"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. In this case, the theory is clearly wrong.
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 American Express (NYSE: AXP ) , Lowe's (NYSE: LOW ) , and Johnson & Johnson (NYSE: JNJ )
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
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.
Lately, the financial media has made a big fuss over Buffett's involvement in the on-again/off-again Kraft (NYSE: KFT ) -Cadbury (NYSE: CBY ) acquisition, which has caused some of his recent stock selections to fly under the radar. For instance, Buffett just opened a position in The Travelers (NYSE: TRV ) , which provides property/casualty insurance.
Buffett has long had a soft spot for insurers, since they collect premium payments from customers long before they must pay out potential claims. In the meantime, insurers can earn a return on that cash -- known as the "float" in industry parlance. It's easy to see why Berkshire likes The Travelers. The company maintains a conservative investment portfolio and concentrates on profitable underwriting. And if Buffett's buying history is any guide, you can be confident that shares are trading at a discount to their intrinsic value.
So what will Buffett buy next? Unfortunately, we'll have to wait until Berkshire files its next Form 13-F with the SEC 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. In fact, Philip's recommendation from last month is a pick that Buffett would love -- an electric utility with stable free cash flow, strong competitive advantages, and a 4.3% dividend yield. To read more about this stock pick, 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 and The Motley Fool own shares of Berkshire Hathaway and Procter & Gamble. Berkshire Hathaway, American Express, and Lowe's are Inside Value recommendations. Berkshire is also a Stock Advisor selection. P&G and Johnson & Johnson are Income Investor picks. The Fool has a disclosure policy.