Does Warren Buffett Really Think Index Funds Are Best for You?

Last week, a fellow Fool passed along an article to me titled "10 Investing Facts You Probably Don't Know -- but Should." The author of the article, Daniel Solin, is a senior vice president at Index Funds Advisors (which seems like a bit of an oxymoron to me), and has written a series of books that focus on investing in low-cost index funds. So it's of little surprise that many of his "investing facts" pointed investors toward -- you guessed it -- index funds.

Now don't get me wrong, I don't have anything against index funds, but I think some of Solin's investment "facts" misfire and one in particular stood out to me. Solin writes:

Warren Buffett advises investors to invest in index funds: Over the years, Buffett has repeatedly recommended that investors stick to low-cost index mutual funds. He even prefers them to ETFs, as he explained in an interview on CNBC in May, 2007.

Interestingly, as proof the article links out to a MarketWatch article that says -- right at the beginning -- that:

Warren Buffett reiterated his view that for most small investors who don't have time to research individual companies, cheap index funds are the best way to invest in the stock market. [emphasis mine]

The basic idea behind the "wisdom" of index funds comes from the efficient markets theory, which says that markets are efficiently priced so you're wasting your time by trying to pick individual stocks and outperform the market. Buffett has actually thumbed his nose at this theory on many occasions, including his 1988 letter to Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) shareholders:

Naturally, the disservice done to students and gullible investment professionals who have swallowed EMT has been an extraordinary service to us and other followers of Graham. In any sort of a contest -- financial, mental, or physical -- it's an enormous advantage to have opponents who have been taught that it's useless to even try. From a selfish point of view, Grahamites should probably endow chairs to ensure the perpetual teaching of EMT.

Fun with semantics
If Solin chose his words a little more carefully, he actually could have been correct. Just about all people -- you, me, Derek Jeter, your cousin's mailman -- have a need to invest so that they can do things like send kids to college or retire. But even though all of these people are investing their money, I wouldn't call them all investors.

So what separates a true investor from everybody else? For one thing, a true investor feels the same way about the efficient market theory as Warren Buffett. That is, they see that while it may sound good to academics, it doesn't hold in the real world and the more the theory is accepted, the easier it makes it for true investors to find cheap stocks that EMT-followers aren't bothering to look for.

Maybe more importantly, investors are willing to pour time into research in order to track down bargain-priced stocks. Agreeing that mispricings exist is a start, but no real investor expects that undervalued stocks are simply going to fall into their laps without doing any research.

Now if we circle back to the original claim that Warren Buffett advises that investors stick to index funds, I think we can agree that it's simply not true. For the average person who doesn't have the time or interest to research individual stocks, Buffett likely would point them toward index funds. However, for investors who are willing to dive into Securities and Exchange Commission filings, industry research, and valuations, there's still good reason to track down the best deals in the market rather than simply buying the whole market.

Taking the efficient out of markets
There are many ways to go about tracking down undervalued stocks. The daily business news can provide some good ideas, you can drill down on a specific industry sector that you think has promise, Buffett has even claimed that he used to go through a list of all publicly traded stocks from A to Z looking for interesting investments.

Personally, I like to use screens. This allows you to pull up a list of stocks that meet certain criteria -- valuation multiples, company performance metrics, insider ownership, etc. Of course these lists are only a starting place for investors as more research is always needed since the numbers don't always tell the whole story.

Here are a few of the stocks that one of my favorite screens -- which looks for dividends, low price-to-earnings multiples, and high returns on capital -- spits out.

Source: Capital IQ, a Standard & Poor's company.

The statistical criteria that I set out in the screen drastically reduce the stock universe from thousands to (in this case) 83. But the real work starts with digging into the 83 to figure out which are actually worthwhile investments.

For instance, investors need to get comfortable with the future of cigarettes and litigation risks if they want to dive in and invest in Philip Morris International. With H&R Block, they have to decide whether the blockheaded decision to get into mortgage lending (since discontinued) was a one-time screw-up or if the tax-prep expert will continue to get in its own way.

Garmin was once the high-flying king of personal navigation, but investors now need to figure out whether a shifting competitive landscape and the rise of phone-embedded GPS will hobble the company. Pitney Bowes is grappling with a similarly shifting industry as it tries to fit its mail services into an increasingly electronic world. And, finally, Intel has been firing on all cylinders as demand for its chips spiked post-recession -- but have the recent good times simply been the peak of a cyclical swing?

So, are you a real investor?
Let's face it, everyone would like to have other investors eat their dust as they trounce the market with amazing stock picks. But the real investors actually relish digging into businesses to figure out whether the market has overlooked a bargain. Those true-blue investors can do well over the long term by continuing to look for individual stocks.

A non-investor ... well, they would rather watch a Dharma and Greg rerun, reorganize their closet, or go to the dentist. These folks are best advised sticking with the advice from Daniel Solin -- and Warren Buffett and Jack Bogle -- and picking up some low-cost index funds.

Real investors only: My fellow Fools have put together a free report detailing five stocks that The Motley Fool owns and they think you should own, too.