Easy and Practical Framework to Invest like Buffett and Beyond
Sometimes I’ll go to YouTube and look up a past episode of American Idol or something similar for a good laugh or inspiration.
On this day, I come across a video it happened to be a young lad coming in for an audition.
He has a great voice, bellows out a fantastic tune and nails it.
Or so I thought.
The judges look down and around, raise their eyebrows at each other and give him the “blank stare of death”.
One by one, they all agree that he doesn’t sing with his own voice. He’s simply imitating another successful artist. (Bono maybe? Can’t remember who.)
But it got me thinking.
When it comes to investing, copying ideas is fine as long as you know why.
It’s the lemming style of copying that is not advised. You’ll freak out at the first sign of bad news or volatility.
In fact, copying a broad range of ideas and allocating an even amount to each idea is better than trying to copy one or two.
But what about trying to copy a guru investor in terms of philosophy and strategy?
The typical path for an investor is:
- randomly read articles and news
- come across a famous investor they click with
- learn their process and adopt their methodology
For value investors, it’s usually Graham or Buffett.
You start with cheap cigar butts like net nets, or cheap based on the value of the balance sheet.
Then you start testing out the waters of arbitrage, buyouts, spin offs, derivatives and so on.
You then look up companies with high competitive advantages, whatever that means to you at the time.
The focus then shifts to long term potential growth and strategy of a company.
Value investors pretty much start at the same position in terms of their investment journey and progress as I outlined above.
Here’s where it changes.
A fork in the road occurs.
Of the group of value investors, one group is steady and continues to do well – but not outstanding or astonishing.
Don’t get me wrong. There is nothing wrong with this group because your portfolio continues to compound.
Let’s say 5 to 10 percent CAGR.
However, the second group smashes through a barrier to greater investment success.
15+ percent CAGR. Wow.
This second group of investors continue to evolve and grow by challenging their own ideas, reasoning, strategies and methodology. They look for differing opinions in order to identify areas their weaknesses.
They aren’t afraid of being wrong or proven wrong.
Being right isn’t the goal.
Investment success is the goal.
Getting back to the young singer example, if Buffett stuck with practicing only what he learned from Graham, Berkshire Hathaway would be a very well known hedge fund.
Not the Berkshire we know today.
Buffett took everything he learned from Graham, applied and mastered it.
He then “pivoted” to a new course with better ideas and has continued to do learn and evolve for decades – catapulting him to the position of second richest person in the world.
Buffett stood on Graham’s shoulders.
There are thousands of people standing on Buffett’s shoulders, but no one has been able to exceed him yet.
Hopefully somebody from the Old School Value community will.
Practical Framework of Buffett’s Launching Pad
Learn, apply, master and improve.
Buffett’s Philosophy and style
Investment in stocks based on their intrinsic value, where value is measured by the ability to generate earnings and dividends over the years.
Buffett targets successful businesses—those with expanding intrinsic values, which he seeks to buy at a price that makes economic sense, defined as earning an annual rate of return of at least 15 percent for at least five or 10 years.
Universe of stocks
No limitation on stock size, but analysis requires that the company have been in existence for a considerable period of time.
Criteria for initial consideration
Consumer monopolies, selling products in which there is no effective competitor, either due to a patent or brand name or similar intangible that makes the product unique. In addition, he prefers companies that are in businesses that are relatively easy to understand and analyze, and that have the ability to adjust their prices for inflation.
- A strong upward trend in earnings
- Conservative financing
- A consistently high return on shareholder’s equity
- A high level of retained earnings
- Low level of spending needed to maintain current operations
- Profitable use of retained earnings
Valuing a Stock
Buffett uses several approaches, including:
- Determining firm’s initial rate of return and its value relative to government bonds: Earnings per share for the year divided by the long-term government bond interest rate. The resulting figure is the relative value—the price that would result in an initial return equal to the return paid on government bonds.
- Projecting an annual compounding rate of return based on historical earnings per share increases: Current earnings per share figure and the average growth in earnings per share over the past 10 years are used to determine the earnings per share in year 10; this figure is then multiplied by the average high and low price-earnings ratios for the stock over the past 10 years to provide an estimated price range in year 10. If dividends are paid, an estimate of the amount of dividends paid over the 10-year period should also be added to the year 10 prices.
Stock monitoring and when to sell
Does not favor diversification; prefers investment in a small number of companies that an investor can know and understand extensively. Favors holding for the long term as long as the company remains “excellent”—it is consistently growing and has quality management that operates for the benefit of shareholders. Sell if those circumstances change, or if an alternative investment offers a better return.
Source: The Warren Buffett Way: Investing From a Business Perspective
Doing It For Yourself
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