Buffett's Two Strategies
Nikhil is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Warren Buffett recently beat the S&P 500 for his 39th year. He is the enigma of investing, the "5-sigma event" that proves the point that many mutual fund managers want to avoid: It is possible to consistently beat the market. So for an investor who is looking for a way to beat the market, it might help to pay more attention to Buffett's strategy. Buffett's strategy has changed over the three main phases of his life, something that is explained in higher detail in this article. As it applies to the individual investor, his strategy can be broken down into two methods of investing: Assets and Earnings.
Value Investing In Assets:
When Benjamin Graham originally coined the term "Value Investing," he was referring to Asset investing rather than Earnings investing. Graham, and later Buffett, would find companies that were trading for below liquidation value and hold them until the market realized that market price was below the worst case scenario. This strategy when strictly followed, is known as Net-Net Working Capital Investing. The strategy dictates that you only buy stocks that are selling for less than Cash and Receivables less Total Liabilities. It would seem to be a riskless strategy, but I would leave it to the experts. The issue for individual investors emulating Buffett's liquidation value approach is that it requires a lot of meticulous research. Often Net-Net Working Capital stocks are valued as less than the worst case scenario because the market believes there is fraud involved. In other cases, the business has management that is burning through cash and reducing the Net-Net Working Capital too quickly. This risk makes it a difficult area of investment for anyone not willing to spend hours picking through SEC filings, however, if you do take on the work, it can pay off handsomely.
An Alternative to this strategy, which is more open to the individual investor, would be to invest in stocks selling for below book value. Buffett demonstrated his use of this strategy when he bought Bank of America(NYSE: BAC) back in August. When he bought Bank of America, it was trading for below half of its tangible book value. His investment is up 40% since then, and his warrants to buy Bank of America at 7.14 are probably worth over double their purchase price. The key to Buffett Style asset investing is that the company has to be able to turn itself around, so that it will be revalued above the value of its assets. Ultimately, I prefer earnings investing because of the long term quality of the investments; However, Asset value investing definitely has its place in a true buffett follower's portfolio.
Value Investing in Earnings:
This is really where an individual investor can benefit from following Buffett. The strategy here is more 'pure' Buffett in that he actually developed the strategy himself, unlike Asset Value investing which he got from Benjamin Graham. The key is to think about investing as if you were in private equity. Without market prices to guide your thinking, how would you intelligently invest? The most important thing is to reduce risk as much as possible by finding companies that share these attributes:
1. Benefits from strong fundamental economics of the business: Generally these businesses will not be highly capital intensive, so the business is able to turn profits faster than its competitors. These economics can come through either of 2 traits: High Margins or High Turnover. The Coca-Cola Company (NYSE: KO), for example, supports a 60% gross profit margin. On the other hand, Costco(NASDAQ: COST) has an inventory turnover of 12.4 compared to industry averages of 8.4(according to Fool.com-http://caps.fool.com/Ticker/COST/Ratios.aspx?source=icasittab0000007).
2. Benefits from a Durable Competitive Advantage: It's crucial that the business has each of these two criteria. First, a competitive advantage has to exist. In Berkshire Hathaway's (NYSE: BRK-A) acquisition of Burlington Northern Santa Fe, the competitive advantage was a natural business advantage over trucking, as railroads provide a more fuel efficient method of transportation. This competitive advantage was durable: trains won't become less fuel efficient than trucking in the near future.
3. Quality Management: Lastly, you need a business, and a management, that can provide high returns on your investment. For that, you need people who are able to achieve consistently high returns on equity without taking on too much debt. The Coca-Cola Company, for example, has had a return on equity above 27% every year for the last 10 years. Furthermore, management should be closely tied to the company and have a keen vision for the company's future. Generally the Durable Competitive advantage and the economics of the business should make the business that anyone could run successfully, but a good management is the key to transforming those business returns into investor returns.
Of course, the key to earnings based investing, as with asset based investing, is that buys should be made at a fair price. Where this price is will ultimately determine your return, and generally it is the patience required to buy in at ridiculous prices that makes Buffett so hard to copy. Buffett believes in a margin of safety of 25%; However, he tends to buy in at even cheaper prices when he can. He bought The Washington Post Company?(NYSE: WPO) at what he believed was an obvious 75% margin of safety. That investment, after a year or two of lounging with -25% performance, went on to blossom above a 1,000% return.
I hope you benefit from the Buffett Strategy in the future, it has clearly worked in the past.
Motley Fool newsletter services recommend Costco Wholesale and The Coca-Cola Company. The Motley Fool owns shares of Bank of America, Costco Wholesale and The Coca-Cola Company. shamapant has no positions in the stocks mentioned above. 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.