect on the valuation of some companies. This could be very frustrating for the student who was supposed to make a recommendation on a particular stock. If it's frustrating for a college student, what will it be for those who are trying to make a living by looking for undervalued stocks?

    A typical response to the foregoing might be, "I don't waste my time trying to forecast growth rates, profit margins, and so forth. I just apply an appropriate multiple to this year's normalized earnings and use that as my estimate of intrinsic value." This doesn't solve the problem, however. It takes the estimation error for all the underlying variables and combines it into a single, massive blob of estimation error for the overall multiple. Where is the precision in this approach?

    The mutual fund performance studies that have been published during the past few decades demonstrate that few if any professional investors are consistently able to earn abnormally high returns by picking stocks. This doesn't really surprise me. How can one be expected to detect valuation errors consistently when intrinsic value is such a difficult quantity to estimate? The picture of active managers dispassionately arriving at precise estimates of value and quickly pouncing on small pricing errors is unrealistic, mainly because estimates of value are frequently imprecise. Because valuing companies is a tough job, so is identifying pricing errors.

  • Report this Comment On March 16, 2009, at 4:44 PM, rollzone wrote:

    hello. Mr. Buffet has all my repect as an honest to himself investor; so i do not propose i can state exactly what he meant by an intrinsic value. an intrinsic value would be the life's blood of the product. if this product is a staple, and not a compulsive item: it has longer legs. if the product dominates the competition: with brand name recognition; and consistent performance quality; it has higher intrinsic value. how many more customers are projected to be using this product in the future: because of population and market growth; is a future cash flow (will robots reduce production costs, materials cost less, etc.). the gamble in investing is that overnight someone will replace a staple commodity with new technology. the soundness of Mr. Buffet's investments only reflects the stagnation of our own technological growth. i pray in the near future there will be twenty new Mr. Buffets; from radical ideas that less conservative investors are willing to gamble on.

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