Is Warren Buffett's Stock Market Strategy Good for You?

20 Ticket Punch Card

Warren Buffett has often said, "I could improve your ultimate financial welfare by giving you a ticket with only twenty slots in it so that you had twenty punches - representing all the investments that you got to make in a lifetime. And once you’d punched through the card, you couldn’t make any more investments at all. Under those rules, you’d really think carefully about what you did, and you’d be forced to load up on what you’d really thought about. So you’d do so much better."

Why? Too often investors throw money around like scattering seed, saying to themselves, "I’ll throw a little here and little there to see what happens." Instead, Buffett advocates a policy of finding the best and richest soil, planting substantial amount of seed in it, and protecting it. This policy may sound simple, and it is. It also can be life changing. Lou Simpson, one of the best investors in the world and head of GEICO’s equity portfolio, once said that this particular Buffett strategy helped him enormously in his record of crushing the market over several decades.

Who is Warren Buffet?


Warren Buffett was born in 1930 in Omaha, Nebraska. He took his first degree at the University of Nebraska and then completed a Master’s degree in economics at Columbia Business School in 1951. He was supervised and mentored at Columbia by stock-investing guru Benjamin Graham, author of Security Analysis.

Buffett received the only mark of A+ Benjamin Graham ever awarded in his security analysis class. From this it’s clear that Buffett had an extraordinary ability in stock analysis from the very beginning of his career.

Warren Buffett grew obsessed with numbers and money from an unusually early age. It wasn’t an obsession founded upon the lifestyle or the goods money could buy. It was a collectors’ obsession. Some boys in the 1930s and 1940s collected stamps. Some collected bird’s eggs. Warren Buffett collected money. He started at the age of five, selling gum and lemonade in the street and he later set up a business, renting pinball machines to local barbers. By his mid-teens, he had made enough money from these earlier efforts and paper rounds to buy land - which he rented to farmers.

Warren Buffett bought his first shares at the age of eleven - his father was a stockbroker - and stock trading gave the young Buffett a natural outlet for his twin obsessions with numbers and money. After completing his master’s degree, Buffett worked as a salesman in his father’s brokerage. Between 1954 and 1956 Buffett worked for his old mentor, Benjamin Graham, then returned to Omaha, ready to begin his own investing business.

Warren Buffett’s progress towards almost unimaginable wealth accelerated in 1957 when he persuaded friends and family to invest $105,000 in his limited partnership. Then he began the process he is famous for, the process of annually compounding the money he manages extraordinary rapidly.

Warren Buffett’s holding company Berkshire Hathaway (NYSE: BRK.B) has been the single greatest investment of our lifetimes. His compounded annual gain from 1966 to 2007 was 21.1% for an overall gain of 400,863%, compared to 10.3% and 6,840% for the S&P 500.


Warren Buffett’s Investing Strategy

How has Warren Buffett’s investment strategy been so successful? He takes a disciplined value approach to investing. And he sticks with it.

Before Warren Buffett invests a dime, he asks:

-Is the company in an industry with good economics? That is, is it not in an industry competing on price?
-Does the company have a consumer monopoly or brand name that commands loyalty?
-Can anyone with an abundance of resources compete successfully with the company?
-Are the earnings on an upward trend with good and consistent profit margins?
-Is the debt-to-equity ratio low, or is the earnings-to-debt ratio high? Can the company repay debt even in years when earnings are lower than average?
-Does the company have high and consistent returns on invested capital?
-Does the company retain earnings for growth?
-Does the business have high maintenance cost of operations, high capital expenditure or investment cash outflow? (If so, that’s not good.)
-Does the company reinvest earnings in good business opportunities? Does management have a good track record of profiting from these investments?
-Is the company free to adjust prices for inflation?

In short, he makes companies jump through a lot of hoops before he considers putting them in his portfolio.

Concentrated Purchases

Buffett also makes concentrated purchases within his investment strategy. For its size, Buffett’s portfolio has few stocks. But once a downturn comes, he buys millions of shares of solid businesses at reasonable prices.

Berkshire is a major player in the markets for insurance, soft drinks, chocolates, shoes, jewelry, publishing, furniture, steel, energy, homebuilding and private jets.

Berkshire owns significant portions in well-known, cheap, dividend paying stocks like:

-Coca-Cola (NYSE:KO)
-Wells Fargo (NYSE:WFC), one of the few U.S. banks in good standing.
-Procter & Gamble (NYSE:PG)
-Anheuser Busch (NYSE:BUD), which has seen a major boost in its share price thanks to the takeover bid from InBev.
-Conoco Phillips (NYSE:COP)
-Kraft Foods (NYSE:KFT) and others.


Is the Buffett’ Strategy Good for Small Investors?

Yes, Warren Buffett is the world’s most successful investor. His investment strategy works marvelously well - for Warren Buffett.

However, many small investors have lost money trying to follow in Buffett’s footsteps. Not that there is anything wrong with Buffett’s methodology per se - his record of success speaks for itself. The problem is that the small, beginning investors who find his folksy investment-talk most appealing often find it very difficult to replicate his techniques successfully.

For a good number of years now, Buffett’s preference has been to buy companies outright. In this article, however, we shall concentrate on Buffett’s stock investing methods, because it is these methods that small investors want to mimic.

How does Warren Buffett Identify the Stocks He would Like to Own?

Warren Buffett works with a list of companies whose stock he would like to own. He compiles his list by studying companies and their management teams in considerable detail. His favorite type of stock is of a company with a uniquely competitive market position. Often the competitiveness arises from the strength of a brand name, such as Coca-Cola or Gillette. He buys a stock if and only if its share price drops below its long-term value (intrinsic value). He is prepared to wait years for an opportunity to buy stocks at the right price.

Buffett calculates the price he is willing to pay for a stock by estimating its future earnings. He then uses this estimate to predict what the stock will be worth in the future. In order to accomplish this with reasonable accuracy, he demands the company can demonstrate more-or-less consistent earnings growth for at least five years - preferably longer. Buffett buys stocks when their prices are at low enough levels to offer him a high probability of significantly outperforming returns offered by government bonds.

If stocks he likes don’t reach his target price, Warren does not buy - no matter how much he may like the look of them. He says that paying too much for a stock is a good way to guarantee a poor return.
If stocks he likes become available at or below his target price, he buys big. Then he waits. This is the "classic" and best-known Buffett investment method. (He has several.)

After he has bought a stock, his preferred holding time is "forever," although he concedes that it is sensible to sell a stock if it becomes grossly overvalued. Over time, his stock buying decisions have been amply rewarded.

Patience and the Concentrated Stock Portfolio

Buffett advocates that investors hold a "concentrated stock portfolio". At any time you should own a very small number of stocks, say six at most, and you should know everything there is to know about these stocks. In total, in a lifetime of investing, you should buy and sell no more than twenty times, as it was mentioned earlier.

Warren Buffett rightly extols the virtues of patience in investing - he says that he read annual reports from Anheuser-Busch Inc. for 25 years before buying their stock. He likens his patience in buying stocks to the patience of the baseball player who waits for the perfect pitch before swinging. We would caution beginning investors to bear in mind, however, that it takes a lot of practice before a baseball player consistently hits home runs from perfect pitches.

The Trouble with Warren Buffett’s Methods

Unfortunately, small investors often fail to implement Buffett’s strategy successfully. For one thing, many of us - Buffett included - learn investing through trial and error. Sure, we read as much as we can before we begin, but reading isn’t enough. It’s only when you’ve put your own savings on the line and lost money that you really learn. Making mistakes is how the majority of us learn our most important lessons.

But if you’ve got to wait five years before a stock you’d like to own becomes available at the right price, then you’re going to miss out on a lot of market experience. And what if it turns out you waited five years to make your first mistake? The next five years will give you a lot of time to reflect on that. You’ll just have to hope that you will learn enough from your first mistake not to make a second. So, we would reiterate - it takes a lot of practice before a baseball player consistently hits home runs from perfect pitches.
Small investors who want to invest like Warren Buffett fail because they do not have access to the quality of information Buffett has. Compared with most of us, Warren Buffett has enjoyed a privileged position from the very beginnings of his career. He is the son of a United States Congressman - a Congressman who was also a stockbroker.

For most of his life, Warren Buffett has been able to chat with and gather information and advice from CEO’s and other big movers that small investors have no access to. Warren began trading in stocks at the tender age of 11 years.

Beginning investors fail because they learn in "How to be a New Warren Buffett" books that they must invest with a ten-year perspective or longer. When their stocks go up, they’re happy. When their stocks do down, they’re less happy but they tell themselves "I’m a long term investor". When their stocks continue to go down, they get worried. When their stocks go down even further, they eventually give in and sell - at a big loss. They do not have the long-term confidence in their stocks that Buffett - through superior information sources and superior market experience - has in his. Those investors who do have confidence in their stock picks often find their confidence is misplaced. They doggedly hold on to inferior stocks, believing they are following the Buffett way. In reality they aren’t and they will not be rewarded because they paid too much in the first place for inferior stocks. Buffett buys his stocks with a skill few of us can match.

Far from trying to exercise patience, some small investors, filled with sheer enthusiasm (and a hint of greed) from reading "How to Become a Millionaire like Warren Buffett" rush out and buy stocks. Unfortunately, most of them pay too much for their stocks or the stocks don’t have as good long-term prospects as Warren’s own picks.

Beginning investors fail because, in addition to lacking Buffett’s superior access to information, they lack his temperament. Buffett says if you cannot watch your portfolio lose 50 percent of its value without becoming panic-stricken, you shouldn’t be in the market. Well, according to that criterion, most of us should think very hard before investing in stocks. Although perhaps not panic-stricken, most of us would be deeply perturbed if our portfolio lost half its value. For the majority of us, the money we’re putting into stocks is hard earned. To watch it disappear is distressing. The distress can result in small investors selling fundamentally sound stocks just before they recover. Unfortunately, people read books about investing like Buffett and convince themselves that they will be able to handle the stress of watching their stocks dropping in value. It’s only when it really happens to them that they learn the truth - watching your stocks sink is extremely stressful and, after holding underperforming stocks for a long time, people sometimes do end up selling at a big loss.
Small investors fail because they do not have Warren Buffett’s genes. Buffett is an unparalleled genius who has thought deeply about investment for decades. Although he talks modestly and in homely tones to the public, he is an extremely clever and competitive man with an enormous capacity to memorize numbers and facts and apply them in financial calculations and in due diligence. He has developed an immense array of strategies and tactics to keep his wealth increasing, irrespective of market conditions. You should no more think you might emulate Warren Buffett after reading a few books than you should believe that by studying physics for a few months in your spare time, you might emulate Albert Einstein or Isaac Newton.
Warren Buffett’s methods are appropriate for experienced investors who share his temperament. New investors may enjoy greater success using less challenging methods.

Sources and Additional Information:
http://www.warren-buffett.net/
http://jutiagroup.com/2008/09/08/warren-buffetts-investment-strategy-time-to-buy-the-ultimate-no-brainer/
http://www.investmentu.com/IUEL/2008/February/warren-buffett.html
http://www.investingator.org/warren-buffett-investment-strategy.html

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