5 Principles for Value Investing

WARREN Buffett is the world’s most successful value investor.

Very few people have ever managed to achieve his level of investment success.  The interesting thing about that fact is that there are only a few simple principles that you need to know if you want to be a successful value investor.

  1. Stick to your Circle of Competence – only invest in companies that you understand.
  2. Value Stocks as the Part Ownership of a Business
  3. Focus on Intrinsic Value – determine the underlying value of a business rather than looking at how much the market might be will to pay. Factors to bear in mind when figuring out the value of the business:
    • Business Drivers – what is the company’s business model? How do they make money?
    • Low Leverage – how much debt does the company have? You want to see as little cash going out of the business as possible.
    • Cash Flow – how much cash flow does the company generate? You want to see more and more cash coming into a business over the years.
    • Sustainable Competitive Advantage – what kind of natural advantages does the business have? To sustain and grow earnings the company needs a large moat with alligators in it. Large moats might come from (1) strong brand, (2) patented technology, or (3) incumbent low cost position in a market with economies of scale.
    • Prospects for Growth – what kind of profitable opportunities are available to the business?
    • Quality Management – the company needs honest and able management because an investor should not need to keep checking whether management is doing its job.
  4. Invest with a Margin of Safety – there is always investment uncertainty, so the price should be low enough to ensure that you have a “Margin of Safety”.
  5. Think Independently – it is difficult to outperform the market if you follow the market. Think independently and “be greedy when others are fearful”.

Warren Buffett on hard work

WARREN Buffett‘s 2006 letter to shareholders makes for very interesting reading.

One of the sentiments that Buffett expresses in the very first page of his letter is one of gratitude to the managers who have run his companies over the last 42 (now 44) years. Buffett indicates that he and Charlie Munger, Berkshire’s vice chairman, run a company that has turned out to be a very big business; one with 217,000 employees and annual revenues approaching $100 billion.

We certainly didn’t plan it that way. Charlie began as a lawyer, and I thought of myself as a security analyst. Sitting in those seats, we both grew skeptical about the ability of big entities of any type to function well. Size seems to make many organizations slow-thinking, resistant to change and smug. In Churchill’s words: “We shape our buildings, and afterwards our buildings shape us.” Here’s a telling fact: Of the ten non-oil companies having the largest market capitalization in 1965 – titans such as General Motors, Sears, DuPont and Eastman Kodak – only one made the 2006 list.

Instead of taking personal credit for Berkshire’s successes, Buffett pays tribute to the managers who have successfully led his companies over the years, and says he knows that he wouldn’t have enjoyed many of the duties that come with their positions – meetings, speeches, foreign travel, the charity circuit and governmental relations.

Buffett claims to have taken the easy route.

My only tasks are to cheer [my managers] on, sculpt and harden our corporate culture, and make major capital-allocation decisions.

If Buffett has taken the easy route, then it is a path that no-one else has cared or managed to follow. From 1964 to 2007, Buffett and his team have managed to grow the net worth of Berkshire Hathaway by 400,863%, no small feat.

Whether or not Buffett has taken the ‘easy’ route, one thing is clear, he hasn’t lost his sense of humour. Buffett says that he has allowed each of his trusted managers to run their own show over the years. Having a self-effacing sense of humour and, not wanting to miss an opportunity, he quips:

For me, Ronald Reagan had it right: “It’s probably true that hard work never killed anyone – but why take the chance?”

To live in a world full of people as lazy as Buffett, if only we should be so lucky.