The Four Buffett Basics

03/26/2004 12:00 am EST

Focus:

Mark Sellers

Editor-in-Chief, Morningstar StockInvestor and FundInvestor

"Psst…Wanna know the secret to Warren Buffett’s investment success?" asks Mark Sellers of Morningstar. "Discipline is the key to investing like the Oracle of Omaha." Here, he explains the four basics of Buffett’s investment approach.

"First, I should admit that in this review I leave out the finer details of Buffett’s success, such as the fact that he studied under famed value investor Benjamin Graham, and that his savvy use of insurance ‘float’ has the effect of juicing his returns. And hey, the guy is just plain brilliant. But in general, his investing style is deceptively simple. So simple, in fact, that almost everyone misses it. Here are his four rules:

  1. Find companies with economic moats.
  2. Always have a margin of safety. 
  3. Be patient.
  4. Never deviate from your strategy, despite what others around you are doing.

" Buffett requires a company to have a sustainable competitive advantage, or what he calls an ‘economic moat.’ This means he looks for companies that are virtually certain to have earnings that are higher in five or ten years than they are today. There are few companies that meet this ‘virtually certain’ criterion. What he tries to do is think about the company’s business as a whole, not just the financial aspect of it, to determine whether it will survive indefinitely.

"He asks questions such as ‘Am I fairly certain that this company’s existing products will be around in ten or 20 years?’ and ‘Does this company have a unique advantage over others in its industry?’ and ‘Will the health of this industry remain strong in coming decades?’ If the answer to those questions is yes, he’ll consider the stock. If the answer to any of those questions is no, he moves on to evaluating another company. Note that there are two components to an economic moat: The competitive position of an individual company within an industry, and the long-term viability of the industry itself. For this reason, it’s very difficult for an airline or chemical or auto company to develop a wide moat these industries are probably going to get weaker over time, not stronger.

"Finding great companies is just the first step. Buffett realizes the difference between a great company and a great investment is the price you pay. He also realizes that he’s human and is prone to making valuation mistakes. To account for this, Buffett uses a technique he calls ‘margin of safety,’ which he defines (following his mentor Graham) as buying a stock well below his calculation of its fair value. Look at it this way: Investing is like gambling, in that they both rely on playing the odds. Buffett won’t always be right, but the odds will always be on his side. If you insist on a margin of safety, the odds will always be on your side, so there's a much higher probability that a stock will do well after you buy it.

"So why can’t just anyone copy Buffett and beat the S&P 500 Index year in and year out? Although many people have the ability to understand Buffett’s investment philosophy, very few have the discipline to execute it. Buffett shows an almost superhuman ability to stick with his investment strategy no matter what’s going on around him. This ability to think independently and keep emotion out of the investment process is the variable that Buffett copycats have a hard time mastering. The ability to think and act with complete independence may be something that can’t be taught, and thus, can’t be duplicated by many people.

"In a nutshell, these four principles are what separate Warren Buffett from everyone else: Invest in companies with wide economic moats, insist on a margin of safety, hold on to them for long periods of time, and think independently by ignoring what other investors are doing."

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