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506- Great Investors: Warren Buffett
 
  Warren Buffett is widely regarded as the world's most successful investor, and
  it is no mistake we have repeatedly echoed his wisdom throughout this
  Investing Classroom series. The book value of his company, Berkshire Hathaway
  BRK.B, compounded at 21.9% per year between 1965 and 2004. That is more than
  double the 10.4% pretax return to the S&P 500 over the same period. According
  to Forbes, Buffett is the world's second-richest man with a net worth of about
  $44 billion at this writing. But he didn't stumble across a giant oil field,
  develop software, or inherit wealth. Rather, he built his fortune solely
  through astute investing. Aspiring investors, then, will certainly benefit by
  studying his methods. Fortunately, Buffett has been forthcoming.
  
  In Berkshire's 1977 annual report, Buffett described the central principles of
  his investment strategy:
  
  "We select our marketable equity securities in much the way we would evaluate
  a business for acquisition in its entirety. We want the business to be one (a)
  that we can understand; (b) with favorable long-term prospects; (c) operated
  by honest and competent people; and (d) available at a very attractive price."
  
  
  Determining Fair Value
  
  
  Buffett determines the attractiveness of a company's price by comparing it
  with his estimate of the company's value. To determine value, he estimates the
  company's future cash flows and discounts them at an appropriate rate.
  Discounting is necessary because $1,000 today is worth more than $1,000
  received after one year. If an investor can earn 6% interest on his or her
  money, then $1,000 today is worth $1,060 in one year. Conversely, an expected
  $1,000 cash flow one year from now is worth only $943.40 today, because
  $943.40 earning 6% grows to $1,000 in one year. (For more on discounted cash
  flow and the time value of money, see Lesson 403.)
  
  This discounted cash-flow valuation method was described by John Burr Williams
  in his 1938 book, The Theory of Investment Value. It is used by countless
  investment professionals, so Buffett's approach to valuation is not a
  competitive advantage. However, his ability to estimate future cash flows more
  accurately than other investors is an advantage.
  
  Another part of his edge may be due to his sharp mind, but Buffett insists
  that successful investing doesn't require a high IQ; it depends more on a
  successful framework and having the proper temperament. Buffett succeeds
  largely because he focuses his efforts on companies with durable competitive
  advantages that fall within his circle of competence. These are key features
  of his investing framework.
  
  
  Understanding Your Circle of Competence
  
  If Buffett cannot understand a company's business, then it lies beyond his
  circle of competence, and he won't attempt to value it. He famously avoided
  technology stocks in the late 1990s in part because he had no expertise in
  technology. On the other hand, Buffett continued to buy and hold what he knew.
  For instance, he was willing to purchase a large stake in Coca-Cola KO because
  he understood the company's products and its business model.
  
  Although it might seem obvious that investors should stick to what they know,
  the temptation to step outside one's circle of competence can be strong.
  During the technology stock mania of 1999, Berkshire's return badly trailed
  the market's return, and a number of observers commented that Buffett was
  hopelessly behind the times for eschewing technology stocks. However, Buffett
  has written that he isn't bothered when he misses out on big returns in areas
  he doesn't understand, because investors can do very well (as he has) by
  simply avoiding big mistakes. He believes that what counts most for investors
  is not so much what they know but how realistically they can define what they
  don't know.
  
  
  Sustainable Competitive Advantages
  
  Even if a business is easy to understand, Buffett won't attempt to value it if
  its future cash flows are unpredictable. He wants to own simple, stable
  businesses that possess sustainable competitive advantages. Companies with
  these characteristics are highly likely to generate materially higher cash
  flows with the passage of time. Without these characteristics, valuation
  estimates become very uncertain.
  
  His large stake in Coca-Cola provides us with an example of the type of
  company he favors. Coca-Cola is more than 100 years old, and it has been
  selling essentially the same product during its entire existence. Coke was the
  leading soft drink in 1896 just as it is today. It seems unlikely that
  customers will ever lose their taste for it. Buffett believes that the product
  and the Coca-Cola brand are durable competitive advantages that will enable
  the company to earn economic profits for shareholders for many years to come.
  
  On the other hand, technology is a fast-changing industry where the leading
  company of today can be driven out of business tomorrow by more innovative
  rivals. Market-leading products are always vulnerable to obsolescence. Thus,
  even if Buffett had technological expertise, he would be reluctant to invest
  in the industry because he couldn't be confident that a technology company's
  cash flows would be materially higher in 10 or 20 years, or even that the
  company would still exist.
  
  
  Partnering with Admirable Managers
  
  
  Buffett seeks businesses with talented, likeable managers already in place.
  Although he has the ability to change the management at Berkshire's wholly
  owned subsidiaries, Buffett believes that power is "somewhat illusory" because
  "management changes, like marital changes, are painful, time-consuming, and
  chancy." He has written that good managers are unlikely to triumph over a bad
  business, but given a business with decent economic characteristics--the only
  type that interests him--good managers make a significant difference. He looks
  for individuals who are more passionate about their work than their
  compensation and who exhibit energy, intelligence, and integrity. That last
  quality is especially important to him. He believes that he has never made a
  good deal with a bad person.
  
  
  An Approach to Market Prices
  
  Once Buffett has decided that he is competent to evaluate a company, that the
  company has sustainable advantages, and that it is run by commendable
  managers, then he still has to decide whether or not to buy it. This step is
  the most crucial part of the process so it deserves the most attention.
  
  The decision process seems simple enough: If the market price is below the
  discounted cash-flow calculation of fair value, then the security is a
  candidate for purchase. The available securities that offer the greatest
  discounts to fair value estimates are the ones to buy.
  
  However, what seems simple in theory is difficult in practice. A company's
  stock price typically drops when investors shun it because of bad news, so a
  buyer of cheap securities is constantly swimming against the tide of popular
  sentiment. Even investments that generate excellent long-term returns can
  perform poorly for years. In fact, Buffett wrote an article in 1979 explaining
  that stocks were undervalued, yet the undervaluation only worsened for another
  three years. Most investors find it difficult to buy when it seems that
  everyone is selling, and difficult to remain steadfast when returns are poor
  for several consecutive years.
  
  Buffett credits his late friend and mentor, Benjamin Graham, with teaching him
  the appropriate attitude toward market prices. You may remember Graham's
  parable in which he said to imagine daily quotations as coming from Mr.
  Market, your very temperamental partner in a private business. Each day he
  offers you a price for which he will buy your share of the business, or for
  which you can buy his share of the business. On some days he is euphoric and
  offers you a very high price for your share. On other days he is despondent
  and offers a very low price. Mr. Market doesn't mind if you abuse or ignore
  him--he'll be back with another price tomorrow.
  
  The most important thing to remember about Mr. Market is that he offers you
  the potential to make a profit, but he does not offer useful guidance. If an
  investor can't evaluate his business better than Mr. Market, then the investor
  doesn't belong in that business. Thus, Buffett invests only in predictable
  businesses that he understands, and he ignores the judgment of Mr. Market (the
  daily market price) except to take advantage of Mr. Market's mistakes.
  
  
  Requiring a Margin of Safety
  
  
  Although Buffett believes the market is frequently wrong about the fair value
  of stocks, he doesn't believe himself to be infallible. If he estimates a
  company's fair value at $80 per share, and the company's stock sells for $77,
  he will refrain from buying despite the apparent undervaluation. That small
  discrepancy does not provide an adequate margin of safety, another concept
  borrowed from Ben Graham. No one can predict cash flows into the distant
  future with precision, not even for stable businesses with durable competitive
  advantages. Therefore, any estimate of fair value must include substantial
  room for error.
  
  For instance, if a stock's estimated value is $80 per share, then a purchase
  at $60 allows an investor to be wrong by 25% but still achieve a satisfactory
  result. The $20 difference between estimated fair value and purchase price is
  what Graham called the margin of safety. Buffett considers this
  margin-of-safety principle to be the cornerstone of investment success.
  
  
  Concentrating on Your Best Ideas
  
  Buffett has difficulty finding understandable businesses with sustainable
  competitive advantages and excellent managers that also sell at discounts to
  their estimated fair values. Therefore, his investment portfolio has often
  been concentrated in relatively few companies. This practice is at odds with
  the Modern Portfolio Theory taught in business schools, but Buffett rejects
  the idea that diversification is helpful to informed investors. On the
  contrary, he thinks the addition of an investor's 20th favorite holding is
  likely to lower returns and increase risk compared with simply adding the same
  amount of money to the investor's top choices.
  
  
  The Bottom Line
  
  Buffett's thinking permeates Morningstar's philosophy and valuation framework.
  We fully believe that you can greatly boost your investment returns if you
  invest like Buffett. This means staying within your circle of competence,
  focusing on companies with wide economic moats, paying attention to company
  valuation and not market prices, and finally requiring a margin of safety
  before buying.