Buy the Stocks Warren Buffett Buys – at the Price He Pays!

Candice is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

In the spirit of the new book out by Carol Loomis, ‘Tap Dancing to Work,’ about Buffett’s writings in Fortune Magazine, I’d like to share my opinion on how I think people are misinterpreting Buffet’s advice.

Lots of people know about Buffett.  He is probably the most successful investor of our time and he has done it with a matter-of-fact, no-nonsense approach to business.  He invests in good businesses and good people. He gives them the autonomy and time to grow their business.  He writes a yearly ‘Letter to the Shareholders,’ which are published on Berkshire’s website for all to read--and many do read them in avid detail.  I actually find his writings relaxing.  Many people probably find that laughable, but give it a shot.  He likes to teach and mentor, and his ‘boil it down to what really matters’ way of thinking is different than most financial writing.  I also like how he lobbies the financial world to keep the financial types honest.  Just read his old letters about stock options that companies use to reward their employees.  These conversations give a good idea of how Buffett thinks and how his companies are held accountable.

Now for the warnings.  Lots of people follow and even idolize Buffett.  They watch what he is buying and selling, and try their best to copy his portfolio.  But I think they are missing the point.

How Buffett Picks Companies

First, Buffett does his homework.  He knows what the company is worth before he buys it and tries to watch for the value of the company to dip to his ‘Margin of Safety’.  For the uninitiated, this margin of safety is when the stock is selling 25% below what Buffett feels the company is worth.  In addition, it is considerably easier to buy at a discount price when you have the buying power of  Buffett.  He can negotiate a better price than you or I because he is ‘buying in bulk’.  Some investors think this is unfair – and maybe they are right – but it is basic economics (just ask Wal-Mart or Costco who bulk in vast quantities to offer us ‘Everyday low prices’).  If you want to be a part of this buy in bulk action, buy Mr. Buffett’s Berkshire Hathaway Berkshire Hathaway (NYSE: BRK-B). The stock is hard to evaluate in a traditional way as it is a mass of separate businesses, but you if you want to buy what Buffett buys then emulate his share buy back program and buy the stock when it dips to 110%-120% of its fair value, which Buffett currently has targeted for low- to mid-$80s.

Next, some try to emulate Buffett by buying what he buys.  Buffet is a large stockholder and has large investments in many companies, thus the SEC releases information on what he has traded and when.  This is not what he is trying to teach you.  Buying what he buys drives the price of the stock up and you pay more than fair value for a stock for which he has paid less than fair value.  This is the main reason why he eventually made Class B Berkshire Hathaway stock available.  He felt that many portfolio managers where getting ready to release ‘Buffet-copied’ portfolios to sell to the general public.  Since there is more to having a Buffett portfolio than simply owing the same stock, he arranged for a Class B Berkshire stock at a fraction of the cost of the original Class A shares.

So, what does Buffett really want to teach us?  I think he wants to teach us to think for ourselves.  He uses his own perspective (I’ll be it he has a vast knowledge of business he has built over many years) to evaluate business opportunities and profit from them.  He wants us to use our own talents and specialties to invest in the areas of business where we feel most comfortable.  We need to do our own homework and research to find the stocks we see as undervalued.

So let's look at a stock like The Coca-Cola Company (NYSE: KO), which Buffet famously owns.  The current price flutters in the $37 range, and the P/E is almost 20.  The 52-week stock price range is the $33.50 – $41 range.  The company has a worldwide network of bottlers to whom it delivers syrup and they convert to final product.  They also have a captive audience built up over the course of a century. The business is a solid brand with a loyal customer following, so it would definitely meet (and does meet) his requirement for a solid business with good people at the helm.  The numbers, however, do not point to a stock that is trading at a bargain.  Certainly many of us would love to own this stock darling, but if we give up our margin of safety, we increase our risk substantially.  This is not how Buffett would invest.

Buffett recently invested in International Business Machines Corp. (NYSE: IBM).  Many people found this out of character for him, because in the 90s, during the technology boom, he said he would not invest in technology as he did not understand the industry.  Again, I believe everyone is missing the point.  Buffett was uncomfortable during the early years of a growing industry with any company whose industry was not fully defined.  Since those early years the technology industry has grown and matured, much like a gawky teenager grows into a young adult.  The long-term picture for these industries is much clearer, and the business case is thus more definite.  That being said, most technology companies still show wide swings in price.  Just look at Apple’s 52-week range of $435 – $705.

In the case of IBM, the company was first known by this name in 1924, so we could definitely say the company has matured to a more stable and predictable state where Buffett would be more comfortable with regards to their future prospects.  They have a well-known brand and a management team committed to achieving the long-term targets set out in their ‘Road Map 2015.’  While Buffett was able to get his stocks at a discount in the range of $159 to $197, we can see from the current price, which flutters around the $200 mark, that the moment may have passed.  The P/E ratio is under 15, which implies an acceptable price, but the current price is still painfully close to its 52 week high of $211.79.

Another very important lesson Buffett teaches us is that everyone makes mistakes.  Buffet famously invested in US Air (NYSE: LCC) in the 1980s and has publicly admitted on many occasions that he wishes he hadn’t.  As recently as February 2008, in a letter to shareholders, Buffett has been known to give quotable lines about the perils of investing in airlines which require large investments to keep them operating.  With a P/E of just over 4, the stock may look like a bargain, but as our hero Buffett discovers, it also costs a lot to staff and airline and pay for new planes, fuel, etc.  The profit margins leave lots to be desired.  The current Gross Margin of about 30% could lead to adequate gains, but the Net Margin of just over 1% leaves little doubt that this industry teeters on the edge of profitability.  So once again, following Buffett into the stock market may not be your best investment.  The best lessons we can learn are sometimes reaped from our mistakes, and if we can learn from the mistakes of others, so much the better.

Buying Like Buffett

So, how do we find a Buffett stock without Buffett?  He obviously uses a very complicated calculation to determine fair value and then discounts it for his margin of safety.  He also goes beyond that to look at the business’ competitive advantage and its managers.  And he is patient.  Buffett waits for his moments and chooses his investment carefully.  This is his lesson to investors.  Before you invest, know what you are investing in and what you expect from that investment.  Then try to buy the stock at a good value and it will grow your wealth.

If you do not believe me, read the book!

candimunroe has no position in any stocks mentioned. The Motley Fool recommends Berkshire Hathaway and Coca-Cola. The Motley Fool owns shares of Berkshire Hathaway and International Business Machines.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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