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Lesson No. 4: Stick with what you know

One of Buffett’s basic rules is: If you don’t understand a company’s product or how it makes money, avoid it. He calls this “staying within your circle of confidence.”

This isn’t always easy. During the late 1990s boom, Buffett famously avoided tech companies, confessing that he could not understand what they did. He looked dumb until the bubble burst. “Ultimately, when it came full circle, he was proven right,” Lowenstein says.

Lesson No. 6: Buy companies cheap

This is the essence of being a value investor. The first step involves calculating what Buffett calls an “intrinsic value” for a business — either by examining what similar companies sell for or calculating the present value of all the cash that will be generated by a company in the future. For more details on how to do this, you’ll have to consult books such as “The Warren Buffett Way” or “The Market Gurus” by Validea’s John Reese.

Next, build in a “margin of safety” by purchasing a stock well below its intrinsic value.

Buffett doesn’t pay much attention to earnings per share, a common measure of value. Instead, he likes to see companies with goodreturn on equity, solid operating margins and reasonable or no debt. He also likes to see that companies generate a lot of cash and that they invest it well or return it to shareholders in the form of dividends or buybacks.

The key throughout this analysis is to look back over five years or more. Buffett wants to see a consistent operating history; he’s not into startup companies. He also prefers to gauge how well a company does in different kinds of markets, not just the good times or the latest quarter.

Lesson No. 7: Look for companies with economic moats

A key characteristic supporting consistent operating history is a sustainable competitive advantage. In other words, a company should have a barrier to entry — or a kind of moat — that keeps potential competitors at bay.

This could be a patent protection on drugs, high costs to get into a business or simple brand power, fund manager Lowenstein says. “Franchise” businesses like these can do well because they have the power to raise prices. In contrast, companies in “commodity” businesses have to take whatever price is set by a competitive market — which can crush profits during hard times.

BNSF Railway is a great example of a “franchise” business. It’s pretty hard for anyone to lay enough track in North America to start a competing railroad. Coca-Cola (KO, news, msgs), another long-term Buffett holding, has barriers to entry in the form of a strong global brand and distribution system that is hard to replicate.

Lesson No. 8: Buy big, concentrated positions

Most professional money managers protect against risk by diversifying. Buffett goes against the crowd here, too. When he finds a company he likes, he piles into it big time.

This is crucial to his success. Money manager Hagstrom calculates that if you eliminate a dozen of Buffett’s best investment choices over his career, he’s only an average performer. Buffett thinks his risk protection comes from understanding a business better than the market does and then being patient enough to buy it at the right price.

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    2012-05-18 02:46

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