Education: Value Investing

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A Quick Bio on Warren Buffett

From 1965 to 2006, the Standard and Poor’s 500 Index—one of the most commonly used benchmarks for the overall U.S. stock market—had an average annual return of 10.4%.

The goal of most investors is to "beat the market", meaning they would like for their portfolio to outperform the S&P 500. This would not have been an easy task over the past 42 years. However, one individual not only beat the market over this time period, he absolutely crushed it. Who, you ask? None other than the “Oracle of Omaha.”

An Investing Genius Is Born

Warren Buffett was born on Aug 30, 1930 in Omaha, Nebraska, to Howard Buffett, a stockbroker and member of Congress, and Leila Buffett. He wasted no time jumping into the investing world—purchasing his first stock, Cities Services preferred shares, at the tender age of 11, for $38 each. He would turn around and sell his holdings and make a cool profit of $2 per share.

You will never guess what unfolded next. The stock eventually hit $200 a few years later. However, this laid the foundation for what would be Buffett’s long-term investment strategy.

In addition to recognizing the importance of the stock market at such an early age, other highlights included Buffett successfully deducting his bicycle as a work expense at 13 years old while filing his first income tax return. Also, in 1944, when he was 14, he invested $1,200 of his savings into 40 acres of farmland. Little did he know at the time that he would eventually be worth more than $40 billion.

Father Knows Best

Warren Buffett is considered by many to be the greatest investor ever. When he took over at Berkshire Hathaway in 1965, its shares sold for $20. They recently traded at a whopping $109,650. That is not a typo—trust me. What is this Wall Street wizard’s recipe for success? Wouldn’t we all like to know? We do have some clues, however.

Buffett worked under the tutelage of Benjamin Graham—the father of value investing. Value investors are constantly on the hunt for stocks that are selling below their true value. When Buffett is contemplating investment opportunities, he goes beyond determining whether or not it is selling below its fair value. The business has to have solid economics behind it as well.

A number of Buffett’s investing tenets have been pointed out by many people. Some of the more popular are covered below. They can serve as a nice blueprint when constructing your value approach to investing.

The Oracle’s Investment Philosophy

1. Buffett will place his investment dollars only in businesses that he fully comprehends. This makes sense: if you don’t understand the business, how can you project future performance? Furthermore, if a company’s life is less than 10 years, it will typically miss his radar.

2. Some of the common financial measures that Buffett will look at include return on equity (ROE) and the debt-to-equity ratio (commonly referred to as a firm’s leverage).

As we mentioned in our article on ROE, it is not only important to find companies in which their ROE’s are improving, but this measure must also be compared to the industry average. Buffett adheres to this.

The debt-to-equity ratio tells investors what proportion of equity and debt the company is using to finance its assets. The ratio is provided below. A high debt-to-equity ratio can lead to greater volatility in a company’s earnings. I bet you can guess what Buffett looks for here.

Debt/equity ratio = Total Liabilities/Shareholder’s Equity

3. Buffett is a stickler for quality management—management committed to expanding profit margins. High and growing profit margins, calculated as net income divided by revenues, are extremely appealing and rightfully so. It is one thing for a company to increase profits, but if it can manage costs along the way, that is the ultimate goal.

4. Economic moat. What? Yeah, that is a rather unusual term that floats around the finance industry (no pun intended). Buffett is credited with coining the term which simply means a company’s competitive advantage. When a company is said to have a wide economic moat, competitors have a much tougher time capturing market share. Buffett favors these types of companies.

5. Last, and certainly not least, Buffett determines what every value investor attempts to uncover—the company’s intrinsic or actual value. No one knows for sure exactly how he arrives at this. Or if someone does, I can guarantee he or she is also a very wealthy individual. Some suggest he utilizes a discounted cash flow model, while others refute this claim. This is the most difficult task for any value investor, except for Mr. Buffett, of course!

Whether you are a Buffett fan or not (Warren, not Jimmy), you cannot argue with the man’s success. When Forbes released its recent list of the world’s richest people, Buffett occupied second place. But he has a firm hold on first place in the hearts of value investors around the world.