If you haven't noticed, we happen to like Warren Buffett a lot at The Motley Fool.
The reason for our admiration is that Buffett has a tendency to cut through the emotions and day-to-day hoopla that plagues traders and is able to simplify investing to a handful of core attributes. These attributes are what have allowed his conglomerate, Berkshire Hathaway (BRK.B -0.30%) (BRK.A -0.36%), to outperform the broad-based S&P 500 in terms of book value growth in 39 of the past 48 years. That isn't luck -- it's the dedication of a master investor.
What might be most remarkable of all is that what Warren Buffett uses to gauge where to put his money is no different from the tools you have available to you. He's just more disciplined and methodical about his investing strategy than the majority of investors. The good news is that you can invest just like Warren Buffett if you're willing to follow five easy steps.
Keep in mind investing like Buffett isn't a strategy that guarantees success – Berkshire Hathaway did lose to the S&P 500 last year. However, Buffett's track record speaks for itself and it would certainly appear to give you a better chance than not of growing your wealth than seeing it shrink.
If the prospect of growing your nest egg intrigues you, perhaps it's time to apply these five steps and invest like Warren Buffett.
When qualifying your investment, ask yourself these five questions:
1. Can I explain this business to someone else in one sentence?
Perhaps one of the bigger differentiating factors that separate Warren Buffett from your average trader who holds a stock for a matter of weeks is his keen understanding of the companies he holds. Not only can Buffett dissect a balance sheet and analyze a cash flow statement, but he seeks out businesses that he can easily understand. The thought here is that if he can understand it with ease, so can many tiers of investors, from novices to Wall Street mavens.
Being able to explain what a business does succinctly is one of the primary reasons you'll see Buffett's portfolio filled with financial and consumer goods companies and generally light on health-care and technology companies.
Take Berkshire's largest holding by market value, Wells Fargo (WFC 1.04%), as the perfect example. Banks might scare some investors away since we're just five years removed from the worst banking crisis we've witnessed in seven decades. However, Wells Fargo has avoided dabbling into tricky derivatives hedges like peer JPMorgan Chase, leaving it to focus on core banking activities like lending and attracting deposits. These may be "boring" banking activities on the surface, but they provide stability and steady growth, which has helped buoy Wells Fargo's share price much more so than its other large money center peers.
By contrast, you're probably not going to catch pharmaceutical giant Roche in Berkshire's portfolio anytime soon, since it has more than 100 ongoing clinical trials that Buffett simply doesn't have the time or energy to follow or quantify. Buffett likes to keep things simple, and it all starts with understanding the basic business.
2. Would I be willing to hold onto this investment for 10, 20, or even 30 years?
Secondly, Buffett believes in a holding period of forever. Theoretically, things may change that necessitate selling your investment, including a divergence from your fundamental thesis, but Buffett approaches each purchase with the idea that if the stock market shut down for the next 10 years or longer his investments would be just fine.
This comes back to one of the core principles of Buffett that you're not buying stocks, you're buying a business. So while the latest technology trend might spark fervor among investors, you have to ask yourself whether you truly believe that the latest hot trend in tech will be thriving 10 years from now. It seemed inconceivable that Myspace wouldn't be around in a decade 10 years ago, but look what happened. Could the same thing happen to Facebook or Twitter? It certainly seems unlikely right now, but it's not out of the question.
This is where seeking out a brand-name product developer like Coca-Cola (KO -0.20%) makes so much sense. Coca-Cola is Berkshire's second-largest holding by market value, and it possesses incredible global brand recognition (94% global logo recognition, according to Business Insider) and practically unsurpassed top and bottom-line stability directly correlated to its geographic diversity (Coca-Cola operates in all but two countries around the globe). Carbonated and distilled beverages aren't exactly a high growth business like social media, but it's also not a business model that's going to change or be replaced anytime soon.
3. Do I believe/have trust in the management team currently running the company?
This question will come with a bit of an asterisk as Buffett prefers to buy into sound business models, since he's been quoted as saying: "I try to buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will." By this context it would appear that Buffett has little credence for the capabilities of most management teams, and focuses solely on a business's potential.
However, I would contend that an effective and ethical management team is what helps drive growth at the businesses that attract Buffett in the first place. Buffett is entirely right when he says the business should be so great it essentially runs itself, but top-tier management teams are what allow Buffett's Berkshire Hathaway to purchase companies and continue to deliver strong results while on cruise control. Berkshire's management style as a holding company is very hands-off, so Buffett does, to some extent, rely on strong and ethical management teams to deliver solid results.
4. Does the business offer a basic necessity product, or can it run itself?
Extending our talk from No. 3, the next question you'll want to ask yourself is whether the business you want to buy into has a basic necessity or highly inelastic product. Buffett has a tendency to buy into what would be perceived as boring businesses, but that's only because they're investments that produce consistent cash flow thanks to the necessary and predictable products they offer.
Two great examples here would be Berkshire's recently announced purchase of NV Energy and its fifth-largest holding, Procter & Gamble (PG -0.40%).
NV Energy is an electric utility in Nevada that isn't likely to see a big increase or decrease in energy demand regardless of whether we're in a recession or a booming economy. We need electricity to cook, heat our homes, and perform a number of other tasks, and it's simply not an expense that many of us would be willing to cut out of our everyday lives.
Likewise, Procter & Gamble is a consumer-goods giant that produces dozens of household items that offer inelastic demand and pricing. Detergent and toothpaste, for instance, need to be bought in any economic environment, which gives P&G little incentive to ever lower its price on its Tide detergent or Crest toothpaste. This consistent demand and strong pricing power lead to a relatively solid operating model that has delivered exceptional long-term results -- and in Procter & Gamble's case, a 56-year streak of increasing dividends.
5. Does the company pay a dividend?
Last, but certainly not least, although Buffett doesn't specifically target dividend-paying stocks, he certainly has a habit of picking them out for his investment portfolio. The reason this question is important is that dividends are only paid on a consistent basis at companies that exhibit steadily profitable results and cash flow. Dividends aren't a guarantee of investing success, but dividend-paying stocks are also far less likely to crash and burn than companies that don't pay a dividend.
The other overlooked aspect here is that dividend stocks provide supplementary income that, when reinvested, can compound your gains rapidly. With Buffett believing in buying and holding stocks for very long periods of time, buying into a company with a growing dividend would fit perfectly with that theme.