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Warren Buffett: How He Does ItWarren Buffett: How He Does It
Posted 19 March 2014 - 11:26 PM
By Investopedia Staff on September 04, 2013
It's not surprising that Warren Buffett's investment strategy has reached mythical proportions. A $8,175 investment in Berkshire Hathaway (NYSE:BRK.A) in January 1990 was worth more than $165,000 by September 2013, while $8,175 in the S&P 500 would have grown to $42,000 within the aforementioned timeframe. But how did Buffett do it? Below are the most important tenets of Buffett's investment philosophy.
Warren Buffett follows the Benjamin Graham school of value investing. Value investors look for securities with prices that are unjustifiably low based on their intrinsic worth. There isn't a universally accepted way to determine intrinsic wroth, but it's most often estimated by analyzing a company's fundamentals. Like bargain hunters, the value investor searches for stocks that he or she believes are undervalued by the market, stocks that are valuable but not recognized as such by the majority of other buyers.
Warren Buffett takes this value investing approach to another level. Many value investors do not support the efficient market hypothesis, but they do trust that the market will eventually start to favor those quality stocks that were, for a time, undervalued. Buffett, however, isn't concerned with the supply and demand intricacies of the stock market. In fact, he's not really concerned with the activities of the stock market at all. This is the implication in this paraphrase of his famous quote: "In the short term the market is a popularity contest; in the long term it is a weighing machine."
He chooses stocks solely based on their overall potential as a company - he looks at each as a whole. Holding these stocks as a long-term play, Buffett seeks not capital gain but ownership in quality companies extremely capable of generating earnings. When Buffett invests in a company, he isn't concerned with whether the market will eventually recognize its worth; he is concerned with how well that company can make money as a business.
Here we look at how Buffett finds low-priced value by asking himself some questions when he evaluates the relationship between a stock's level of excellence and its price. Keep in mind that these are not the only things he analyzes but rather a brief summary of what Buffett looks for:
1. Has the company consistently performed well?
Sometimes return on equity (ROE) is referred to as "stockholder's return on investment." It reveals the rate at which shareholders are earning income on their shares. Buffett always looks at ROE to see whether a company has consistently performed well compared to other companies in the same industry. ROE is calculated as follows:
= Net Income / Shareholder's Equity
Looking at the ROE in just the last year isn't enough. The investor should view the ROE from the past five to 10 years to gauge historical performance.
2. Has the company avoided excess debt?
The debt/equity ratio is another key characteristic Buffett considers carefully. Buffett prefers to see a small amount of debt so that earnings growth is being generated from shareholders' equity as opposed to borrowed money. The debt/equity ratio is calculated as follows:
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= Total Liabilities / Shareholders' Equity
This ratio shows the proportion of equity and debt the company is using to finance its assets; and the higher the ratio, the more debt - rather than equity - is financing the company. A high debt level compared to equity can result in volatile earnings and large interest expenses. For a more stringent test, investors sometimes use only long-term debt instead of total liabilities in the calculation above.
3. Are profit margins high? Are they increasing?
A company's profitability depends not only on having a good profit margin but also on consistently increasing it. This margin is calculated by dividing net income by net sales. For a good indication of historical profit margins, investors should look back at least five years. A high profit margin indicates the company is executing its business well, but increasing margins means management has been extremely efficient and successful at controlling expenses.
4. How long has the company been public?
Buffett typically considers only companies that have been around for at least 10 years. As a result, most of the technology companies that have had their initial public offerings (IPOs) in the past decade wouldn't get on Buffett's radar (not to mention the fact that Buffett will invest only in a business that he fully understands, and he admittedly does not understand what a lot of today's technology companies actually do). It makes sense that one of Buffet's criteria is longevity: value investing means looking at companies that have stood the test of time but are currently undervalued.
Never underestimate the value of historical performance, which demonstrates the company's ability (or inability) to increase shareholder value. Do keep in mind, however, that a stock's past performance does not guarantee future performance - the value investor's job is to determine how well the company can perform as it did in the past. Determining this is inherently tricky, but evidently Buffett is very good at it.
5. Do the company's products rely on a commodity?
Initially you might think of this question as a radical approach to narrowing down a company. Buffett, however, sees this question as an important one. He tends to shy away (but not always) from companies whose products are indistinguishable from those of competitors, and those that rely solely on a commodity such as oil and gas. If the company does not offer anything different than another firm within the same industry, Buffett sees little that sets the company apart. Any characteristic that is hard to replicate is what Buffett calls a company's economic moat, or competitive advantage. The wider the moat, the tougher it is for a competitor to gain market share.
6. Is the stock selling at a 25% discount to its real value?
This is the kicker. Finding companies that meet the other five criteria is one thing, but determining whether they are undervalued is the most difficult part of value investing, and it's Buffett's most important skill. To check this, an investor must determine a company's intrinsic value by analyzing a number of business fundamentals including earnings, revenues and assets. And a company's intrinsic value is usually higher (and more complicated) than its liquidation value - what a company would be worth if it were broken up and sold today. The liquidation value doesn't include intangibles such as the value of a brand name, which is not directly stated on the financial statements.
Once Buffett determines the intrinsic value of the company as a whole, he compares it to its current market capitalization - the current total worth (price). If his intrinsic value measurement is at least 25% higher than the company's market capitalization, Buffett sees the company as one that has value. Sounds easy, doesn't it? Well, Buffett's success, however, depends on his unmatched skill in accurately determining this intrinsic value. While we can outline some of his criteria, we have no way of knowing exactly how he gained such precise mastery of calculating value.
As you have probably noticed, Buffett's investing style, like the shopping style of a bargain hunter, reflects a practical, down-to-earth attitude. Buffett maintains this attitude in other areas of his life: He doesn't live in a huge house, he doesn't collect cars and he doesn't take a limousine to work. The value-investing style is not without its critics, but whether you support Buffett or not, the proof is in the pudding. He is one of the richest people in the world, with a net worth of more than $53 billion (Forbes 2013). Do note that the most difficult thing for any value investor, including Buffett, is in accurately determining a company's intrinsic value.
Posted 19 March 2014 - 11:49 PM
1. Trying to time the market. "People that think they can predict the short-term movement of the stock market — or listen to other people who talk about (timing the market) — they are making a big mistake," says Buffett.
2. Trying to mimic high-frequency traders. Buying stock in a good business and hanging on for the long term, he says, is a better strategy than flipping stocks like a short-order cook flips pancakes.
"If they are trading actively, they are making a big mistake," Buffett says.
3. Paying too much in fees and expenses. There's no reason to pay an expensive management fee to invest in a mutual fund when super-low-cost index funds that mimic large indexes like the Standard & Poor's 500-stock index are available, he says.
"If they are incurring large expenses in connection with their investing," says Buffett, "they are making a big mistake."
Buffett, of course, is famous for buying stocks when they are cheap, buying solid businesses that make a lot of money today and will make a lot of money tomorrow, and hanging on to his investments for a long time to better maximize profit potential.
Posted 21 March 2014 - 09:02 AM
Warren Buffet is undoubtedly the best man when it comes to making Investments. It is popularly said that his hands have a Midas touch and whichever investments he makes; it earns him a healthy profit. As per Forbes, Warren Buffet’s wealth has been estimated at a whopping 50 billion dollars (As of March 2011) and most of this wealth has been made through Investments But how does Warren Buffet do so? What is his Investment style that makes him unique and which no-one has been able to replicate since decades? A recent study conducted by LouAnn Lofton who studied the habits of the world’s most renowned investor has revealed that Warren Buffet’s investing style can be correlated to that of a woman. Yes, you read it right, Warren Buffet has a Feminine Investing Style.
Warren Buffet has time and again reiterated that it is the Temperament and not the Intellect that makes you a good long term investor. And a look back at the studies conducted on men and women in the past 10 years reveals that women tend to naturally have this temperament that creates Long Term Investing Success.
Men are more emotional when it comes to investing. They trade too much and view investing as a game. They are driven by ego, overconfidence and testosterone. They’re more likely to trade on hot stock tips and without doing enough research. Men were more likely to panic and sell at the bottom—at the exact wrong time. They were unable to control their emotions. Whereas women tend to be calmer and patient with a longer-term outlook.
Buffett is renowned for his research. He reportedly reads five newspapers a day and countless annual reports. Irrespective of how much knowledge he has about a company, he is always on the lookout for more knowledge.
And the same is the case with Women who tend to spend more time researching their Investments and tend to take less risk than men do. This prevents them from chasing hot tips and prevents them from whims. Women are also more likely to seek out Information that challenges their assumptions.
3. Time Horizon
Warren Buffet has always been a keen advocator of the fact that it is always advisable to let your Investment grow. He does not believe in Trading but rather focuses on Investing and prefers to Buy and Hold on to his Shares rather than looking out for some quick bucks by trading on short term tips.
And when the author compared the Investing Style of various men and women, the conclusions revealed that men trade 45% more often than women do, and although men are more confident Investors, they are more susceptible to becoming overconfident. By trading more often – and without much research – men end up reducing their net returns and increase Transaction Costs and Capital Gains taxes.
4. Trust your decisions
Warren Buffet believes in the fact that if after researching, you think it is a good time to sell while others think it is a good time to buy – always rely on your Research as others may be wrong.
And this is a trait which is commonly found in females. They aren’t susceptible to peer pressure as men are, which results in a more level-headed, patient approach to Investing.
The eight traits female investors share with Warren Buffett:
1. Trade less than men do
2. Exhibit less overconfidence: men think they know more than they do, while women are more likely to know what they don’t know
3. Shun risk more than male investors do
4. Be less optimistic, and therefore more realistic, than their male counterparts
5. Put in more time and effort researching possible investments, considering every angle and detail, as well as considering alternate points of view
6. Be more immune to peer pressure and tend to make decisions the same way regardless of who’s watching
7. Learn from their mistakes
8. Have less testosterone than men do, making them less willing to take extreme risks, which, in turn, could lead to less extreme market cycles