Where Buffett and Others Are Wrong

We are strong believers in learning from the masters -- of standing on the shoulders of giants, if you will. The people we list below have passed on immeasurable knowledge to us in the form of books, speeches, and interviews. They have inspired us beyond all reason, and today we're going to … take them down a few notches.

Curiosity feeds learning, and it can never be fully effective unless it's free to challenge whatever it encounters. In that spirit, we've picked out a core principle of six investing masters to quarrel with. Experienced investors with at least a decade of success under their belts may be able to put these principles to use, but most individual investors should question them.

1. Warren Buffett's punch card. Buffett suggests you think of investing like a 20-hole punch card, one for each stock you're allowed to buy in a lifetime. He wants investors to be absolutely sure about each purchase, and to counteract the temptation to trade actively and rack up excessive fees in commissions and taxes.

We applaud the intent, but oppose buying just 20 stocks in a lifetime. Instead, buy frequently and broadly, then apply Buffett's philosophy and set a reasonable limit on the number of stocks you're allowed to sell when you don't need the cash.

2. Benjamin Graham's cigar butt. Graham earned 20% yearly returns for decades by simply purchasing stakes in public companies whose shares traded below the value of their net net working capital (current assets minus all liabilities). It's like buying fixed assets for nothing and is an elegant system for locating deeply undervalued stocks.

But in most market environments, you won't find many that meet these criteria. Often, when you do, you'll own cigar-butt stocks with just a few puffs of value left in them. After factoring in the trading and tax costs of the approach, you won't keep up with long-term investors who found incredible historical gains in the likes of Microsoft (Nasdaq: MSFT), Oracle (Nasdaq: ORCL), and Nike (NYSE: NKE). These companies had a mixture of strong sales and free cash flow growth, superior returns on capital, heavy insider ownership, and healthy assets -- something you won't find in cigar-butt stocks. They still have these traits, which is one reason we both own one of these (Microsoft) today.

We have no quarrels with buying a few deep value stocks along the way, of course, but focus more of your attention on undervalued long-term growth stories.

3. Peter Lynch's earnings line. If you haven't read his classic book One Up on Wall Street, it should be the next thing on your list after "buy more milk." It's essential reading for investors who want to beat the market and thoroughly enjoy the experience. Lynch argues that the value of a company is based on the accounting profits it generates and that it will generate in the future.

We do, however, take issue with his enthusiasm for earnings-per-share figures. Free cash flow can give a much clearer look into corporate profitability. Enron, for example, had great EPS numbers but very little free cash flow as it headed toward bankruptcy -- while the Apples (Nasdaq: AAPL) and Ciscos (Nasdaq: CSCO) of the world generate tons of the green stuff and have rock-solid businesses. In fact, if you can find companies with free cash flow greater than net income, you'll go a long way toward avoiding the Enrons of the world and identifying undiscovered value.

The following companies clearly show they have ample real cash flow backing up their earnings, meaning their financial statements are far more trustworthy to us than free cash flow-poor businesses:

Data from Capital IQ, a division of Standard & Poor's.
LTM = last 12 months.

As you read Lynch's book, focus on free cash flow per share, and you'll find superior investments where others don't.

4. Shelby Davis' margin buying. Davis had a great method: He bought actively, sold rarely, diversified broadly, and yet stayed close to his circle of competence. This fueled the growth of his personal $50,000 portfolio into $900 million 47 years later.

But some of his success came because he aggressively used margin (buying stocks with borrowed money), which knocked his portfolio down from $50 million to $20 million during the bear market in the early '70s. No amount of money is worth facing the deep troubles many endured because they invested on margin heading into the recent crisis -- and lost fortunes.

5. John Neff's free plus. Neff generated outstanding pre-tax returns during his 30-year reign as manager of the Windsor Fund. In his writings, he's talked about the joy that his most successful investments brought as they unlocked value hidden from him. Neff looked for companies with low P/Es and the potential for unexpected new product applications, asset sales, and spinoffs that could take his stocks into "free plus" territory, where Neff earned much higher returns than he could have modeled.

Our problem isn't with holding out for the free plus. Exactly the opposite! We think Neff applied the principle too infrequently and thus sold too often. There are many more free plus situations out there, persisting longer than you might expect. When a company of yours doubles in a year, hold it if you think you can earn yearly gains of 12% over the next decade. That amounts to tax-deferred returns of 18% per year ... with the potential for more free plus gains.

6. Hetty Green's obsession. And finally, Hetty Green is one of America's greatest all-time investors. She was mathematical, frugal, and ambitious. By age 13, she was a full-time bookkeeper in her father's business. As an adult, she'd sprawl out on the floor at her brokerage firm, reading financial filings and placing orders. When she died in 1916, she left a fortune valued at $20 billion in today's dollars.

But she was also a miser. When her son seriously injured his knee in a sledding accident, she kept him from medical experts to save cash. His leg was eventually amputated. We advise you to save weekly and invest monthly, but act generously and live your life fully. Platinum and diamonds won't get you much in the graveyard.

Question us
In addition to the six things you've learned above, we hope you'll take away from this article the same questioning curiosity that we're using. This is part of our methodology at Motley Fool Stock Advisor, where we examine dozens of investing ideas each month. We're on a relentless quest for strong sales and free cash flow, high inside ownership, and strong balance sheets. We buy often and sell rarely, preferring to let our winners run.

In the eight years since inception, we've beaten the market by an average of 58 percentage points per recommendation. We invite you to look at our recommendations, question us, and see if you agree with our thinking. A 30-day free trial is on us, and includes our top five stocks to buy right now. Here's more information.

Fool co-founder Tom Gardner and analyst Rex Moore have long questioned the management philosophy of the Washington Redskins. Tom owns shares of Microsoft and Cisco. Rex owns shares of Microsoft. Microsoft is a Motley Fool Inside Value pick. Apple is a Motley Fool Stock Advisor recommendation. The Fool owns shares of and has written puts on Oracle. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool has a disclosure policy.