Value Investing - The WB Way
If you're looking to learn value-investing, the main tenets are out in the public, and have been so for the past 4 decades. In this 1977 shareholder letter, Warren Buffet shares his 4 main criteria for stock-picking and choosing the right companies to invest in. If you go to the original letter (link provided above), 3/4 down the letter, Warren Buffet shares his investing philosophy, one that has not changed (much) for the past 4 decades, and one which we at BTS vigorously encourage, and is on the first page of this website. We reproduce it verbatim below.
We select our marketable equity securities in much the same
way we would evaluate a business for acquisition in its entirety.
We want the business to be (1) one that we can understand, (2)
with favorable long-term prospects, (3) operated by honest and
competent people, and (4) available at a very attractive price.
Key Takeaway A: Buy A Business
Many readers may miss the most important takeaway in this short paragraph, but the key point that Warren Buffet is trying to put across is this: You must buy stocks as though you are buying the entire business (assuming you have limitless amounts of money). Most beginners make the mistake of buying the stocks very differently from the way they buy their first car. You are not merely renting, you are buying ownership (albeit partial) of the company, so evaluate the business with the same (or more) rigour than if you were buying your first car (or home).
Key Takeaway B: Just 4 criteria
If you learn nothing else, just these 4 points will be worth millions of dollars in your investing journey in the decades ahead. While it will be very difficult to find the perfect public company that satisfies 100% all 4 criteria, it's worthwhile to check all 4 every single time before you decide to put your hard-earned money into it. Let's talk a little about each point:
Checkbox #1: One that you understand
By definition, the majority of businesses that you can buy stocks here will fail this first criteria, simply because we just dont have enough time to understand every single company and industry in the investable universe. Understanding an industry or company, even something that you use/consume everyday (e.g. McDonalds) will still take a while, so why kill yourself? Find a simple business that's understandable given the limited time that you have. Many investors also advocate that you find a business that you'll be interested enough to keep up with on the latest news.
ACTIONABLE: Focus on businesses that are simple and that you're interested in.
Checkbox #2: Favourable long-term prospects
This is obvious and intuitive. Of course you will want to invest in a company that has a huge upside potential in the future. Who will want to invest in a company that's sinking? While that much is obvious, what's not-so-obvious is how do you tell if a company will have favourable long-term prospects? Even if it has been doing well for the past decade, how do you know if it will continue doing so in the next decade?
Good question: And the key is to identify the economic moats that the company enjoys. As long as the company's moat is not in any real danger of disappearing in the next decade, your investment is likely to do well. A quick search on google will yield several articles on economic moats: Low-cost production (think Walmart), high switching costs (think telcos), network effects (think Facebook), patents/regulations (think IBM) and brand (think luxury goods).
ACTIONABLE: During your research, think of the type of moat(s) the company has, and whether the moat(s) will persist for another 10 years.
Checkbox #3: Operated by honest and competent people
Is the CEO invested personally, emotionally, spiritually, and whole-heartedly in the business? Is the whole board committed? OR are they just in it for the paycheck? The private jets? The luxurious retreats? Companies tend to do well when the management behaves like owners, and not merely "management". But is it all qualitative (listen to what they say in interviews, earnings calls etc)? Actually, in this letter, in the fourth paragraph no less, Warren Buffet shares this gem:
we believe a more appropriate measure of managerial economic performance to be return on equity capital
In this short sentence, Warren Buffet shares one of the most important quantitative measures that we should focus on, when we stock-pick: ROE (return on equity) or ROC (return on capital) or ROIC (return on invested capital): fairly similar concepts. This is an important number to check as it gives you an indication on whether the business is well-run.
ACTIONABLE: Listen to the interviews, read the annual letters by the CEO to understand him/her and get a sense of his integrity, his competence, whether he understands his company etc
Checkbox #4: Available at an attractive price
Let's say I'm selling ten-dollar bills. Would you buy a ten-dollar bill from me, for fifteen dollars? Obviously not? But we see it all the time when the market gets irrationally exuberant.
Would you buy a ten-dollar bill from me, for ten dollars? Again, probably not. Why bother? You're exchanging ten dollars for another ten dollars. A waste of time, and a waste of effort.
But would you buy a ten-dollar bill from me, for five dollars? A no-brainer you say? And that's what Warren Buffet is saying here. Look for businesses where you make money the moment you enter the trade.
But how do you know if the company is worth ten dollars? Good question, and this is something that Warren Buffets talks about a lot: The intrinsic value of a company. More on this in future posts.
Key Takeaway C: Companies sometimes go on sale
The next paragraph in the letter is an important one, and one that contradicts what business schools and academics have been teaching (the Efficient Market Hypothesis).
...outstanding businesses sometimes sell in the securities markets at very large discounts from the prices they would command in negotiated transactions involving entire companies...
This quote here is absolutely essential to value-investing. It's all well and good to understand the 4 criteria, but if you don't believe that sometimes companies sell at a large discount to their intrinsic value, then you will never invest.