book.chapter Section 1 – overview of buffett's investment principles

Grasping warren buffett's investment approach is straightforward; the challenge lies in its execution, diverging from the norm for most investors. Over time, buffett's strategy has developed, fundamentally encompassing five critical components, making its application the real test. Maintain liquidity amidst scarcity Despite the trepidation surrounding california's real estate market in 1990, which mirrored the crisis in new england and led to a nearly 50% drop in wells fargo's stock within months, we saw an opportunity. Our prior investments in the company at higher prices didn't deter us; instead, the plummeting prices were a welcome chance to increase our holdings significantly. This perspective is one that all investors who anticipate being consistent purchasers over their lifetimes should share. Rather than rejoicing when stock prices climb and lamenting when they fall, a more logical approach is to embrace market volatility as an opportunity. Warren buffett has consistently advocated for buying stocks when they are out of favor. The prolonged recession has resulted in stock prices being slashed to levels unseen since the early 1980s. For instance, coca-cola was trading at 16 times earnings in 2011, a stark contrast to its 47 times earnings valuation in 1999. Similarly, wal-mart's p/e ratio stood at 12 at the end of 2011, down from 38 in 2001. Procter & gamble's p/e ratio also decreased to 16 at the end of 2011 from 29 in 2000. This pricing environment allows investors with liquidity to select from the best investment opportunities available. Buffett is familiar with this pattern, often selling when the market is high and then holding onto cash for years, waiting for the next downturn. He strategically invests in companies with strong economic fundamentals and a lasting competitive edge. Buffett began his career as a staunch value investor, seeking undervalued stocks. However, this often meant investing in lesser companies, leading him to liquidate his portfolio in 1969 and wait out the market frenzy. He re-entered the market during the crash of 1973-1974, focusing on top-tier companies with sustainable competitive advantages. In 2007, sensing an overheated market, he again accumulated cash within berkshire. The 2008 crash found berkshire with $37 billion in cash, enabling buffett to acquire significant stakes in premier american companies at deeply discounted prices. Buffett's strategy of buying during bear markets, industry downturns, or when exceptional events impact strong companies has yielded substantial returns for berkshire hathaway. The strategy is straightforward: accumulate cash, identify companies with enduring competitive advantages, purchase them in a down market, and hold for the long term. While this may seem simple, most investors are conditioned to buy during bull markets, leaving them without the necessary cash reserves when a bear market emerges. Consequently, they not only lose money but also miss out on the opportunity to capitalize on favorable prices. Choose stocks with proven histories Warren buffett's investment philosophy is deeply rooted in the principle of predictability. He seeks out companies whose future he can foresee with a reasonable degree of certainty. For instance, consider the enduring appeal of wrigley's chewing gum; it's unlikely that technological advancements will alter the fundamental habit of chewing gum. Buffett's assertion that "predictable products equal predictable profits" encapsulates his approach. Buffett's portfolio predominantly consists of venerable firms offering familiar products and services, a deliberate choice reflecting his investment strategy. The longevity and renown of a product or service enable an investor to discern whether a company possesses a lasting competitive edge. A firm that has thrived for over half a century is likely doing something commendable. Moreover, with established companies, it's more straightforward to determine if the industry demands continuous investment in research and development to remain competitive. Buffett tends to avoid industries where companies must invest heavily to stay afloat. He prefers businesses with products and operations he can easily comprehend. If a company has been marketing its product for a century, it instills a strong confidence that it will continue to do so for the next decade or two. Seasoned companies typically have earnings patterns that can be evaluated for predictability, a desirable trait for any investor. The company's age and the stability of its revenue are often indicative of a sustainable competitive advantage. Buffett's strategy during market downturns is also telling. Rather than seeking out the undervalued stocks he once favored early in his career, he concentrates on exceptional companies with a durable competitive advantage. This focus is highlighted by mary buffett and david clark, who point out that buffett's attention during these times is not on fleeting bargains but on businesses with enduring strengths. Seek earnings stability and growth Warren buffett is renowned for his investment strategy, which hinges on the stability of a company's earnings over an extended period. He steadfastly avoids investing in businesses that fall outside his sphere of understanding, exemplified by his decision to not invest in intel. His investment philosophy is predicated on the ability to predict future earnings with a high degree of certainty, and he steers clear of industries that are enigmatic to him. Buffett is also wary of companies that exhibit volatile earnings, which often indicates that their products are undifferentiated commodities competing primarily on price. The airline industry, where competition is fierce over the cost of seats, is a classic example of this scenario. Another cautionary sign for buffett is a company whose products require frequent updates and redesigns to remain competitive. This characteristic is typical of the high-tech industry, which is prone to rapid and extreme fluctuations, and it explains buffett's general aversion to such investments. The investment choices of warren buffett are reflective of his principles. He has chosen to invest in companies like procter & gamble, coca-cola, and johnson & johnson, which have demonstrated consistent earnings, allowing for reliable long-term forecasts. Conversely, he has not allocated berkshire hathaway's funds to companies like united continental holdings, ford motor company, or advanced micro devices, inc., due to their erratic earnings histories. Buffett's investment philosophy is succinctly captured in the words of mary buffett and david clark: "a long-term or durable competitive advantage in a stable industry is what we seek in a business." this approach underscores the importance of understanding the businesses one invests in and avoiding those that are difficult to predict or comprehend. View investments as equity bonds In the realm of investing, bonds are known for their stable returns, fixed for the bond's duration. Warren buffett likens certain stocks to bonds, coining the term "equity bonds" for stocks of companies with highly predictable earnings due to their exceptional quality. These equity bonds, according to buffett, offer a fixed rate of return similar to traditional bonds. However, if the company's earnings per share (eps) continue to grow, the return on the equity bond increases over time, creating what buffett calls an "expanding equity bond," which is an ideal investment in his view. The return on these equity bonds is also influenced by the price at which shares are acquired. Buying shares below book value enhances the return, while purchasing above book value diminishes it. Any changes in earnings will affect the return rate. To illustrate, consider berkshire hathaway's 1988 investment in coca-cola. At that time, coca-cola's book value was $1.07 per share, the market price was $5.22 per share, and the eps was $0.36, yielding a 6.8% return. By 2011, coca-cola's eps had risen to $3.85, and the share price to $65, resulting in a 1,145% return on the original investment, or an 11.59% annual compound rate over 23 years. Identifying a good investment retrospectively is straightforward, but projecting future value is more complex. For coca-cola, the process involves examining historical earnings for consistent growth, calculating the growth rate using financial tools, and estimating future eps by projecting current growth rates into the future. If coca-cola maintains a 9.18% growth in eps, it could reach $9.27 by 2021. A conservative future share price can be estimated by applying the lowest historical p/e ratio to the projected eps. Adding expected dividends to this projection further enhances the potential return. Finally, using these projections, one can estimate the annual rate of return, which in this case could be around 9.9%. This method is only suitable for companies with stable earnings, a long history of financial data, and conservative p/e ratios. It's ideal for the types of stocks buffett selects for berkshire hathaway, as companies with a durable competitive advantage can grow their eps and intrinsic value over time, which the stock market will eventually recognize, even if short-term stock prices fluctuate. Prioritize companies with dominance Warren buffett's investment strategy includes a keen focus on companies that possess customer monopolies or significant consumer loyalty. To assess this, buffett pays close attention to changes in a company's book value per share, which is calculated by dividing total assets by the number of outstanding shares. This growth in book value is indicative of a company's long-term economic health. Companies that maintain a competitive edge typically exhibit consistent growth in their book value. It's important to note that book value differs from intrinsic value, which considers future revenue streams discounted to their present value. While a company's intrinsic value can fluctuate daily for various reasons, a consistent upward trend in book value is often a reliable indicator of long-term growth in intrinsic value. For example, between 1995 and 2011, coca-cola experienced a 578% increase in its per share book value, translating to an annual growth rate of 12.72% over sixteen years. In contrast, ford motor company saw its per share book value decline by 86.48% during the same period, equivalent to an annual growth rate of -11.76%. Coca-cola's impressive growth in book value underscores its long-term investment appeal. Although there are several reasons why a company's book value might decrease, such as spinning off a subsidiary or making a high-priced acquisition, a consistent increase in book value is a strong indicator of a sustainable competitive advantage. Observing a steady rise in book value should prompt further investigation into the company's economic history to determine the presence of a lasting competitive edge.