Warren Buffett on long term value investing

BACK IN 1998, Warren Buffett gave an inspirational talk to a group of MBA students at the University of Florida, College of Business. In the speech, Buffett gives his perspective on investing, in which he outlines the need to understand the underlying economics of the businesses that you invest in, and the need to stick to disciplined principles of business evaluation without being swayed by passing investment fads.

Here are 15 of the most interesting and insightful points made by Buffett in his speech about successful long term investing, as follows:

1. Return on equity is key

Return on equity is fundamental. In general, there is no point to investing, just because of the availability of cheap financing, if a business has a low return on equity. It’s hard to earn much as an investor when the business you’re in doesn’t earn very much money. Buffett elaborates that when he started out as an investor he would sometimes purchase very ordinary stocks at prices way below the value of working capital. This is what Buffett calls the ‘Cigar Butt’ approach to investing. You look around for a cigar butt (i.e. really cheap company), you find one that is old and soggy. You get one free puff out of it, and then you throw it away and try to find another one. If you’re looking for a free puff then this approach to investing works, but these are very low return businesses. By investing in a wonderful business with a high return on equity then, even if you initially pay a little too much, you’ll do well if you stay in for a long time.

2. Ownership of a stock is partownership of a business

Ownership of a stock is part ownership of a business.  With that in mind, the investors should not pay attention to the day to day stock fluctuations.

3. Invest in businesses that you understand

As Buffer jokes, this significantly narrows down the number of companies that he has to look at. You need to look for a simple business which is easy to understand, and which has honest and able management. Buffett says that this lets him understand where a company is going to be in ten years time. If he can’t see where the company will be in ten years, he won’t buy it. Buffett says that “investing is putting out money now, to be sure of getting more money back later at an appropriate rate. To do that you need to understand the business.” Buffett says that he wouldn’t invest money in a new internet business because he doesn’t understand that business and couldn’t say where it would be in ten years time. In his early years he would conduct extensive industry research. For example, by asking every CEO in an industry “if you could buy the stock of one other company in the industry, which one would it be and why?”

4. Invest within your circle of competence

The nice thing about investing is you don’t need to learn anything very new. Buffett says that he learnt about Wrigley’s chewing gum 40 years ago, and still understands that industry today. As a result, you will develop a pool of knowledge about different industries that builds up over time. Interestingly, Buffett says that most of his deals get completed in a matter of hours. If you don’t know enough about a business instantly, you won’t know enough in a month or two.

5. Invest based on solid reasoning

If someone told you about a company at a cocktail party or the charts look good, that’s not good enough. Paying a little too much for a wonderful business, you’ll do well if you stay in for a long time. You buy a lousy business for a good price; you stay in for a long time you’ll get a lousy result. If you’re right about the business, you’ll make a lot of money.

6. Invest for the long term

Buffett recommends buying businesses that you would be happy to own forever. It may happen that you have to sell for one reason or another, but you should, at the time you buy, want to be buying a company that you’ll own forever.

7. Strong businesses need a durable competitive advantage

A strong business needs a durable competitive advantage. Buffett says that although he wants to understand the businesses he goes into, he doesn’t want a business that is easy. You want a business with a moat around it with a duke defending the castle. That moat might be low cost operations, quality of products, service, patents, real estate location, or share of mind (Buffett explains that thirty years ago, Kodak’s moat was as wide as Coke’s moat. Kodak had share of mind, forget about share of market. They had something in everybody’s mind that said, “Kodak is the best”).

8. Feel strongly about the products

You want a business that has products that are not price dependant. Disney and Coca-Cola have developed a favourable impression in the mind of consumers that allows these companies to charge more for their products and sell more of them than other companies in the same industry.

9. Don’t borrow money that you don’t need

Buffett says that he never borrows money. He loves his job and was doing the same thing when he had $10,000 and when making $1,000 was a big deal. He recommends taking a job that if you were independently wealthy you would take. “If you think you’re going to be a lot happier if you have 2X instead of X, then you’re probably making a mistake.”

10. You only have to get rich once

Risking what you have and need to get what you don’t have and don’t need is foolish. Buffett gives the example of Long Term Capital Management. This hedge fund was run by smart people, with extensive experience and with their own money invested. To make money they didn’t have and didn’t need, they risked money they did have and did need. Buffett says, “if you risk something that is important to you for something that is unimportant to you, that decision just doesn’t make sense.”

11. Be patient, think carefully and avoid over stimulation

Buffett says that, in his opinion, the best way to think about investments is to sit in a room and just think. The problem with being in a market environment is that you get the feeling that you have to do something everyday, you get over stimulated. You want to be away from any environment that stimulates activity. Get one good idea a year, and ride it to its full potential.

12. Professional investors should not diversify

Buffett believes that if you are not a professional investor, which is ninety nine percent of people, then you should extensively diversify your investments and not trade. However, once you decide that you are going to bring an intensity to the game and start evaluating businesses and bring the effort, intensity and time involved to get that job done, then Buffett believes that diversification is a terrible mistake. In his opinion, if you really know businesses then you shouldn’t own more than 6 of them. “Very few people have got rich on their seventh best idea.”

13. Business size is not the important consideration

When investing, business size is not the important consideration. Small, medium and large cap stocks can all represent good investment opportunities. It doesn’t matter about the size of the business; it’s the certainty of the returns that counts. The relevant questions are:

  1. Can we understand the business?
  2. Do we like the people running it?
  3. Does it sell for a price that is attractive?

14. Only worry about what is important and knowable

Anything that is unimportant or unknowable, you should forget about it. Buffett outlines that market predictions do not affect his investment decisions. “I have no idea where the market is going to go.”

15. Make investment mistakes

Buffett says that the mistakes that he has actively made have been far less costly than his mistakes of omission. He reflected that the times where he understood a business, saw an opportunity and sat on his hands and did nothing have cost him tens of billions of dollars.