"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 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 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 Coca-Cola (NYSE: KO ) , Wells Fargo (NYSE: WFC ) , and Washington Post.
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 returns 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 that stand 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.
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.
The investing world is still abuzz over Berkshire's $44 billion acquisition of Burlington Northern Santa Fe (NYSE: BNI ) . Buffett has been bullish on railroads for years now -- Berkshire also owns stakes in Norfolk Southern (NYSE: NSC ) and Union Pacific (NYSE: UNP ) -- but this latest purchase has really upped the ante.
It's easy to see why Berkshire likes this type of company. Although operating a railroad requires loads of capital, these companies enjoy a permanent geographic barrier that protects them against new entrants -- the exact sort of economic moat Buffett's always searching for.
In addition, if you believe that oil prices are headed higher (and Buffett's bet on ConocoPhillips suggests that he does) or international trade is bound to increase, then owning a railroad is a smart way to profit from these trends.
Unfortunately, it appears the stock market has already figured this out, as railroad shares have surged in the aftermath of Buffett's announcement. But that doesn't mean we can't apply Buffett's wisdom elsewhere.
Another company that enjoys significant geographic advantages is Waste Management (NYSE: WM ) , the nation's largest trash hauler. As the owner of America's largest network of landfills, Waste Management enjoys steady demand for its services and strong pricing power. This enables the company to post impressive free cash flow, no matter how bad the recession gets.
Might Waste Management or No. 2 player Republic Services (NYSE: RSG ) be next on Buffett's shopping list? We'll have to wait until Berkshire files its next Form 13-F to know for sure.
Of course, that's the problem with following Buffett's stock picks -- we'll never know what he's buying today until long after the fact. In the meantime, another place to find great value-stock ideas is Motley Fool Inside Value. Philip Durell, the advisor 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. Philip is outperforming the market with this approach, used 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.
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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. Berkshire Hathaway, Coca-Cola, and Waste Management are Inside Value recommendations. Berkshire is also a Stock Advisor selection. Coca-Cola, Republic Services, and P&G are Income Investor picks. The Motley Fool owns shares of Berkshire Hathaway and Procter & Gamble. The Fool has a disclosure policy.