Six Keys to Investing Buffett Style
Buying low isn't enough. You need to see the future
Make money by not losing money. It's an oft-quoted Buffettism: "The first rule of investing is don't lose money; the second rule is don't forget Rule No. 1." Buffett's greatest achievement may be that between 1965 and 2006, through three bear markets, Berkshire Hathaway lost value in only one calendar year, 2001. Even then, it still bested the Standard & Poor's 500 index.
Buffett understood this math foible: If you start with a dollar and lose 50 percent of your money, you'll be left with 50 cents. But then it takes a 100 percent return just to get back to your original dollar. So it's best not to fall into a hole.
Don't get fooled by earnings. Buffett has noted that "most companies define 'record' earnings as a new high in earnings per share." But he says the fact that earnings per share are rising in itself tells you little, because it does not take into account how much shareholders have invested. The more that shareholders invest in a company, the greater its earnings should be.
That's why Buffett favors a different measure of profitability—return on equity. ROE is calculated by taking a company's net income and dividing it by shareholders' equity. Since ROE measures profits as a percentage of what investors actually own, it reveals how efficiently a company's profits are growing.
It's unclear if Buffett demands a minimum ROE among his stocks, but some of his value-investing disciples look for companies with a return on equity of at least 15 percent. Within Buffett's basket of publicly traded stocks, his top holding, Coca-Cola, sports an ROE of greater than 30 percent, Anheuser-Busch tops 51 percent, and American Express 37 percent.
Look to the future. They don't call Buffett the Oracle of Omaha for nothing. While Graham was always reluctant to predict the health of a business, Buffett makes a conscious attempt to identify companies with a good chance of continuing their success 25 years into the future. "Buffett talks a lot about looking through the front window and not through the rearview mirror," says John Rogers, chairman of Ariel Capital Management in Chicago.
Buffett peers into the future partly by attempting to calculate the current value of a company's expected future cash flows. It's his way of assessing a company's intrinsic value. Then Buffett looks for companies selling at a deep discount to that value. Often, Wall Street—or "Mr. Market," as Buffett says, echoing Graham—realizes its error only after Buffett steps in. For example, Burlington Northern and Union Pacific, two plodding railroad stocks that Buffett recently disclosed owning, saw their shares shoot up more than 18 percent and 34 percent, respectively, so far this year.
But he also has admitted that "anyone calculating intrinsic value necessarily comes up with a highly subjective figure that will change both as estimates of future cash flows are revised and as interest rates move." Some investors use Buffett-inspired Web calculators to try to emulate the Oracle, including http://www.moneychimp.com/articles/valuation/buffett_calc.htm.
Stick with companies with wide "moats." Since it's risky to predict the future, Buffett always talks about favoring companies with wide "economic moats." This doesn't necessarily mean that a company has to have a lock on a product or a market. Coca-Cola, for instance, certainly has competition. But Buffett always looks for companies with long-term competitive advantages that make forecasting safer.
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