Warren Buffett, CEO of Berkshire Hathaway, attends the 2019 Annual Shareholders Meeting in Omaha, Nebraska, May 3, 2019.
Johannes Eisel | GT
Warren Buffett, founder of Berkshire Hathaway — one of the world’s most successful investors — says he and Vice Chairman Charlie Munger are “not stock pickers; we’re business pickers.”
In the company’s annual shareholder letter published over the weekend, Buffett explained that the “secret sauce” for their investment success is making “investments in businesses with favorable long-term economic characteristics and trustworthy managers.”
This approach is known as value investing, where the goal is to stick to the top performing stocks rather than trade stocks based on short-term price fluctuations, known as active investing.
Of course, choosing winners is not easy. But Munger previously outlined four rules the two Berkshire Hathaway executives follow when choosing to invest in a company.
Aside from Buffett’s rule #1, “Don’t lose money,” here are four questions Munger and Buffett ask when deciding whether or not to invest in a company.
Aside from knowing how a company operates and what it offers consumers, you also want an idea of where the company will be in 10 years, if not decades, says Buffett. He wrote, “If you are not willing to own a stock for 10 years, don’t even consider owning it for 10 minutes.” In his 1996 letter to shareholders.
Berkshire Hathaway famously lost tech companies Google and Amazon in the early 2000s because Buffett wasn’t sure he understood the business in terms of its long-term profitability. This made it difficult to determine the value of their stock.
While Berkshire may have passed on Google and Amazon, other investments in big companies like American Express and Coca-Cola have paid off over time.
This cautious approach could mean missing out on more speculative opportunities, but Buffett said he and Munger “miss a lot of things, and we’ll continue to do that.”
Buffett has said that the “most important” factor in choosing a successful business investment is a company’s competitive advantage, which he likens to the “moat” surrounding an “economic fortress.”
The more secure the competitive advantage, the more likely it is that the company will prosper over decades.
A competitive advantage can be a strong brand that people are always willing to pay for, like Coca-Cola, or it can be a unique business model, like selling insurance directly to the consumer instead of through insurance brokers, as is the case with Geico.
Buffett said he looks for three things in a manager or leader: intelligence, initiative, and integrity. But integrity is most important of allIn a 1998 speech, he said, “Because if you’re going to have someone without integrity, you’re going to want them lazy and stupid.”
“We do not wish to associate with managers who lack admirable qualities, no matter how attractive their business prospects,” Buffett wrote in a 1989 shareholder letter. “We never make a good deal with a bad person.”
With integrity comes trust. This means that Buffett and Munger don’t have to spend as much time micromanaging every decision a leader makes.
“The big thing we do with managers, in general, is find . 400 hitters and then not tell them how to swing,” Buffett said at the 1994 Berkshire Annual Meeting.
As passive investors, Buffett and Munger look for companies that appear to be trading below their intrinsic value.
Although there is no universal measure of value, companies with long-term earning potential tend to have stable profits, good cash flow, and a low amount of debt. When the share price seems low compared to the company’s value, this is a buying opportunity.
But that doesn’t mean that Buffett and Munger are looking for the best deals based on share price alone. Simply getting a fair price for a company’s stock can also be an effective strategy. You are investing in the business for the long term, not just the stock price at the time of purchase.
Buffett wrote, “It is much better to buy a great company at a fair price than to buy a company at a great price.” In its 1989 annual letter to shareholders. “When buying companies or common stocks, we look for first-class companies with first-class management.”
Get CNBC for free Warren Buffett’s Guide to Investingwhich summarizes the #1 billionaire’s best advice for ordinary investors, the do’s and don’ts, and three key investing principles into a clear and simple how-to guide.
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