Damn Fucking Right! You Can Apply Warren Buffett’s Investment Strategy!

Do not seek to follow in the footsteps of the wise. Seek what they sought.

 

Matsoo Basho 

 

 

I’ve read numerous articles over the years claiming you cannot use the same investment strategy as Warren Buffett, plastered all over investment website platforms, and Investopedia is full of these articles.

Those articles were probably a reflection of the author’s own ability, not their readers.

In this article, I will outline the reasons why they were wrong and how you can use the same investment strategy. This article will focus on Buffett’s investment strategy to buy listed stocks and not his strategy for purchasing whole businesses (even through the methods are virtuality the same).

The commonality of the articles is simply this: they confused the following terms objective and tactics with strategy.

Buffett’s wrote in his 1960 partnership that his “continual objective in managing partnership funds is to achieve a long-term performance record superior to that of the Industrial Average.” (Bolded emphasis mine)

And more specifically, investors close to Buffett, have informed me that Buffett will add the yield on U.S. 30 Year Treasury to 7 percent (2.786 % + 7% = 9.80%, rounded is 10%). This is appropriate as to take into account the effect of inflation. In addition, Buffett required a seven year payback period for each individual investment. 

That was Buffett’s objective, but what was his Strategy?

Buffett’s wrote in 1958 “I make no attempt to forecast the general market – my efforts are devoted to finding undervalued securities.

And Buffett has repeated this strategy throughout the years in his Berkshire Hathaway annual letters to shareholders.

It is well known that Buffett has evolved his investment strategy from his early days of picking up cigar butts, undervalued business based upon static valuation ratios, taught to him by his mentor Benjamin Graham.

Too buying undervalued franchised businesses, which exhibit competitive advantages. The two people who helped Buffett evolve his investment strategy in those early days were Charlie Munger and Phil Fisher. All this is well documented in Alice Schroeder’s book, The Snowball: Warren Buffett and the Business of Life.

But Buffett didn’t change any method in his investment strategy that conflicted with the fundamental principles of investing.

For instance, when Buffett learnt about Phil Fisher’s methods for seeking out high [probable] growth stocks, he always made the effort to check that a high growth business was adding value to the bottom line.

In Buffett’s words…

“…most analysts feel they must choose between two approaches customarily thought to be in opposition:  “value” and “growth.”  Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing.

We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago).  In our opinion, the two approaches are joined at the hip:  Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.

In addition, we think the very term “value investing” is redundant.  What is “investing” if it is not the act of seeking value at least sufficient to justify the amount paid?  Consciously paying more for a stock than its calculated value – in the hope that it can soon be sold for a still-higher price – should be labeled speculation (which is neither illegal, immoral nor – in our view – financially fattening).” (Bolding emphasis mine) Source

How does Buffett assess if a growth business is adding value? Read on

Now we know that Buffett’s strategy is to buy undervalued businesses coupled with competitive advantages (or as he refers to them Moats), listed on U.S. stock exchanges, but it was a tactical decision to focus his attention on industries within his circle of competence.

Buffett wrote in 1996, “an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”:  You don’t have to be an expert on every company, or even many.  You only have to be able to evaluate companies within your circle of competence.  The size of that circle is not very important; knowing its boundaries, however, is vital.”

This tactical aspect of the investment strategy is what we cannot copy and use ourselves, which is self-explanatory.  This is what those authors were trying to get at, plus of course, we cannot replicate Buffett’s results, again that is self-explanatory.

Bertrand Russell’s observation about life in general applies with unusual force in the financial world: “Most men would rather die than think. Many do.” Warren Buffett

Watch Fortune Mag interview Jeremy Miller, author of ‘Warren Buffett’s Ground Rules for Investing.’ This book is endorsed by Buffett! 

 

How can you apply the same investment strategy?

Back to how you can determine if a high growth business is adding value to its bottom line. 

You want to be checking that its equity is growing. Two places you can check, the first is the businesses Statement of Changes in Equity. 

There will be a column called retained earnings, keep an eye on it. It should be growing, and question when they pay out dividends.

The second is calculating the return on equity. It requires a few steps, but a simple way to check is to simply divide this year’s earnings by last years equity total. You should really make adjustments to the earnings to reflect a truer earnings picture.

Another aspect to look at is the cash flow statement. Growth is most sustainable when is it is funded by excess cash flows from operations. Amazon is a prime example. Whereas most of the time it is funded with debt, and looking at the section titled financing activities within the cash flow statement, you can compare the amount of money earnt by operations and the amount of money raised by debt instruments. 

Debt isn’t bad or good, it how it is used, that is how it is allocated by the CEO. During the tech boom of the late 90s and early 2000’s, the debt risen was used heavily for marketing activities. And within the Financing Activities is also where they report money raised through IPO and share issuances made as a listed business. Always question why the business require more outside funds?

Pets.com began to sell pet supplies to retail customers in 1998, it closed in 2000 and US$300 million of investment capital vanished, as a result. It spent $1.2 million of its IPO money raised on a Superbowl commercial.  

To learn how to invest successfully, that is to make money and limit your risk of losing, really is not as hard as people make out. 

Once I learnt the rules of the investing game, including the fundamental investing principles and then applied them with an investment framework (strategy), I suddenly saw thru all the bullshit – the marketing activities & published articles – that exist out there on the web and other sources. 

I take Charlie Munger’s advice seriously, especially when he said, “Don’t sell anything you wouldn’t buy your self.” And that is why I created this Premium Membership.

When I first started out, I felt lost with all the conflicting information out there on the web and in print. I didn’t find one place where you could learn the rules of the investing game, the underlying investment principles and a proven strategy to apply them within. 

What annoyed me the most is, if I came across a website that was selling the latest hot strategy, or what I found most common in my search is that they are selling the latest HOT stock you have to buy RIGHT NOW, not a minute later, otherwise you miss out on MILLIONS of dollars….arrrggghhh no I missed out, my life is ruined! FML

But none of them came with a guarantee that if it doesn’t work you’ll get your money back or even bothered to prove with results over a time frame, say 20 years, anything less than 20 years means it hasn’t stood the test of time, their product.

Oh and one last thing, you don’t need to become an excel expert, even an immediate user of excel. As Monish Pabrai, who Charlie Munger describes as brilliant, says “If Your Investment Thesis Requires You To Fire Up Excel, It Should Be A Big Red Flag!” 

Someone invent a time-machine and go back to 2008 and tell me this, please!!!


Links 

These are Warren Buffett’s ‘Ground Rules’ for Investing (endorsed by Buffett) 

Buffett’s Partnership letters (download here) 

Warren Buffett: Why stocks beat gold and bonds 

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