EIGHT SIMPLE STEPS TO INVEST LIKE BILLIONAIRE WARREN BUFFETT By Greg Canavan
EIGHT SIMPLE STEPS TO INVEST LIKE BILLIONAIRE WARREN BUFFETT BY Greg Canavan, Editor, The Daily Reckoning AUSTRALIA Dear Reader, Warren Buffett is quite rightly viewed as the greatest investor of all time. His philosophy and investment approach is a simple one. Yet for mere investing mortals like me and you, Buffett is a very difficult investor to mimic. Put simply, we re not Warren Buffett. He is wired differently to the rest of us. That s what makes him unique. And it s what makes the follow Warren Buffett on the path to riches story so maddening. It won t happen! You wont get rich following someone else s path. You have to follow your own. I m guilty of falling into this trap. For years I tried to emulate Warren Buffett. I read all his books. I worked out his valuation methodology. I believed in it. I still do. But I believe it s wrong to tell people they can simply invest like Buffett. Buffett has too many unique personal traits that shape his investing success. But that doesn t mean you can t use Buffett s vast knowledge to put you on the right path. Knowing what parts of Buffett s wisdom and insights to use, and what ones to discard, will make you a better and more confident investor. In the following report I ll show you how to do just that. What you ll read below will help you make the smartest investment decisions you ll ever make...using some of the most overlooked, common-sense investing guidelines you ve ever seen. These guiding principles could help you: Scoop up bargain stocks in quality companies Stop investing in overhyped shares that may be teetering on the brink of a disastrous price collapse Help you spot mistakes other investors make, all too often, and avoid them. Build a portfolio of great businesses so you can enjoy years of capital gains and dividends. 2
Benjamin Graham laid out the principles of value investing more than 70 years ago in his investing masterpiece The Intelligent Investor. If you ve never read Ben Graham, I m sure you ve heard about his most famous student, Warren Buffett. Buffett is the chairman, president and CEO of Berkshire Hathaway, one of the largest public companies in the world. Buffett is certainly one of the most famous investors, if not the most, in the world. He s averaged a compound return of just under 20% for over 45 years. Forbes puts his net worth at $58 billion. How did he get so rich? By applying the principles that Ben Graham taught him about value investing. Buffett was the only student Ben Graham ever gave an A+. These rules Buffet has used so successfully over almost half a century should form the foundation for your investment philosophy. They can help you identify the best-value stocks on the ASX under ANY market conditions. These principles allow you to pinpoint quality stocks on the ASX trading below their intrinsic value and snatch them up before the market realises its blunder and re-rates the price. This will give you the best chance of succeeding in the share market and growing your wealth. The trouble is they seem SO simple and obvious that 99% of average stock-market participants, investment brokers and so-called finance professionals overlook them. My name is Greg Canavan. I m the editor of The Daily Reckoning Australia, the free e-letter you just signed up for. A big part of my job is providing our readers with a big picture view of the markets that gives you insight into the direction of the Aussie stock market. But I m a big advocate of value investing, which is a generic term for Warren Buffett s basic approach. It s a style of investing I recommend. However, there are some flaws for the unwary investor. Below I outline eight simple rules to guide your thinking and help you invest like the great Warren Buffett. I ll also point out where his approach could get you into trouble. Remember, Buffett has decades of experience under his belt. Most investors don t, and may misinterpret his lessons. I know I did when I was starting out. Rule #1: Select winning stocks the way you buy groceries (and NOT the way you choose perfume) There are really only two approaches you can take when you re investing in a stock. One is similar to buying perfume. Let s call it the speculative approach... This is the approach you need to avoid. 3
If you pay $80 for a bottle of perfume, you re paying for perceived quality. You can t measure it in terms of real value. You can t really tell why one type of perfume costs $350 and another which smells exactly like it goes for around $150. If you live for the thrill of taking a chance on a stock with a good story in the hope it will double or triple your money very quickly you might be attracted to this exciting but risky way of investing. But it s really gambling. The way to build long term wealth is through value investing like Warren Buffett. Like a good supermarket shopper, it means you ll look at all the stock on the shelf, sum up the prices, compare the quality and work out which gives you the most bang for your buck. It s not just about buying bargains. It s about getting the best quality for the best price. When you re thinking of investing, you need to approach every stock purchase as if it was an item you were about to drop it in your supermarket trolley. You know your favourite brands and items in your weekly shop. Make sure you know and trust the companies you re investing in the same way. You have to make sensible, rational investment decisions based on your knowledge of the company s value. As an intelligent investor, you need to base your buying and selling decisions on sound evidence. That means understanding the financial fundamentals and the outlook for the business. Speculation can have its place in a portfolio, but do you really want to gamble with the money you need for your retirement? And don t forget, like savvy shopping, cheaper is not always better. Value investing doesn t necessarily mean buying the cheapest stocks. Cheap stocks are often poor quality and should be avoided. Rule #2: Never pay more than what a company s worth If you want to make money in shares, the simplest way is to pay LESS than what a share is worth...like buying a share worth $1 for 80 cents. I m not talking about haggling with your broker, or some kind of discount trading. It s about knowing the difference between a share s PRICE and its VALUE. You want to buy at a price BELOW the value. You ll be surprised how often the market gives you the opportunity to buy screaming bargains once you know what to look for. So how do you work out whether you re getting a fair price? You can do it right now using a quick, easy sum that s so simple a 12 year old could do it. 4
Simply multiply the company s share price by the total number of company shares outstanding. Then ask yourself, if I bought the whole company would it really be worth this much money? Am I paying more or less than its actual, intrinsic value? You can work THAT out by looking at a company s profitability. Don t worry, you don t have to do it ALL yourself. There are online valuation tools that can help the maths, ratios and figures. You just need to make sure the assumptions are reasonable and conservative. Once you know the company s profitability, you can estimate what you should pay to receive those profits. If you re going to invest intelligently, you need to realise that you re not just buying a single stock. You re buying a share of a business. Forget the price that goes up or down on any given day. Think about the business as a whole. Warren Buffett reiterated this view in his famous Graham and Doddsville speech given in 1984, when talking about those investors who had followed Graham s principles over the long term. While they differ greatly in style, these investors are, mentally, always buying the business, not buying the stock. This is the secret of intelligent investing. Rule #3: Never trust analysts estimates Analysts constantly evaluate what they think a company will earn in a given period. This influences the share price in the short term, depending on how positive or negative they are as a group. The trouble with these projections is they re just estimates. It s someone s prediction for what might happen, based on the current financial situation and a forecast for that figure growing or shrinking in the future. But the track record of analysts is mixed. That s why share prices jump around so much. There are hundreds of factors impacting on any given company and its profitability every day, week and year. These constantly change the outlook for any given company, and hence its market valuation. In other words, you can never take it for granted that an analyst s forecast will be accurate. The key thing for you as an intelligent investor is to be sceptical. Sceptical of 5
analysts forecasts, company guidance, CEO commentary in the annual report, and anything else you hear. This where you can learn from Warren Buffett. You need to come up with your own company valuation, like he does, and have the courage to act on your own findings. Over the years, I have come up with a method to protect my portfolio from overoptimistic assumptions from analysts or CEO hype. I simply look at a share price chart. Interpreted correctly, a chart provides a wealth of information. It will tell you if analysts forecasts are overly rosy, and it will tell you if a CEO is blatantly talking his book. While reading a chart is beyond the scope of this report, it s something to keep in mind as a complement to the common sense Buffett approach. Rule #4: Always have a margin of safety Some investors make the mistake of thinking you need to be some sort of math whiz to figure out a company s intrinsic value and invest with any success. They spend hundreds of dollars on online trading programs that use technical algorithms to identify buy recommendations for you. But you really only need basic math skills to calculate a company s intrinsic value...as long as you know which figures you need to pay attention to. I m talking primary school level maths. Once you ve estimated a reasonable value for a company, you want to buy below this level. This is called your margin of safety. You need to give yourself some wiggle room because your estimates may be wrong, or off slightly. If you ARE wrong, buying with a margin of safety is your best chance of minimising any losses. And if you re right, you ve got more to gain. This margin of safety practice can help ensure you re buying quality stocks at sensible prices. Of course, you need to accept you re probably NEVER going to estimate the intrinsic value of a company to the exact cent with 100% accuracy. No matter how much data you have about a company s profitability and the macro outlook, you re NEVER going to be able to get the intrinsic value spot on. And really, there s no such thing. Value is subjective. Five different investors might come up with five different estimates of value. You ll never get it right. 6
But you can do the next best thing... You can invest with a margin of safety. Such a margin takes differing forms. It can be buying an out of favour stock that is momentarily cheap, or it might be that a current stock price doesn t adequately reflect a company s growth potential. Keep in mind though that investing with a margin of safety in this day and age is difficult. Central bankers have pumped a huge amount of liquidity into markets, pushing up the price of all assets, good and bad. Rule #5: Buy good stocks at sensible prices There are certain tell-tale signs that give a good business away. And once you know what you re looking for, they re easy to spot. Things like a company s: Profitability (as measured by something called return on equity ) Dividend-payment history High levels of retained earnings Low debt ratio If these are in good shape, chances are it s a company worth investigating, provided it s trading at a reasonable price. As with all of Buffett s guidelines, it comes back to value. As I mentioned earlier, the biggest mistake amateur investors make is buying poor stocks that will never amount to anything, just because they re cheap. Or worse buying good stocks at their peak. The price you pay determines your return. Focus on buying quality stocks at sensible prices and you will limit your mistakes. Rule #6: When in doubt, follow the dividend trail Another of Buffett s rules of thumb when it comes to sniffing out quality companies to invest in is to follow the dividend trail. A company with a long track record of making dividend payments is probably less of a risk than a company with NO track record of paying dividends to its shareholders. The reason being that it (generally) proves the company generates more cash than it needs. 7
As a shareholder, you re entitled to some of that money. If you buy a good dividend paying stock at a fair price, over the long term you should receive a healthy mix of income and growth. Rule #7: If it doesn t pay straight away, wait! When you invest in a quality company trading below its intrinsic value, chances are it s going to pay off in the long term. But in the short term, sometimes you need to be prepared to weather what Mr Market throws at you. Mr Market was Ben Graham s famous allegory for the market. Sometimes Mr Market is in a bad mood and will offer you a poor price for your shares because he s feeling gloomy about the world. Other days Mr Market will offer you very lucrative prices for your shares because he s feeling so positive. The good news for you is that Mr Market will offer you a price every day. You can ignore him until you re ready to sell or buy Over time, he WILL come to his senses and, if you ve bought correctly, re-rate your stock higher. But this can take some time. The reason you can buy a stock so cheaply in the first place is often because a lot of negative sentiment surrounds the sector. Plenty of good businesses get stuck in the doldrums for one reason or another. If you want to make money buying discounted stocks, you need to be prepared to wait for the price correction to come. As Graham taught Buffett: in the short run, the stock market is a voting machine but in the long run it is a weighing machine. If you re prepared to wait and you ve done the maths and disaster doesn t hit chances are your intelligent investments will win out in the long run. Your aim is to wait patiently for compelling opportunities and then move with conviction. Over the years, I have discovered that it s better to wait for the price trend to start rising before buying in. When a company runs into short term trouble, its price may fall and look cheap. But it may continue to fall for some time thereafter. The cheap price just gets cheaper. Or the company makes an announcement that makes you realise just why the price has been falling. 8
When a price falls, even though it may look cheap, I wait. I wait until the price stops falling and starts rising again before getting interested. You won t pick the bottom using this method, but you will avoid buying into cheap stocks that just keep getting cheaper. So remember, be patient, and invest with the trend. Rule #8: Don t worry about what anyone else thinks Warren Buffett has said: There are two requirements for success in Wall Street. One, you have to think correctly; and secondly, you have to think independently. And this is something I ve advocated all along. Ignore the hot stock tips dished in every financial news source. Trust only the information you can see and verify with your own eyes. Don t react to market sentiment Mr Market will offer you prices based on how miserable or euphoric he s feeling...not based on how sound your investment is. That s why it s so important you control your emotions and base your decisions on value and evidence. If a company has low debt, looks profitable and according to your calculations is trading below intrinsic value...buy IT (subject to it being in a price uptrend, as stated in the rule above). Ignore what the other experts and stock market participants are saying. Nobody ever made money investing in the same thing as everyone else. It s HARD to spot value in a crowded market. So instead, think for yourself and follow the rules you know to work. That is the key to investing intelligently. Follow the principles of value investing, with a few tweaks that work for you, and you ll grow your wealth in the share market over time. The Daily Reckoning In the coming days, your Daily Reckoning subscription will become active. Value investing and buying with the trend is something I often write about. But as you ll see, the financial world and the investment markets cover many different topics. By necessity, The Daily Reckoning does too. Each day we look at current events, and try to anticipate the events of the future to help 9
our readers profit and protect themselves. There is a whole universe of ideas from history to economics to geopolitics, and we explore them all to make sure we re on the right track. Bill Bonner who founded the Daily Reckoning and still writes daily after twelve years has shown that financial markets often defy reason. This is because crowds follow each other, not logic. Our goal is to present ideas to you that never follow the crowd. They re often unique and you may not always agree with them. But we hope you enjoy them. Make sure to check out our website at www.dailyreckoning.com.au for the latest articles, commentary and updates on value investing and other stories. Regards, Greg Canavan Editor, The Daily Reckoning All content is 2005 2015 Port Phillip Publishing Pty Ltd All Rights Reserved Port Phillip Publishing Pty Ltd holds an Australian Financial Services License: 323 988. ACN: 117 765 009 ABN: 33 117 765 009 All advice is general advice and has not taken into account your personal circumstances. Please seek independent financial advice regarding your own situation, or if in doubt about the suitability of an investment. Calculating Your Future Returns: The value of any investment and the income derived from it can go down as well as up. Never invest more than you can afford to lose and keep in mind the ultimate risk is that you can lose whatever you ve invested. While useful for detecting patterns, the past is not a guide to future performance. Some figures contained in this report are forecasts and may not be a reliable indicator of future results. Any potential gains in this letter do not include taxes, brokerage commissions, or associated fees. Please seek independent financial advice regarding your particular situation. Investments in foreign companies involve risk and may not be suitable for all investors. Specifically, changes in the rates of exchange between currencies may cause a divergence between your nominal gain and your currency-converted gain, making it possible to lose money once your total return is adjusted for currency. The Reader acknowledges that the contents of this newsletter and all associated intellectual property rights of Port Philip Publishing Pty Ltd (PPP) including copyright, design rights, property rights, rights to data and databases, trademarks, service marks and any other rights created or developed in the course of the provision of the newsletter shall be and remain the sole and exclusive property of PPP. No person is permitted to copy, forward or reproduce the newsletter and/or its contents without express consent of PPP. Subscribers to the newsletter are permitted to use this material for their own personal and investment use. If you would like to contact us about your subscription please call us on 1300 667 481 or email us at cs@portphillippublishing.com.au Port Phillip Publishing Attn: The Daily Reckoning PO Box 713 South Melbourne VIC 3205 Tel: 1300 667 481 Fax: (03) 9558 2219 10