HOW TO PICK STOCKS LIKE WARREN BUFFETT - Profiting From the Bargain Hunting Strategies of the World's Greatest Value Investor
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www.TheInvestorsBrain.com | www.100Mills.com
HOW TO PICK STOCKS
LIKE WARREN BUFFETT
Profiting From the Bargain
Hunting Strategies of the
World’s Greatest Value Investor
TIMOTHY VICK
TIMOTHY VICK is a senior analyst with Arbor Capital Management. He is also the founder and former editor
in chief of Today‟s Value Investor, a market newsletter. Mr. Vick is the author of Wall Street on Sale – How to
Beat the Market as a Value Investor. He also serves as a business consultant in the valuation and strategic
planning specialties. Mr. Vick is a graduate of Purdue University.www.TheInvestorsBrain.com | www.100Mills.com How to Pick Stocks Like Warren Buffett - Page 1
MAIN IDEA
Warren Buffett’s track record as an investor speaks for itself – he quite simply has no equals.
So how does he pick which stocks to invest in? The core strategy he uses is built around four clear and consistent principles:
1. Have the right investment philosophy – which will encompass everything from a long-term viewpoint to a feel for the numbers.
2. Analyze potential investments astutely – looking at earnings, return-on-equity and book value rather than stock price.
3. Avoid getting into a loss situation carefully and judiciously
4. Take into account and follow the general rules of good investment strategy – a mindset more than anything else.
Clearly, then, any investor aspiring to emulate Buffett’s results must first attempt to understand why he picks some stocks to invest in
and not others. As Warren Buffett himself has stated on a number of occasions, investing doesn’t have to be a difficult or complicated
activity so long as you are prepared to develop the right kind of intellectual framework.
Warren Buffett’s Investment Strategy
Principle #1 Principle #2 Principle #3 Principle #4
Have a street smart Analyze all potential Avoid getting into loss Obey the general rules of
investment philosophy. investments astutely. situations religiously. good investment strategy.
1 Understand the power of 1 Value a business solely 1 Avoid losses by locking in 1 Follow your own counsel.
c om p o u n d i n g as t h e on its future earnings, g ai ns an d t ak i ng th e
engine of growth in value. discounted for risk. m ar k e t ou t of t h e 2 Never be a price taker.
equation.
2 Buy low, concentrate your 2 Increase in book value is 3 Common sense outweighs
investments and watch the b es t a v a i l ab l e 2 Devote at least part of academic ideas.
costs to enhance returns. measure of growth. your p or t f o l i o to
uncon ventional 4 Ignore daily fluctuations.
3 Maximize gains with a 3 Use return-on-equity as a i n v es t m e n t s wh i c h
buy-and-hold strategy. predictor of future growth. guarantee a s pecif ied 5 Avoid relying on forecasts.
return.
4 Always take into account 4 Only buy stock that will 6 B u y a p i ec e of t h e
the future opportunity cost increase in value by at company, not a certificate.
of money. least 15-percent per year.
7 Shun arrogance.
5 D on ’ t t r y an d c r e at e 5 D on ’ t f ac t or i n a n
cause-and-effect in d ef i n it el y f avor ab l e 8 Make time your friend.
relationships where none future.
actually exist. 9 Don’t overanalyze.
6 Select stocks for stability,
Plan on staying actively not meteoric growth. 10 Stay with your strengths.
6
i n v ol v e d i n m ak i n g
investments for 30-years Pick stocks which have an 11 Look at worth and costs.
7
or more. earnings yield exceeding
12 Avoid perception props.
t h at of f er e d by
government bonds.
13 Seek companies that are
franchises.
14 Do your homework.
15 Don’t buy or sell simply
because its fashionable.
16 B u y s t oc k i n g o od
companies, not bargains.
Principle #1 – Have a street smart investment philosophy.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Pages 2 - 3
Principle #2 – Analyze all potential investments astutely. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Pages 4 - 5
Principle #3 – Avoid getting into loss situations religiously. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 6
Principle #4 – Obey the general rules of good investment strategy. . . . . . . . . . . . . . . . . . . . . . . . . . . Pages 7 - 8www.TheInvestorsBrain.com | www.100Mills.com How to Pick Stocks Like Warren Buffett - Page 2
Principle #1 “Investors have been so oversold on diversification that fear of
Have a Street Smart Investment Philosophy. having too many eggs in one basket has caused them to put too
little into companies they thoroughly know and far too much into
others about which they know nothing at all. It never seems to
1 Understand the power of compounding as the engine of occur to them that buying a company without having sufficient
growth in value. knowledge of it may be even more dangerous than having
inadequate diversification.”
Warren Buffett excels at holding stocks for a long period of time,
resisting the urge to trade incessantly. His main rationale for – Warren Buffett
such a long time frame is that while there may be short term “I put heavy weight on certainty. If you do that, the whole idea of a
inconsistencies, over the long run, there must be a perfect risk factor doesn‟t make any sense to me. You don‟t invest where
correlation between price and value. you take a significant risk. But it‟s not risky to buy securities at a
No force exerts more influence over the growth in value of a fraction of what they‟re worth.”
stock portfolio as time. Therefore, smart investors wait patiently – Warren Buffett
and let time work to their advantage by choosing good
companies and then waiting for the stock price to steadily 3 Maximize gains with a buy-and-hold strategy.
increase to match the growth in earnings of the company.
Compounding also amplifies the benefit of beating the market. If Warren Buffet avoids short term trading activities with a passion.
the general market is advancing at 10-percent per year and an To him, the ideal holding period is “indefinitely” and rapid trading
investor puts together a portfolio which performs just another 2- wastes money that could otherwise be applied to building
to 3-percent more per year, the end result after 30 or more years wealth.
of compound growth is very large. By buying-and-holding stock, not only are transaction costs
eliminated but continuity in evaluation methods exists. There’s
“Time is the friend of the good business, the enemy of the poor.”
no need to develop new ways to measure growth in value, and
– Warren Buffet
progress can be determined quite simply using year-to-year
“Watching great companies increase their sales and earnings measurements.
consistently is a dream come true for an investor. Strong
“Most of our large positions are going to be held for many years,
enterprises see their intrinsic value rise consistently, lifting the
and the scorecard on our investment decisions will be provided
stock every step of the way. The power of compounding begins
by business results over that period, and not by prices on any
working its magic as the years progress and allows your net
given day. Just as it would be foolish to focus unduly on
worth to gather momentum and increase (in dollar value) by
short-term prospects when acquiring an entire company, we
greater and greater amounts.”
think it equally unsound to become mesmerized by the
– Timothy Vick
prospective near-term earnings when purchasing small pieces
“The inescapable fact is that the value of an asset, whatever its of a company.”
character, cannot over the long term grow faster than its – Warren Buffett
earnings do.”
“In the real world, investors have a habit of wanting to change
– Warren Buffet
chairs, or at least getting advice as to whether they should, and
that costs money – big money. My estimate is that investors in
2 Buy low, concentrate your investments and watch American stocks pay out well over $100 billion a year to move
costs to enhance returns. around on those chairs or to buy advice whether they should! In
other words, investors are dissipating almost a third of
To enhance investment returns beyond the general market’s everything the Fortune 500 is earning for them by handing it over
performance, Warren Buffet uses three specific strategies: to various types of chair changing and chair-advisory „helpers‟.”
1. Buy stocks only when their market price is below the actual – Warren Buffett
value of that company – because these stocks will have the “Our goal is to have our shareholder-partners profit from the
greatest rate of growth in the years ahead. achievements of the business rather than from the foolish
2. Buy stocks in only as many companies as you can behavior of their co-owners.”
realistically keep watch on their financial performance – – Warren Buffett
which will invariably mean investing in at most 10 - 15 stocks.
“I am a better investor because I am a businessman, and a better
3. Eliminate all unnecessary costs – by minimizing businessman because I am an investor.”
commissions, avoiding frequent trades and automatically
– Warren Buffett
reinvesting dividends.
These three points are very simple and common sense, yet it is “Thousands of experts study overbought indicators, oversold
surprising how many investors ignore them and make things indicators, head-and-shoulder patterns, put-call ratios, the Fed‟s
more difficult for themselves. policy on money supply, foreign investment, the movement of
the constellations through the heavens and the moss on oak
“The investor who can rationally size up a company‟s prospects trees, and they can‟t predict markets with any useful
and be ready to pounce when the quote is right possesses an consistency, any more than the gizzard squeezers could tell the
insurmountable advantage over investors who follow each Roman emperors when the Huns would attack.”
others lead.” – Warren Buffett
– Timothy Vickwww.TheInvestorsBrain.com | www.100Mills.com How to Pick Stocks Like Warren Buffett - Page 3
4 Always take into account the future opportunity cost of 6 Plan on staying actively involved in making investments
money. for 30-years or more.
Warren Buffett is well known for being frugal and highly Warren Buffett is the consummate patient investor. He plans on
conservative in his personal and business expenditure habits. being intimately involved in making investment decisions
What’s less well publicized, however, is the reason for this – he forever. Therefore, he never feels under pressure to act. He
understands better than most the opportunity costs of any knows there will still be a large number of equally good offers
money spent rather than invested. tomorrow.
Opportunity cost reflects what the future value of money would In a similar vein, investors should never act on an offer just
be rather than simply its present value. For example, $100 because a stock is temporarily undervalued or simply because of
compounded at 25-percent per year for 30 years would be worth emotional factors. Instead, investors should wait patiently for the
$80,779. market price of good quality stocks to decline.
In essence, then, Warren Buffett knows that every dollar not For example, Warren Buffett identifies all the stocks he would
spent needlessly today can be turned into large amounts of like to own over the next several years, on the basis of the
capital in the future. From an opportunity cost perspective, all company’s value and potential for earnings growth. He also sets
spending decisions are simply opportunities for future wealth to a share price target at which he is willing to buy those shares. He
be won or lost. then waits and holds on to his cash. If the stocks do not fall to his
target price, he does nothing. He only buys when the stock
“No one advises you to give up pleasures, hobbies or a fun day at passes his predetermined buy point.
the ballpark for the sake of amassing a greater pile of wealth, but
great investors such as Buffett remain cognizant of the true costs “You should avoid the temptation of buying stocks simply
of their activities. If you can compound money at great rates, as because you have cash on hand, Buffett believes. More often
Buffett can, it behooves you to become a saver rather than a than not, a heavy wallet invites mistakes. At the beginning of
consumer.” 1999, Buffett was holding more than $35 billion in cash and
– Timothy Vick bonds in Berkshire Hathaway‟s investment portfolio. He was
content to hold this great sum of money, which was equal to the
total yearly output of dozens of smaller countries, indefinitely
5 Don’t try and create cause-and-effect relationships until he found suitably priced companies to purchase. In
where none actually exist. contrast, most investors feel a psychological need to put their
loose change to work almost immediately. Rather than wait
patiently for their favorite stocks to decline, they purchase
At its very heart, investment is a straightforward and simple shares of lower quality companies without spending time to
business activity. In fact, it’s really just a statistical game of study their fundamental properties.”
probabilities – quantify the risks, calculate the potential return, – Timothy Vick
decide the probabilities of various events occurring. Do that and
very quickly, a stock selection mechanism can be put in place. “In investments, there‟s no such thing as a called strike. You can
stand there at the plate and the pitcher can throw the ball right
Many professional investors try to make it more difficult,
down the middle, and if it‟s General Motors at $47 and you don‟t
however, by trying to factor in loads of complex variables. Or
know enough to decide on General Motors at $47, you let it go
they might undertake extensive comparative analysis exercises.
right by and no one‟s going to call a strike. The only way you can
However, Warren Buffett doesn’t do any of that. He simply
have a strike is to swing and miss.”
analyzes a company to try and determine what its most likely
– Warren Buffett
future earnings stream will be.
“The stock market doesn‟t compel you to act, although it may
“Extra care in thinking is not all good but also introduces extra
dearly tempt you. You‟ll never risk any cash by walking away
error. Most good things have undesired „side effects‟, and
from an investment you don‟t fully understand whose price isn‟t
thinking is no exception.”
attractive enough, and you‟ll improve your batting average in the
– Charles Munger
process. Once you discover a stock to your liking, one the
“The strategy we‟ve adopted precludes our following standard market has offered up at a ridiculously low price, swing for the
diversification dogma. Many pundits would therefore say the fences. Buffett notes that great opportunities truly are rare. You
strategy must be riskier than that employed by more may find two dozen such opportunities over a 20-year period.
conventional investors. We disagree. We believe that a policy of The number of good opportunities might be closer to 100. Poor
portfolio concentration may well decrease risk if it raises, as it opportunities number in the hundreds each day.”
should, both the intensity with which an investor thinks about a – Timothy Vick
business and the comfort level he must feel with its economic
“Investment is an activity of forecasting the yield on assets over
characteristics before buying into it.”
the life of the asset. Speculation is the activity of forecasting the
– Warren Buffett psychology of the market. If you are an investor, you are looking
“Full time professionals in other fields, let‟s say dentists, bring a at what the asset – in our case, business – will do. If you are a
lot to the layman. But in aggregate, people get nothing for their speculator, you are primarily forecasting on what the price will do
money from professional money managers.” independent of the business.”
– Warren Buffett – Warren Buffettwww.TheInvestorsBrain.com | www.100Mills.com How to Pick Stocks Like Warren Buffett - Page 4
Principle #2 complete and total control over. By contrast, management can
Analyze all potential investments astutely. do very little, if anything, to control the day-to-day market price of
their stock.
Therefore, from Warren Buffett’s perspective, increases (or
1 Value a business solely on its future earnings, decreases) in per-share book value is the most meaningful and
discounted for risk. reliable performance measure.
“A significant and growing number of otherwise high-grade
There are many sophisticated methodologies investors use to managers have come to the view that it‟s okay to manipulate
try and determine the future value of a business. Warren Buffett, earnings to satisfy what they believe are Wall Street‟s desires.
however, uses just one simple approach – he bases his Indeed, many CEOs think this kind of manipulation is not only
calculation of the value of a business on: okay but actually their duty. These managers start with the
1. Its current book value and earnings. assumption, all too common, that their job at all times is to
2. The possibility earnings will increase in the future. encourage the highest stock price possible (a premise with
3. The business risks involved in generating future earnings. which we adamantly disagree). To pump the price, they strive,
admirably, for operational excellence. But when operations don‟t
Once he has placed a value on a firm, Warren Buffett then
produce the result hoped for, these CEOs resort to unadmirable
decides whether the stock price being offered is reasonable. If
accounting stratagems that either manufacture the desired
so, he acts, otherwise he passes.
„earnings‟ or set the stage for them in the future.”
“It is an almost unbelievable fact that Wall Street never asks, – Warren Buffett
„How much is the business selling for?‟ Yet this should be the first
question in considering a stock purchase. If a business man
3 Use return-on-equity as a predictor of future growth.
were offered a 5-percent interest in some concern for $10,000,
his first mental process would be to multiply the asked price by
20 and thus establish a proposed value of $200,000 for the entire
Warren Buffett suggests the best and most reliable predictor of
undertaking. The rest of his calculation would turn about the
future success is to look for companies which have a
question whether the business was a „good buy‟ at $200,000.”
consistently high return-on-equity (ROE). This is simply because
– Benjamin Graham 1934
a high ROE necessarily leads to strong earnings growth,
“Charlie Munger and I have not learned how to solve difficult increases in stockholder’s equity, an increase in the company’s
business problems. What we have learned is how to avoid them. intrinsic value and a correspondingly increase in stock price.
To the extent that we have been successful, it is because we In evaluating ROE, keep in mind these points:
concentrated on identifying one-foot hurdles that we could step 1. High ROE achieved with little or no debt is better than
over rather than because we acquired any ability to clear equivalent ROEs attained with high debt.
seven-footers.”
– Warren Buffett 2. Different industries typically have different levels of debt –
and therefore varied levels of ROE rates.
“Where Buffett differs from most other business analysts is that 3. Stock buybacks impact on ROE – and can significantly
he assumes, correctly, that standards of valuation are universal. enhance an otherwise inferior ROE.
He is not swayed by new-era preachings that claim that
technology businesses deserve to be treated differently, or more 4. ROEs reflect the general business cycle and ebb and flow in
leniently, because of their novelty. All businesses must synch with economic conditions.
ultimately be judged by how they can convert sales to earnings 5. Restructuring charges, asset sales and one-time gains can
and the annual rate at which they can increase earnings. An also substantially impact on ROEs.
Internet company can be, and should be, valued by using the In practice, Warren Buffett strongly believes there is a strong
same yardsticks as a railroad, an electric utility, a software correlation between the trend of a company’s ROE and the trend
developer, a filmmaker or a retailer. All of these enterprises are of its future earnings. By focusing on ROE, investors can
worth no more and no less than the present value of their forecast future earnings with some degree of certainty.
expected earnings. If they are not expected to earn money
sometime in the future, they have no value.” “The investor cannot pinpoint just how much per share a
– Timothy Vick particular company will earn two years from now. As a matter of
fact, the company‟s top management cannot. Under these
circumstances, how can anyone say with even moderate
2 Increase in book value is the best available measure of precision just what is overpriced for an outstanding company
growth. with an unusually rapid growth rate? If the growth rate is so good
that in another ten years the company might well have
Warren Buffett focuses keenly on increasing the book value of quadrupled, is it really of such great concern whether at the
his company, Berkshire Hathaway. He believes that the more he moment the stock might or might not be 35-percent overpriced?
can grow the book value of his company, the more intrinsic value That which really matters is not to disturb a position that is going
and earnings will increase, which will lead in turn to a to be worth a great deal more later.”
correspondingly higher share price. – Warren Buffett
Equally, Buffett looks to invest in companies which have a
growing book value. He uses this as a key to assess the
competence of the firm’s management. This is a very rational
approach, since book value is something managers havewww.TheInvestorsBrain.com | www.100Mills.com How to Pick Stocks Like Warren Buffett - Page 5
4 Only buy stock that will increase in value by at least 6 Select stocks for stability, not meteoric growth.
15-percent per year.
The one key quality Warren Buffett looks for in a stock is
Warren Buffet’s rule-of-thumb is that he will only buy shares in a consistency – because consistency reduces risk in a portfolio.
company which he believes will increase its earnings by Other money managers and investors might be busy trying to
15-percent per year over a long period. Since there is a direct hitch their wagon to a star identifying a rapid growth stock, but
correlation (in his mind) between earnings and stock price, Buffett avoids volatile stocks with a passion.
Buffett then expects those stocks will appreciate in price by an And there’s only one way a stock can attain consistency – with a
equivalent 15-percent per year proven track record of solid earnings growth year-in and
To determine which stocks will generate a 15-percent yearly year-out.
growth rate, Buffett estimates what a company’s earnings will be “The classic case is Coca-Cola, which went public in 1919. We
in 10-years time and what its share price would be at that have had depressions. We have had wars. Sugar prices have
earnings level (assuming the industry’s average P/E ratio is gone up and down. A million things have happened. How much
maintained). If the future price and dividends does not generate more fruitful is it for us to think about whether the product is likely
an annual growth rate of 15-percent, he will pass on the to sustain itself and its economics than to try to be questioning
opportunity to buy shares. whether to jump in or out of the stock?”
“Put together a portfolio of companies whose aggregate – Warren Buffett
earnings march upward over the years, and so also will the “Let‟s say you were going away for 10 years and you wanted to
portfolio‟s market value.” make one investment and you know everything you know now,
– Warren Buffett and couldn‟t change it while you were gone. What would you
“It‟s a real tragedy when you buy a stock that‟s overpriced, the think about? I would want certainty, where I knew the market was
company is a big success and still you don‟t make any money.” going to continue to grow, where I knew the leader would
– Peter Lynch continue to be the leader – I mean worldwide – and where I knew
that there would be big unit growth. I just don‟t know anything like
“The price you pay determines your rate of return.” Coke.”
– Timothy Vick – Warren Buffett
“It doesn‟t have to be rock bottom to buy it. It has to be selling for 7 Pick stocks which have an earnings yield exceeding
less than you think the value of the business is, and it has to be that offered by government bonds.
run by honest and able people. But if you have to buy into a
business for less than it‟s worth today, and you‟re confident of
the management, and you buy into a group of businesses like Warren Buffett thinks of stock as a dynamic security that can
that, you‟re going to make money.” substitute for government bonds. The key difference is that
– Warren Buffett whereas bonds offer a known yield, a company’s earnings (and
therefore its stock price) is far more variable.
Thus, if you choose to buy a piece of stock rather than invest in a
5 Don’t factor in an indefinitely favorable future. bond, Buffett suggests it’s essential the company’s earnings:
1. Grow each year at a faster rate than inflation.
In an extended bull market, most investors tend to get caught up 2. Rise steadily over an extended time period.
in a momentum paradigm – they expect prices to move steadily 3. Generate a return exceeding that of bonds.
upwards indefinitely. Warren Buffet cautions against that kind of Inflation, in particular, is an important factor in investment
logic, and suggests long-term, a company simply cannot be strategy. Warren Buffett works on the basis inflation is an
worth more than what investors will ultimately take out of it in economic force that will always be present to one degree or
earnings. another. Therefore, instead of dismissing it lightly, every
For that reason, Warren Buffett insists on injecting a lot of investor’s strategy should make allowances for it.
common sense into his investment approach. He freely admits There is a highly correlative relationship between stocks, bonds
he cannot accurately pinpoint the exact future value of a and inflation. Over long periods, stock and bond prices will
company because of all the usual external factors. ultimately respond to the same economic factors. At various
times, stocks will generate earnings yields far exceeding those
“This concept of an indefinitely favorable future is dangerous, offered by bonds. By always looking at stock as a bond
even if it is true; because even if it is true you can easily substitute, Buffett is always positioned to place capital where it
overvalue the security, since you can make it worth anything you will generate the greatest gains.
want it to be worth. Beyond this, it is particularly dangerous too,
because sometimes your idea of the future turns out to be wrong. “Inflation is a far more devastating tax than anything that has
Then you have paid an awful lot for a future that isn‟t there. Your been enacted by our legislature. The inflation tax has a fantastic
position then is pretty bad.” ability to simply consume capital. It makes no difference to a
– Benjamin Graham widow with her savings in a 5-percent passbook account
whether she pays 100-percent income tax on her interest
“Humans are not hard wired to rationally weigh risk and reward. income during a period of zero inflation or pays no income taxes
We are still better suited to run when we see a saber-toothed during years of 5-percent inflation. Either way, she is taxed in a
tiger than to consider potential returns of intangible assets.” manner that leaves her no real income whatsoever.”
– Warren Buffett – Warren Buffettwww.TheInvestorsBrain.com | www.100Mills.com How to Pick Stocks Like Warren Buffett - Page 6
Principle #3 2 Devote at least part of your portfolio to unconventional
Avoid getting into loss situations religiously. investments which guarantee a specified return.
In addition to taking long-term buy-and-hold positions in stocks,
1 Avoid losses by locking in gains and taking the market Warren Buffett also invests in arbitrage trades for publicly
out of the equation. announced takeovers. The returns generated in this type of
activity can be substantial, and can serve as a buffer against any
When Warren Buffett was asked to summarize the essence of losses which can be generated by stock trading activities.
good investing once, he said it all came down to two simple rules: The concept is actually quite straightforward. When a public
Rule Number 1: Don’t lose money. company announces that it is going to acquire or merge with
Rule Number 2: Don’t forget rule number 1. another company, there are always regulatory hurdles to be
cleared. Therefore, the market price of stock in the company
Buffett, of course, has excelled at avoiding losses over his entire being acquired will not always align precisely with the price the
portfolio. He has made occasional mistakes on individual stocks
acquiring company is willing to pay. This discrepancy in pricing
(attracting considerable comment) but long-term, he’s managed creates a short term investment opportunity a savvy investor like
to adroitly avoid yearly losses over his entire portfolio. Buffett can exploit.
Throughout his investing career, what Warren Buffett didn’t buy
Arbitrage, in this situation, means to capture the spread between
has probably contributed as much to his performance as what he the existing market price of a stock and the price the acquiring
did purchase. At times, he has been an active buyer, while for company has publicly stated it is willing to pay at some time in the
extended periods, Buffett has been prepared to wait on the future. By buying stock in the company soon to be acquired,
sidelines for better market conditions to arrive. Warren Buffett is able to generate some quite impressive
Generally speaking, Warren Buffet looks at these factors in returns. In addition, this is an activity which can be undertaken
trying to decide whether or not the time seems right to become quite consistently. Every day, around 10 - 20 mergers are
active in buying stocks: announced. Many of these create impressive opportunities to
1. The stock yields to bond yields ratio. generate profits for investors that are smart and quick to act.
If bond yields overtake stock yields, the market is To invest profitably in arbitrage deals:
overvalued. Buffett only gets active when earnings yields
1. Invest in publicly announced cash deals and not in
(the inverse of P/E ratios) are above bond yields.
transactions that involve share swaps.
2. The rate of climb of the stock market.
2. Before taking a position, calculate the probabilities and the
The market cannot climb indefinitely at rates exceeding the
potential return. If you can’t make 20- to 30-percent, it’s not
growth of economic output. Expect a correction when stock
worth getting involved.
prices have risen too far too fast. And conversely, expect a
boost to the market when stock prices are falling while the 3. Make sure the deal will ultimately get consummated,
economy is surging. Long term, these two always match up. otherwise you could lose out in a big way.
3. The prevailing P/E ratios. 4. Make arbitrage a boost for your profits rather than your sole
When P/E ratios are growing at an unsustainable rate, business activity.
investors should anticipate a correction taking place very 5. Don’t be afraid to buy arbitrage stocks on margin if you’re
soon. highly confident the transaction will ultimately proceed.
4. The general state of the economy. “We sometimes engage in arbitrage as an alternative to holding
When the economy is in a depression, there will frequently short-term cash equivalents. We prefer, of course, to make
be some very good buys available in stocks. That’s the time major long-term commitments, but we often have more cash
to load up on stocks. Conversely, when the economy is
than good ideas. At such times, arbitrage sometimes promises
running at full throttle, stocks will already be highly valued. much greater returns than Treasury bills and, equally important,
That’s the time to be selling stocks rather than buying them. cools any temptation we may have to relax our standards for
5. The big picture. long-term investments.”
Higher stock prices don’t exist in a vacuum – they must be – Warren Buffett
linked to economic fundamentals. Therefore, keep an eye on
the fundamentals, and whether or not they can reasonably “At any given time, we may be in 10 to 15 arbitrage situations;
be expected to sustain higher stock prices. some just beginning and others in the late stage of development.
I believe in using borrowed money to offset a portion of our
“Warren Buffett owes his success through the years as much to workout portfolio since there is a high degree of safety in this
what he didn‟t buy as to what he did. Likewise, what he sold – category in terms of eventual results and immediate market
and when he sold it – played just as prominent a role in his behavior.”
returns as did decisions to buy and hold Coca-Cola, GEICO or – Warren Buffett
Gillette.”
– Timothy Vick “In the short run, the market is a voting machine but in the long
run, it is a weighing machine.”
“The market is there only as a reference point to see if anybody is – Benjamin Graham
offering to do anything foolish. When we invest in stocks, we
invest in businesses.”
– Warren Buffettwww.TheInvestorsBrain.com | www.100Mills.com How to Pick Stocks Like Warren Buffett - Page 7
Principle #4
5 Avoid relying on forecasts.
Obey the general rules of good investment strategy.
“I have no use whatsoever for projections or forecasts. They
1 Follow your own counsel. create an illusion of apparent precision. The more meticulous
they are, the more concerned you should be. We never look at
“You have to think for yourself. It always amazes me how many projections, but we care very much about, and look very deeply,
high-IQ people mindlessly imitate. I never get good ideas talking at track records. If a company has a lousy track record, but a very
to other people.” bright future, we will pass on the opportunity.”
– Warren Buffett – Warren Buffett
“If you have formed a conclusion from the facts and if you know “We essentially spend no time thinking about macroeconomic
your judgement is sound, act on it – even though others may factors. We simply try and focus on businesses that we think we
hesitate or differ. You are neither right nor wrong because the understand and where we like the price and management. We
crowd disagrees with you. You are right because your data and try to price rather than time purchases.”
reasoning are right.” – Warren Buffett
– Warren Buffett
6 Buy a piece of the company, not a share certificate.
2 Never be a price taker.
“Investing is found in the attitude towards stock-price
“In any sort of a contest – financial, mental or physical – it‟s an movements. The speculator‟s concern is anticipating and
enormous advantage to have opponents who have been taught profiting from stock-price fluctuation. The investor‟s primary
that it‟s useless to even try. In today‟s investment world, most interest is in acquiring and holding suitable securities at suitable
professionals and academics talk of efficient markets, dynamic prices. Market fluctuations are important to the investor because
hedging and bvetas. Their interest in such matters is they create low price levels to buy and, alternatively, high price
understandable, since techniques shrouded in mystery clearly levels to refrain from buying. The investor with a portfolio of great
have value to the purveyor of investment advice. After all, what businesses should expect prices to fluctuate and should neither
witch doctor has ever achieved fame and fortune by simply be concerned by sizable declines nor be wildly excited by sizable
advising „Take two aspirins‟?” advances.”
– Warren Buffett – Warren Buffett
3 Common sense outweighs academic ideas. 7 Shun arrogance.
“To invest successfully, you do not need to understand beta, “The first principle is that you must not fool yourself and you‟re
efficient markets, modern portfolio theory, option pricing or the easiest person to fool.”
emerging markets. You may, in fact, be better off knowing – Richard Feynman, Nobel laureate and physicist
nothing of these. That, of course, is not the prevailing view at
most business schools, whose finance curriculum tends to be “Virtually every investment expert‟s public assessment is that he
dominated by such subjects. In our view, though, investment is above average, no matter the evidence to the contrary.”
students need only two well-taught courses – How to Value a – Warren Buffett
Business and How to Think About Market Prices.”
– Warren Buffett 8 Make time your friend.
“I have seen no trend toward value investing in the 35-years I‟ve
practiced it. There seems to be some perverse human “There is also another alternative: Don‟t do anything. More
characteristic that likes to make easy things difficult.” fortunes are made by sitting on good securities for years at a
– Warren Buffett time than by active trading.”
– Warren Buffett
4 Ignore daily fluctuations. “When you‟ve found the right stock and bought it, and all the
evidence tells you it‟s going higher, and everything is working in
“For some reason, people take their cues from price action rather your direction, then it‟s a shame if you sell. A fivefold gain turns
than from values. What doesn‟t work is when you start doing $10,000 into $50,000, but the next five folds turn $10,000 into
things that you don‟t understand or because they worked last $250,000. Investing in a 25-bagger is not a regular occurrence
week for somebody else. The dumbest reason in the world to even among fund managers, and for the individual, it may only
buy a stock is because it‟s going up.” happen once or twice in a lifetime. When you‟ve got one, you
– Warren Buffett might as well enjoy the full benefit.”
– Warren Buffett
“I never attempt to make money on the stock market. I buy on the
assumption that they could close the market the next day and not “Time is the enemy of the poor business and the friend of the
reopen it for five years.” great business. If you have a business that‟s earning 20% - 25%
– Warren Buffett on equity, time is your friend. But time is your enemy if your
money is in a low return business.”
– Warren Buffettwww.TheInvestorsBrain.com | www.100Mills.com How to Pick Stocks Like Warren Buffett - Page 8
9 Don’t overanalyze. 13 Seek companies that are franchises.
“Investors should remember that their scorecard is not “The key to investing is not assessing how much an industry is
computed using Olympic diving methods: Degree-of-difficulty going to affect society, or how much it will grow, but rather
doesn‟t count. If you are right about a business whose value is determining the competitive advantage of any given company
largely dependent on a single key factor that is both easy to and, above all, the durability of that advantage. The products or
understand and enduring, the payoff is the same as if you had services that have wide, sustainable moats around them are the
correctly analyzed an investment alternative characterized by ones that deliver rewards to investors.”
many constantly shifting and complex variables.” – Warren Buffett
– Warren Buffett
“The stock market is a no-called-strike game. You don‟t have to 14 Do your homework.
swing at everything – you can wait for your pitch. The problem
when you‟re a money manager is that your fans keep yelling, “I don‟t think you can really be a good investor over a broad
„Swing, you bum!‟.” range without doing a massive amount of reading. You might
– Warren Buffett think about picking out 5 or 10 companies where you feel quite
familiar with their products, but not necessarily with their
10 Stay with your strengths. financials. Then get lots of annual reports and all of the articles
that have been written on those companies for 5 or 10 years.
Just sort of immerse yourself. And when you get all through, ask
“Intelligent investing is not complex, though that is far from yourself, „What do I not know that I need to know‟?”
saying that it is easy. You don‟t have to be an expert on every – Warren Buffett
company, or even many. You only have to be able to evaluate
companies within your circle of competence. The size of that
circle is not very important; knowing its boundaries, however, is 15 Don’t buy or sell simply because it’s fashionable.
vital. Your goal as an investor should simply be to purchase, at a
rational price, a part interest in an easily-understandable “We don‟t get paid for activity, just for being right. As to how long
business whose earnings are virtually certain to be materially we‟ll wait, we‟ll wait indefinitely. You do things when the
higher five, ten and twenty years from now. Over time, you will opportunities come along. I‟ve had periods in my life when I‟ve
find only a few companies that meet those standards – so when had a bundle of ideas come along, and I‟ve had long dry spells. If
you see one that qualifies, you should buy a meaningful amount I get an idea next week, I‟ll do something. If not, I won‟t do a damn
of stock.” thing.”
– Warren Buffett – Warren Buffett
11 Look at worth and costs. 16 Buy stock in good companies, not bargains.
“The strange thing – it‟s a real contradiction – is that if a business “Price fluctuations have only one significant meaning for the true
is earning a given amount of money and everything else is equal, investor. They provide him with an opportunity to buy wisely
the less it has in assets, the more it‟s worth. You won‟t get that in when prices fall sharply and to sell wisely when they advance a
an accounting book. The really desirable business is that one great deal. At other times he will do better if he forgets about the
that doesn‟t take any money to operate because it‟s already stock market and pays attention to the operating results of his
proven that money will not enable anyone to get a position within companies.”
the business. Those are the great businesses.” – Warren Buffett
– Warren Buffett
“I consider there to be three basic ideas that if they are really
ground into your intellectual framework, I don‟t know how you
12 Avoid perception props. could help but do reasonably well in stocks. None of them are
complicated. None of them take mathematical talent or anything
“Don‟t trap yourself into believing a business or product is worth of the sort. Benjamin Graham said you should look at stocks as
exactly what someone is willing to pay. Someday, you‟ll end up small parts of the business. Look at stock fluctuations as your
paying dearly for a business propped by perception only. For friend rather than your enemy – profit from the folly rather than
example, maybe grapes from a little 8-acre vineyard in France participate in it. And Graham said the three most important
are really the best in the world, but I have always had a suspicion words of investing: „margin of safety‟. I think those ideas, 100
that about 99-percent of it is in the telling and about 1-percent is years from now, will still be regarded as the three cornerstones of
in the drinking.” sound investing.”
– Warren Buffett – Warren Buffett
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