Warren Buffett is known as one of the greatest investors of our time and possibly of all time. Warren Buffett’s investing philosophy has been the subject of much study and research.
That’s no surprise considering his stock portfolio has yielded a compounded annual growth rate of around 19% over 50 years.
Compare that to 10.6% the S&P produced during that same period.
Putting that into perspective, if you invested 10,000 with the Oracle of Omaha 50 years ago you would end up with around $60 million in your portfolio. Yes, that’s right, I double-checked just in case!
If you are reading this you are probably wondering, what makes him so good? How can he accomplish such a high rate of return?
Truth is, Buffett’s investment philosophy is not that hard to grasp, as the legendary investor relies on some basic principles rather than using complex technical analysis tools or Excel-based financial models.
So, if you want to learn more about how he has achieved these eye-popping returns, keep reading and you’ll find out how “easy” it may be to invest like Warren Buffett.
Buffett’s Approach to Stock Picking
One of Mr. Buffett’s distinctive features when it comes to investing is that he prefers to see stocks as pieces of a business rather than isolated pieces of paper, or digital tickers in our modern context.
In this regard, Buffett’s first stock-picking advice is to understand the business before you invest in the stock.
This leaves aside technical analysis as a way to measure a stock’s value, as Buffett focuses on identifying businesses with strong competitive advantages that can eventually turn into market leaders.
The Oracle’s most famous analogy in this regard is to watch out for businesses that have built a “moat” around their castles, which means that it will be difficult for the competition to storm in and steal market share from them.
One good example of this is Coca Cola (KO) a business that Buffett has heavily invested in over time as he identified Coca Cola as a timeless brand and coke as a timeless product with no contestant capable of stealing its massive market share.
So far, he has been proven right.
The second most important aspect of Buffett’s investment philosophy is financial analysis.
In this sense, Buffett has mentioned that he spends most of his days reading annual reports from companies that interest him, seeking to identify potentially undervalued or fairly valued businesses.
As part of his analysis, Buffett evaluates a company’s net assets which can be calculated by deducting the company’s total liabilities from its current assets.
If the market value of the company is close to its net assets, that company is possibly a great investment opportunity.
Meanwhile, he also evaluates the company’s free cash flow, which results from deducting essential capital expenditures from the business operating cash flow, and uses that figure to determine the value of the company based on reasonable multiples.
Mr. Market’s Analogy
Another pillar of Buffett’s approach to stock picking is the way he deals with bear and bull markets.
In this regard, he uses an analogy from Benjamin Graham’s book, The Intelligent Investor, to describe how the stock market is constantly fluctuating and he uses an impersonation of the market he calls “Mr. Market” to portrait his behavior.
According to Graham, Mr. Market calls every day to buy or sell stocks to you and he is sometimes in a mood.
When he is optimistic about the future he will increase his prices and may continue to push those prices until you buy.
Meanwhile, when he is pessimistic about what’s going on, he may throw in significant discounts.
Buffett’s success can be attributed, to some extent, to the fact that he tries to buy shares at prices that are close to the intrinsic value of the company (fairly valued or undervalued stocks) while avoiding buying from Mr. Market during times when his optimism appears to be unfounded (overvalued stocks).
The Margin of Safety Principle
This principle is another cornerstone of Buffett’s philosophy and it consists of establishing a ‘margin of error’ for the analyst’s estimation of the company’s fair value.
This means that after conducting a sound financial analysis on the underlying business, the analyst should only buy the stock if there’s a reasonable margin of safety (MOS), suggesting at least a 30% MOS.
Let’s say that by your estimations, the fair value of Apple’s (AAPL) stock is around $291 per share, while its current market price is $276.
Based on the margin of safety principle, you can multiply your estimation by 0.70 (1 – 0.30) and the result would be the fair price at which you could safely buy Apple, giving your valuation some room in case you missed a few details.
In this hypothetical scenario, you would only buy Apple at $203.7 ($291 * 0.70) or below.
Are you ready to invest like Buffet?
Thanks for reading,
Options Trading IQ
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Gavin has written 8 books on options trading and you can find more from him at www.optionstradingiq.com