How Warren Buffett Wins at Investing

Most of us know the lessons that superinvestor Warren Buffett offers through his example. Buy and hold. Be greedy when others are fearful, and fearful when others are greedy. A frosty cherry cola complements any good steak. (OK, maybe not that last one.)

But we rarely step back and look at all of his principles as a whole -- even though his advice adds up to a powerful combination. Let's list his lessons, and then examine the one stock that unites them all.

Stick with what you understand
If we invest only in companies and industries whose workings we can easily grasp, we'll be less likely to end up blindsided. For many of us, that means pursuing retailers or consumer-product companies, instead of biotech specialists or even banks.

Buffett even avoids well-regarded technology companies, because he can't be reasonably sure of their competitive position or performance a few years down the road.

Ensure a margin of safety
Just because you understand a company doesn't mean you can flawlessly predict what will happen to it. That's why investing with a margin of safety is important -- it ensures that you aren't paying too much for what you'll likely get.

Most people would agree, for example, that Amazon.com (Nasdaq: AMZN  ) is a terrific company. The online megastore has revolutionized the retail industry and averaged 27% stock-price growth over the past 12 years. But opinions are divided on whether it's a compelling buy at recent levels, with its price-to-earnings (P/E) ratio north of 60.

Some, for example, think the new iPad outclasses Amazon's Kindle reader, while others see Amazon profiting mightily from book sales for the iPad. Most agree that the company's innovation, leadership, and growth rates are truly impressive. But at some point, even the best companies can be overvalued.

Buffett has said that he'd rather buy a great business at a fair price than a fair business at a great price. To seek out portfolio candidates that seem strong and undervalued, you might screen for those with high returns on equity, solid revenue growth, and low or reasonable P/E ratios. Here are a few companies that meet those criteria:

Company

ROE

3-Year Avg. Revenue Growth

P/E

Research In Motion (Nasdaq: RIMM  )

32%

71%

16

Hewlett-Packard (NYSE: HPQ  )

19%

6%

16

Gilead Sciences (Nasdaq: GILD  )

41%

32%

16

eBay (Nasdaq: EBAY  )

17%

13%

14

Best Buy (NYSE: BBY  )

20%

12%

15

Data: Motley Fool CAPS.

While P/E alone won't tell you whether something is undervalued, it will give you candidates for further research.

Quality, fussiness, and patience
Buffett likes sustainable competitive advantages. These can include brand power, economies of scale, and the hassle required for customers to switch to a competitor.

Think of Microsoft's ubiquity, and how its software comes pre-loaded on most computers purchased each day. Think of the power Wal-Mart (NYSE: WMT  ) wields over suppliers because of its dominance as a purchaser. These kinds of competitive advantages aren't likely to disappear easily.

Stick with it
Buffett picks great stocks, but he also holds on to them -- letting the power of compounding work in his favor. Microsoft, for example, has averaged 21% growth over 20 years, while Wal-Mart has averaged 12.5%. Sticking with great performers for decades has helped build many investors' fortunes.

Putting it all together
The more of Buffett's lessons you incorporate in your investing, the better you'll likely do. It's easy to disregard a lesson when it's inconvenient -- say, when you really want to own a certain stock that's overvalued -- but the true power of Buffett's maxims lies in their combination.

Want a stock that has it all, Buffettwise? Look no further than Wal-Mart. It's a fairly straightforward retailer, with few of the complicated business structures seen in other sectors. It dominates its industry, yet still has room to grow as it expands internationally and increases the scope of the goods it sells. (It's now a major player in the grocery industry, for example.)

Wal-Mart's return on equity tops 20%, and its net profit margin recently approached 4%, a respectable number for a retailer. Couple that margin with its massive $400 billion in revenue, and you've got a powerful profit-making formula.

In fact, Wal-Mart's return on assets and return on equity have both increased over the past few years. The company also offers a 2.2% dividend yield, which it has hiked by an annual average of 16.5% over the past five years -- income on top of growth. And our Motley Fool Inside Value team believes Wal-Mart remains undervalued by about 20%. With its strong brand and future promise, it's the kind of company that Buffett likes -- and indeed, in which he's invested.

By looking for -- and recommending -- companies like this, Inside Value has been beating the market by 7 percentage points on average. You can try it free for 30 days just by clicking here. There's no obligation to subscribe.

Longtime Fool contributor Selena Maranjian owns shares of eBay, Microsoft, and Wal-Mart. Best Buy, Microsoft, and Wal-Mart are Motley Fool Inside Value recommendations. Amazon.com, Best Buy, and eBay are Stock Advisor picks. Motley Fool Options has recommended a bull call spread position on eBay and a diagonal call position on Microsoft. The Fool owns shares of Best Buy. The Fool's disclosure policy prefers an old-fashioned cream soda with its medium-rare ribeye.


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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 April 20, 2010, at 4:30 PM, madmilker wrote:

    "Think of the power Wal-Mart (NYSE: WMT) wields over suppliers because of its dominance as a purchaser. These kinds of competitive advantages aren't likely to disappear easily."

    duh! all it took was for the nice people of South Korea and Germany to read this on Wal*Mart's China web page...

    "Wal-Mart China persists in local procurement which provides more job opportunities, supports local manufacture industry and promotes local economy. So far, 95% of merchandising sold at Wal-Mart China store are local products by which Wal-Mart has established business relations with nearly 20,000 suppliers. At Wal-Mart, we treat suppliers as partners and would like to develop with them. In 2008 Wal-Mart won the Supplier Satisfaction published by Business Information of Shanghai for five consecutive years."

    and ask themselves this...

    Does that support exports and jobs in Germany and South Korea in which they realized it didn't and that was the mean reason they took Sam Walton's advise.....

    "There is only one boss. The customer. And he can fire everybody in the company from the chairman on down, simply by spending his money somewhere else." -- Sam Walton

    This is what it takes when the people of a country takes pride in their flag and not at what they spend inside a supermarket.

    So....

    "These kinds of competitive advantages aren't likely to disappear easily."

    In which I say....

    Never underestimate the consumer.....they at times may not have very much money....

    but they all walk with a every large size when it comes to ba!!s.

  • Report this Comment On April 21, 2010, at 9:20 AM, sept2749 wrote:

    Nice style. Love the quote of "who the boss is"

    Made me happy today!

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