Warren Buffett Favorites
Top-Ranked Funds that Mimic Legendary Billionaire Warren Buffett's Investment Approach

Ask virtually anyone to list the world's most successful investors, and odds are excellent that the name Warren Buffett will appear at the top of the list.

As one of the world's richest people, he has amassed billions in wealth over the past few decades. And unlike many of his contemporaries who made their money in real estate or oil, virtually every dollar of Buffett's fortune has come from gains made in the stock market.

Not surprisingly, an entire library of books has cropped up trying to distill Buffett's methodology into a formula that today's investors can emulate. Unfortunately, Buffett's amazing track record may never again be duplicated. However, by studying his time-tested investment approach and prudent money management philosophies, we can see into Buffett's mind -- and that knowledge serves as the foundation for decades of investing success.

In today's report, we will outline the specific attributes that Buffett looks for in a company, as well as the criteria he uses to evaluate prospective investments. We will also discuss the broader money management philosophies that have guided his tactical portfolio decisions over the years. Finally, for those who want to put this accumulated wisdom to work in their own portfolio, we'll profile two standout closed-end funds whose objectives match up well with Buffett's teachings.

(1.)  The Early Years

For those who are not familiar with Buffett's illustrious career, a brief recap might be in order.

Warren Buffett was born in Omaha, Nebraska on August 30th, 1930. It didn't take long for the man who would one day be known as the "Oracle of Omaha" to show a strong entrepreneurial spirit and a remarkable aptitude for money and finance. At the age of 11, he was already working in his father's brokerage firm.

That same year, Buffett made his first stock market investment, purchasing three shares of Cities Service Preferred for $38 per share. Buffett then held fast when the stock plunged (something older and more experienced investors have trouble doing), and eventually sold it at $40 for a modest gain. However, the shares eventually skyrocketed to around $200 -- perhaps ingraining the buy-and-hold philosophy that has since defined Buffett's career.

After high school, Buffett studied at the University of Pennsylvania's prestigious Wharton School of Business. Later, he attended graduate school at Columbia and was taught by none other than Benjamin Graham -- considered by many to be the "father of value investing." Buffett excelled under the tutelage of his new mentor and years later would eventually be hired to work at Graham's Wall Street firm.

With Buffett's knowledge of the markets increasing, it was in 1956 that he moved back to Omaha and convinced seven family members and friends to invest in Buffett Associates (later known as Buffett Partnership Limited). From a humble beginning with just over $100,000 in assets, the partnership would enjoy tremendous returns under his leadership, racking up a gain of +1,156% during the first decade alone.

Naturally, this stellar performance attracted many subsequent investors, and the partnership thrived during the bull market of the late 1960s (making $40 million in 1968 alone). However, citing a lack of quality investment ideas, Buffett chose to dissolve the partnership in 1969. Those original investors who stuck with him from 1956 to 1969 were richly rewarded, earning extraordinary annual returns of around +30% during that period.

Over the next year, Buffett liquidated nearly all of the partnership's portfolio holdings. One of the few exceptions was Berkshire Hathaway (NYSE: BRK-A) -- a small textile company that Buffett had begun buying seven years earlier at $8 per share (at the time, the firm had $16.50 per share in working capital). The partnership would eventually become Berkshire's largest shareholder, and Buffett quickly assumed control of the company -- naming himself chairman. At this point, his personal net worth was already in excess of $25 million.

The rest, as they say, is history.

Buffett proved to have a magical touch when it came to allocating Berkshire's capital, and the company's investment portfolio (and shares) zoomed higher through the years -- trouncing the major averages by a wide margin. By the early 1980s, Berkshire's stock had climbed to $750 per share, and Warren Buffett had already become a household name. But he was just getting started.

Berkshire Hathaway shares now trade over $100,000 per share -- placing the personal net worth of its chairman somewhere in the neighborhood of $60 billion before recent charitable donations. This almost inconceivable track record of success has made Warren Buffett one of the world's richest individuals and has secured his status as one of the most legendary investors of all time.

(2.)  Buffett's Key Investing Principles

Fascinating as Buffett's biography may be, there are bigger questions that need to be answered. Specifically: What type of companies does Buffett invest in, and as an investor, how can you profit from his approach?

Unfortunately, there is no simple answer to that question. Looking back over the past five decades, Buffett has made money on small companies and large companies, stocks and bonds, domestic and foreign firms -- and even outright speculation on foreign currency and commodities futures contracts.

Yet, while it is difficult to draw up a formulaic investing approach based on Buffett's past stock selections alone, his comments and actions have yielded some very valuable insights. At the same time, by analyzing the commonalities within Berkshire's portfolio, we can better determine the traits that Buffett searches for in a prospective investment.

With that in mind, we have distilled many of Buffett's core philosophies into the following checklist. Before investing, carefully consider each of the following questions:

What makes the company stand out?  Does the firm have a well-defined economic moat? Does it benefit from any sustainable competitive advantages?

How unique is the business?  Has the company found a way to differentiate its products, or does it sell commodity-like items with little pricing power? How strong are the firm's profit margins?

How predictable are future earnings?  When it is difficult to accurately forecast future cash flows, it becomes nearly impossible to calculate a stock's intrinsic value with any degree of precision. Not surprisingly, Buffett shuns hot IPOs, risky technology companies, rapidly changing industries, and young firms with cloudy outlooks that haven't yet proven they can successfully navigate a challenging operating cycle.

Does the firm generate strong returns on capital?  Have returns on equity (ROE) been consistently higher than 15%? How about returns on invested capital (ROIC)? How do these key profitability metrics stack up against those of industry rivals?

Is the company financially healthy?  Does the firm maintain a strong balance sheet, or is it highly leveraged? Is it generating sufficient cash flows to adequately service and pay down its outstanding debt obligations? How capital intensive is the business?

Can management be trusted?  Do leaders candidly admit mistakes? Are the incentives of a company's managers aligned with the interests of rank and file shareholders? Does the stock have relatively high insider ownership?

(3.)  The Bigger Picture

By looking beneath the numbers and delving deeper into the factors that influence them, you will have taken a big first step. However, keep in mind that stock selection is only part of the bigger picture -- you should also consider a number of other factors.

How many stocks or funds should I buy? What percentage of my portfolio do I allocate to each? When should I consider selling? Without question, these topics can have an even greater impact on your investment returns than actual stock selection.

So in conjunction with the guidelines above, be sure to also stay within the larger Buffett framework. Over the past 50 years, the following tenets have formed the foundation for his success:

Diversification is for beginners only.  Buffett believes strongly that intelligent investors should focus on their best investment ideas and maintain concentrated portfolios. Aside from the fact that it can be difficult to track a sprawling portfolio, having too many stocks usually leads to index-like returns. How can you beat the broader market when your portfolio is the market?

Invest for the long term. With a preferred holding period of "forever," Buffett clearly is a big proponent of buy-and-hold investing. It is next to impossible to time the market consistently, and those trading in and out of stocks usually end up with mediocre performance -- often triggering excessive commissions and hefty tax liabilities in the process.

Don't buy a share, buy a business. Buffett stresses the difference between being a trader and an investor. Resist the temptation to track day-to-day price fluctuations. If a company's business fundamentals are improving, then it will eventually be reflected in the share price.

Stick with what you know. With investments in well-known firms like Coca-Cola (NYSE: KO), Procter & Gamble (NYSE: PG), and Wal-Mart (NYSE: WMT), Buffett believes in owning established companies with recognizable brands and easily understood business models. Those who invest in companies they don't understand may not spot potential problems until it's too late.

As a rule, Buffett places a premium on the importance of experienced and trustworthy management. He also looks for mature companies with high returns on capital and sustainable competitive advantages. In many cases, his actions go against conventional Wall Street thinking, but then again, marching along with the herd has never made anyone stand out from the crowd.

Those wanting to follow Buffett's lead have several choices. The most obvious, of course, is to invest directly in his firm -- Berkshire Hathaway. However, while there is every reason to believe that Berkshire will continue rewarding its owners, the price of the shares might be out of reach for some investors. We're not referring to valuation here; investors must come up with more than $4,000 to buy just a single share of the class 'B' stock -- and the class 'A' shares trade for well over $100,000. 

More importantly, though, many of Berkshire's largest portfolio holdings have been held for decades, and simply don't have the same growth prospects or upside potential as they did in years past. Fortunately, there are many other options -- including several closed-end funds (CEF) that exhibit strong Buffett-like characteristics. 

After scouring the entire CEF universe for these gems, we have identified two exceptional funds that are closely aligned with Buffett's investing methodology. Throughout the remainder of today's report, we'll provide a detailed analysis of these two funds. . .

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I sincerely hope you've enjoyed today's report -- Warren Buffett Favorites.




Nathan Slaughter
Editor
The ETF Authority
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