Investing Like Buffett
How to Profit from the Wisdom of the "Oracle of Omaha"

In 1962, a successful young fund manager began buying a sleepy New England textile firm. But by the time the 1960s rolled around, the U.S. textile industry was already in decline -- losing out to cheaper foreign competition and getting squeezed by rising labor costs. A small textile company with a few plants in Massachusetts certainly showed little growth potential or future.

This hardly sounds like the ideal company for the world's most successful investor. After all, a sleepy industry in a state of terminal decline is about as far away as you can get from Wall Street.

But that manager was a 32-year-old Warren Buffett, and the textile manufacturer was Berkshire Hathaway (NYSE: BRK-B). Buffett took total control of the company in 1965 and replaced the company's management team. You see, Buffett wasn't interested in the textile business itself, but was instead interested in the firm's cash. While the business wasn't growing, Berkshire generated copious free cash flow and had plants, equipment and land that could be liquidated to provide even more cash.

With this in mind, Buffett dissolved his investment partnership and began instead to invest Berkshire's excess cash flows, offering his investors a stake in Berkshire in lieu of their previous fund holdings. Investors who took that deal were amply rewarded. Buffett's returns have been nothing short of legendary, averaging nearly +22% annually since he took over Berkshire's reins in 1965.

As our chart illustrates, $10,000 invested in Berkshire in the 1960s would be worth more than $36 million today against less than $700,000 for the same sum invested in the S&P 500. That's more than a +361,000% gain.

Amazingly, out of the more than 40 years Buffett has been at the helm of Berkshire, there has only been one year in which Berkshire's book value actually fell. And Berkshire stock has only underperformed the S&P 500 six times in that timeframe.

Buffett's long track record of success is unprecedented -- according to Forbes, Warren Buffett is among the richest men in the world with a total net worth in the neighborhood of $50 billion. But what's even more unique is that he is one of only a handful of names on that list to attain virtually his entire wealth by investing in the stock market.

Berkshire's performance is proof of the wisdom and value of Buffett's approach. Not surprisingly, dozens of books have been written on the subject, probing virtually every aspect of the Oracle's life and all of his legendary investment decisions.

While it is nearly impossible to neatly distill all of his wisdom into any single book or article, we can study some of the key concepts and fundamental criteria that underpin Buffett's time-tested approach to investing. In today's report, we will outline the key traits that Buffett looks for in an investment, and show you how to put that knowledge to work in your own portfolio.

(1.) Buffett's Philosophy

Some of the concepts that follow are rather subjective, while others are more quantitative. However, the bottom line is that a solid understanding of each can help improve any investor's performance. Let's review:

Easy-to-Understand Businesses
"There are all kinds of businesses that Charlie and I don't understand, but that doesn't cause us to stay up at night. It just means we go on to the next one" 
-- W. Buffett

If you're a fan of retired Fidelity Magellan fund manager Peter Lynch, then you may remember his "buy what you know" concept. Buffett has long espoused a similar investing mantra. Essentially, Buffett believes in limiting your investments to companies with businesses that can be easily understood and analyzed. After all, if you can't understand how a business makes money, then how can you possibly gauge its financial performance or estimate its true value?

More importantly, it's easier to forecast future results for companies with straightforward and uncomplicated business models. Buffett always strives to look into the future when he invests, searching for businesses that he feels will still look solid at least 10 or 20 years down the road.

In short, if you can't fully explain a business and why you should own its shares in just a few, coherent paragraphs, then you should walk away.

Low Debt Levels
"Good business or investment decisions will eventually produce quite satisfactory economic results with no aid from leverage."
-- W. Buffett

By looking through his previous success stories like Coca-Cola (NYSE: KO), The Washington Post Co. (NYSE: WPO), and Moody's (NYSE: MCO), it is clear that Buffett carefully examines a company's balance sheet, and prefers to invest in those with relatively modest debt burdens.

During the 1990s, investors largely ignored debt levels and focused instead on growth metrics. However, to his credit Buffett has never wavered in his focus on debt. In his 1987 letter to shareholders, Buffett eloquently noted that: "Good business or investment decisions will eventually produce quite satisfactory economic results with no aid from leverage." In the years since, adhering to that policy has kept Berkshire shareholders out of trouble.

When it comes to funding future growth, Buffett prefers companies that can meet their requirements through internally generated cash, as opposed to raising capital by taking on debt or issuing more stock. Companies that can grow using only their existing cash flows are more or less internally financed. In other words, these firm's aren't dependant on securing loans to stay in business. By contrast, companies with large debt loads are usually reliant on external financing -- in most cases this means the capital markets -- to keep growing and operating.

There are risks to these external financing sources. We all know that conditions in the capital markets can shift on a dime. Back in 1999, for example, a tech company could get showered with cash by simply listing its stock for public trading. However, by 2001 a bear market in technology stocks essentially closed that window. The same can be said for the bond market -- interest rates rise and fall and bond investors' perception of risk sometimes changes overnight. Of course, a credit downgrade can make it much more costly to secure financing, and higher interest payments tend to eat into profits.

When measuring a company's reliance on debt, it's usually helpful to begin by examining its debt-to-equity (D/E) ratio. D/E can be easily calculated by dividing a particular company's total debt load by its shareholder's equity. Both of these key figures are located on the balance sheet. There's no hard-and-fast rule for evaluating this metric, but as a broad average for non-financial companies, it's usually wise to look for firms with D/E ratios below 0.50 (50%). 

High Profitability and Return-on-Equity
"Time is the enemy of the poor business and the friend of the great business." 
-- W. Buffett

If there's one single piece of financial data that's more often associated with Buffett than any other, it's return-on-equity (ROE). The calculation of ROE is relatively simple, and this metric can be found on just about every financial website. Simply divide a company's net income -- defined as total profits after interest, taxes, and depreciation -- by its shareholder equity. This ratio measures how much profit a company produces relative to shareholders' investment in the firm.  

Earnings growth is fine, but that growth always comes at a price. That's where ROE comes in. This extremely informative figure tells us how efficiently a company is using the capital at its disposal. As a rule of thumb, it's often best to stick with companies showing ROE of 15% or higher.

But don't assume that you can invest like Buffett simply by running a screen for stocks with very high ROE. There are a couple of additional points to keep in mind. First, looking at the current figure in isolation only tells part of the story, so check to see whether ROE has been falling, rising, or stable over time. Also, if a company has a particularly strong year, then its net income figure can be inflated, which can cause ROE to be exceptionally strong. Such one or two-year blips have a tendency to fade quickly once the business environment becomes less favorable. Therefore, it's always important to examine ROE performance over a five or ten-year period. 

The second point to consider is the relationship between ROE and D/E. By taking on additional debt, companies can effectively lower the amount of shareholder's equity they need to stay in business. By definition, this tends to inflate ROE. Therefore, it's crucial to look for companies that have a high ROE and low D/E.

Proven Managerial Expertise
"The managers at fault periodically report on the lesson they have learned from the latest disappointment. They then usually seek out future lessons." 
-- W. Buffett

As we said earlier, not all of Buffett's investing criteria is objective. Case in point: Buffett seeks out firms with highly competent management teams.

When Buffett makes an investment, he believes that he is buying a management team, as well as the business itself. In fact, when Berkshire makes an acquisition, the existing management team usually remains in place after the deal is completed. 

Typically, this has often meant getting to know a management team on a personal level. A great example of that is Clayton Homes, as detailed in Berkshire's 2003 annual report. In a letter addressed to Berkshire's shareholders, Buffett explained how he became interested in and ultimately acquired Clayton Homes, a manufactured home builder.

In this case, Buffett first became aware of Clayton Homes in the 1990s when he bought the distressed, junk-rated debt of Oakwood Homes, an investment that got wiped out when Oakwood declared bankruptcy. The problem with the manufactured home industry, according to Buffett, is that overly generous consumer-lending practices often lead to a buildup of non-performing loans, and in severe cases, high default rates can eventually lead to bankruptcy.

Buffett was first attracted to Clayton because the company's management team was well known in the industry for its conservative lending practices, which included larger down payment requirements and shorter-term loans. Ultimately, he contacted the company's CEO, Kevin Clayton, and was impressed with the way he described the company's risk-management style. Buffett also attributed a great deal of his knowledge about the company to a biography he read on Clayton Home's founder, Jim Clayton, the father of the CEO. 

It is unlikely that the average investor will be able to precisely mimic Buffett's approach to understanding corporate management teams, or have the opportunity to interview them personally. However, there are still plenty of important lessons to learn here. Chief among them is the fact that Buffett prefers companies with capable, experienced, and trustworthy management teams -- particularly if they have an economic stake in the business. 

In short, a company is only as strong as its leaders, so ask yourself these questions before investing: 

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? Has the firm made rational decisions with its retained earnings? Is management committed to delivering long-term shareholder value, or does it destroy value by employing tactics designed to meet arbitrary short-term earnings targets and appease Wall Street analysts?

Remember, financial results can change overnight, so it pays to also evaluate the leaders responsible for delivering those numbers. 

Attractive Valuation and Measurable Margin of Safety
"The more vulnerable the business is...the larger margin of safety you'd need." 
-- W. Buffett

At the end of the day, we all invest with one goal in mind: to buy a stock at one price, and then later sell it at a higher price. Therefore, the price we pay should always be the first and most important consideration. 

On that front, the related concepts of intrinsic value and margin of safety form the core of what is considered value investing. Buffett's use of both intrinsic value and margin of safety were heavily influenced by the teachings of mentor Benjamin Graham. 

As opposed to P/E ratios and other similar valuation tools, which only tell us how expensive one stock is relative to another stock, intrinsic value attempts to capture the true worth of a company, and by extension, its share price. Of course, investors often take different approaches when attempting to estimate a firm's intrinsic value. As a result, you'll often see wildly different assessments of what a particular stock is worth. However, most estimates incorporate many of the same variables, including the value of a firm's real assets, its current and future earnings, and the value of intangibles like brand names. 

Graham focused mainly on a company's current assets and book value -- the actual numbers that can be found on the balance sheet. Buffett, however, tends to lend more credence to intangibles and potential growth in a business, and his analysis of intrinsic value focuses on key fundamentals like revenues, assets, cash flow (see below), and projected growth. In other words, Buffett believes that a company's valuation is often driven by its long-term earnings power. 

However, nobody can precisely project a company's future earnings exactly, so it is important to leave some room for error -- or a margin of safety. In essence, the idea is to give yourself room to make mistakes when assessing intrinsic value. After all, if you overestimate the value of a business, then you're likely to overpay for its stock. However, if you require a large margin of safety before making any investment, then you'll reduce the chances of making a poor decision. 

For example, paying $45 for a stock with an intrinsic value of $50 might be okay if everything goes according to plan -- but what if the company's growth rates began to miss the mark? By refusing to pay any more than say, $30 for that same stock, you would have substantial room for future downward adjustments to intrinsic value. In other words, if the company's results stray off target or some unexpected problem pops up, dropping the intrinsic value to $40, then the stock would still have $10 of upside potential.  

Graham would not invest in a stock unless it was trading at a minimum 25% margin of safety. Likewise, Buffett looks for companies that are trading at steep discounts to his calculation of their intrinsic value. 

Sustainable Economic Moats
"The key to investing is ... determining the competitive advantage of any given company and, above all, the durability of that advantage."
-- W. Buffett

It has long been one of the most fundamental axioms of basic economics: success invites competition.

Regardless of the industry, any company that finds a way to earn outsized profits will sooner or later attract competition. While no company is immune, some are less susceptible to the threat of competition than others. Those with well-developed "economic moats" in place are much more likely to withstand an attack from competitors.

Think of a medieval castle surrounded by a moat full of water. The wider the moat, the more difficult it is for invaders to successfully attack and conquer the castle. So, how does this concept apply to the financial markets? It's simple -- companies that have wide moats are better insulated from competitive threats and fluctuations in the business cycle. Because Buffett is always thinking down the road, this concept is central to his investment philosophy. 

Some economic moats are easily spotted. For example, stringent SEC regulations and oversight have long thwarted new companies trying to enter the credit ratings business, and that barrier to entry has dug a wide economic moat for established players like Moody's (NYSE: MCO). A strong brand name would be another example. Coca-Cola (NYSE: KO) is one of the most widely recognized names in the world, and that valuable brand gives the firm significant pricing power, as millions of consumers are willing to pay premium prices for Coca-Cola beverages. Not surprisingly, both Moody's and Coca-Cola are long-time Berkshire holdings.  

However, there are many other competitive advantages that are not easily recognized. For instance, a powerful retailer might have tremendous bargaining power over suppliers, and thus be able to negotiate favorable purchasing terms -- a firm like Wal-Mart (NYSE: WMT) springs to mind here. The network effect is another intangible, but very real competitive advantage. Just think of online auction giant eBay (Nasdaq: EBAY). Millions use eBay to sell items because of the large number of potential buyers the site reaches. Meanwhile, millions of buyers shop on eBay because of the high number of sellers offering a variety of products. As the site's membership continues to grow, the benefit to both buyers and sellers grows as well -- further strengthening the company's position in the market.    

Consistent Free Cash Flow and Owner Earnings
"Calculate owner earnings to get a true reflection of value."
-- W. Buffett

Due to the nature of accrual accounting, a company's net income often bears little resemblance to its true net cash profits in any given period. Therefore, it is usually a good idea to also keep track of free cash flow (FCF) -- or operating cash flows less capital expenditures. Free cash flow measures the cash available to shareholders after a company has paid all of its bills in full. Buffett relies heavily on a similar metric that he dubs "owner earnings."

One way to gauge a firm's cash flow production is to examine its free cash flow yield. This is calculated by dividing free cash flow by market capitalization, or the inverse of the Price/FCF ratio. A firm with a free cash flow yield of 10%, for example, generates 10% of its total market value in cash each year. That cash, in turn, can be used to pay dividends or fund share buybacks -- items that enhance shareholder returns. 

Buffett always looks for companies that have a proven ability to generate healthy, consistent free cash flows over the long-haul. 

(2.)  How You Can Profit from Buffett's Teachings

Those looking to gain from the wisdom of the Oracle of Omaha are in luck -- there are several ways for you to do so.

Of course, the most obvious method is to buy shares directly in Berkshire Hathaway itself. Berkshire is an unusual entity. Since Buffett took effective control of the holding company in 1965, he has never split the stock or declared a dividend, believing that any excess earnings should be held for reinvestment -- and it is hard to quibble with this reasoning. The other thing to remember about Berkshire is that the investment side of the firm's business is only part of the story. Berkshire is also one of the world's largest insurance companies. Keep in mind that insurance firms make money in two ways: underwriting income and investment income.

On the underwriting side, Berkshire is very profitable. The company's GEICO subsidiary focuses on insuring low-risk drivers at favorable rates. That's a solid niche business to be in -- it's easier to model the claim payouts necessary to cover safer drivers. Meanwhile, the company's reinsurance unit (reinsurance is the business of insuring other insurance companies as a means to spread risk) is one of the largest and most profitable players in the industry.  

While underwriting profits are certainly desirable, Berkshire's insurance operations come with an added benefit -- they feed Buffett a large pile of cash to invest. Specifically, after the firm's insurance units take in premiums, Buffett is then free to invest these funds until they have to be paid out as claims. This cash, called the float, forms the core of what Buffett invests for Berkshire. Of course, all insurance companies invest their float in stocks and bonds. However, when it comes to Berkshire, you're buying the investment savvy of Warren Buffett as part of the mix.

There's also another unique way for individual investors to invest directly in Buffett's philosophy, the Wisdom Fund (WSDVX). This mutual fund's stated goal is to mimic the investments made by Berkshire Hathaway, and its top holdings include Coca-Cola, Wells Fargo, American Express and Johnson & Johnson -- mirroring Buffett's long-time core positions. Keep in mind, though, that the fund's returns may differ from those of Berkshire, as Buffett also has stakes in many private businesses, as well as foreign securities. Nevertheless, the fund is still a quick and easy way to follow in Buffett's footsteps.

Applying Buffett's Teachings
Investing in Berkshire, the Wisdom Fund, or just picking up stocks that are traditional Buffett favorites are all good ways to cash in on Buffett's timeless value philosophy. However, the best idea of all is to learn from Buffett's investments and try to adapt his techniques to your own investment strategy. 

First, many of Berkshire's holdings were purchased years ago, and are no longer considered bargains at today's levels. In fact, Buffett himself is only projecting the firm's investments to grow at a modest +6-8% annualized pace over the next decade. Furthermore, Berkshire's immense size virtually precludes taking a meaningful position in any smaller companies, and strictly limiting your portfolio to the large-cap universe is a good way to overlook many quality, undervalued stocks.

Therefore, it's best not to just copy Buffett's work -- but to learn from it. 

Keep in mind, actual security selection is only part of the bigger picture, and some of Buffett's most important advice extends to broader portfolio management lessons. Regardless of your particular investment strategy, Buffett would advise a long-term, buy-and-hold perspective. He also believes that diversification is for beginners only, as more experienced investors are better off sticking to their best ideas than spreading their assets too thin. Look for mature, well-run companies with good cash flow visibility, high returns on capital and sustainable competitive advantages. And when you find them, resist the urge to get caught up in day-to-day fluctuations.

With all this in mind, we spent countless hours scouring the market for a few stocks that we believe fit Buffett's criteria. None of these picks are currently in Berkshire's portfolio. However, for a variety of reasons we believe they best exemplify the sprit of Buffett's philosophy. 

We're going to dedicate the remainder of today's article to a review of three quality Buffett-like investments . . .

END OF FREE CONTENT

The remainder of this report is available exclusively to paid subscribers. In it, we use what we have learned by watching Buffett and detail several stocks we feel would fit into his style of investing. These include: 

A payroll processing firm that helps companies comply with complex tax laws and has an operating margin that is twice the industry average. With more than 400 new tax laws each year, many companies see this firm as indispensable. 

An alcoholic beverage company that owns almost half of the world's top brands. Even though its returns have consistently beaten the S&P 500, the firm's stock still trades in value territory.

Thanks for reading today's special report -- Investing Like Buffett.

Good investing!

-- Research Staff
StreetAuthority.com
http://www.StreetAuthority.com

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