Warren Buffett “Oracle of Omaha” – Three Tips to Investment Success!
Can We Invest Like Him?
Every year around the Berkshire Hathaway annual meeting, the investing world pauses to listen to the wisdom of Warren. And why not, he is brilliant and willing to share some of that wisdom. Taking it a step farther, CNBC created a synopsis from their interviews with Warren over the years; boiling his sage advice into his best three investment tips. In CNBC’s view, the three best tips are –
- “Circle of Competence” – Judging the Future Economics of a Business
- “Piece of Business” – You are Not Buying a Stock but a Piece of a Business
- “Margin of Safety” – Your Purchase Price should be Lower Than your Valuation Price
Does the business have a superior product which you and your friends use and will continue to use? If yes, why not buy some stock in the company? You use the product which cost you money; why not invest in the company and earn some money back?
You are buying into their business; the stock is just the means to do so. At what price is the stock attractive? Cheaper, than it is today, sounds good. I will buy when the stock market drops, for whatever reason, purchasing the company stock on sale. If I can do these three things, I will invest well; just like Warren. Right?
What I just described, in my opinion, is the general interpretation of Mr. Buffett’s advice. On the surface the advice seems easy to follow; We can all be Warren Buffet! And that is exactly what CNBC is selling. I don’t know for sure, but I’m willing to guess CNBC’s ratings are higher when Warren takes up all three hours of the networks morning show.
First, these three tips are solid advice. Second, they are very difficult to put into action without working knowledge of advanced financial concepts developed with more than a casual background in quantitative math.
I’m not trying to discourage you. What I hope to offer is briefly enlightening you on these three investment concepts, followed by a “working persons” guide to investing. You probably will not end up a billionaire, but there is nothing wrong with only being a millionaire! Mr. Buffet joked that if he invested $10,000 in an index fund when he bought his first stock, he would only have $51 million today. Sounds Okay to me and you do not have to be a genius to buy an index fund! You don’t know what you don’t know!
#1 – Circle of Competence: Judging the future economics of a business
Predicting rain doesn’t count. Building arks do.
What are the companies within your area of expertise? I love this question, playing video games does not make one an expert in technology no more than owning a car makes one an automotive insider! Don’t take this the wrong way, I believe a suitable place to start looking for investing ideas involves simply looking around your house or apartment for the products that you use. Chances are good if you like the product so do other people. This speaks to the future economic benefit of the company.
However, just because you use today’s great product does not mean that the company will produce the next “Great Thing” or because you use the company product, the company is the next “Great Thing.”
The reference to this point is how does the company make its money and what is the sustainability of its profit margins over the long run?
The answer to this question is quite complicated. How much does the company spend on research and development? How effective has the R&D department been over the years? What stage of the business cycle is the company in? How much debt does the company have? How much free cash flow does the company generate? Have all their financials been trending? How do these trends compare with the competition?
Google a list of financial ratios. Not only do investors like Warren Buffett know all these ratios, including how to calculate them and analyze them, they also have access to the books and corporate officers of companies. Do you?
#2 – Piece of the Business: You don’t buy a stock you own a piece of the business
If a business does well, the stock eventually follows.
One of my favorite Warren Buffett stories goes back to the 90s when a company called “Long-Term Capital Management” was about to collapse and take the stock market down with it. The Treasury Secretary, the Federal Reserve Chairman, and the CEO’s of some of the world’s largest banks were all in a room trying to determine what to do. They tried to call on Warren Buffett for help, hoping he would take over all or some of the company assets for pennies on the dollar. They had trouble getting in touch with Mr. Buffett; he was taking a donkey ride in the Grand Canyon with his good buddy. Bill Gates and his cell phone was having trouble finding a signal.
The only part of this story that most of us can relate to is the lack of cell phone reception on vacation! You are buying the stock because you can’t buy enough shares to be a part of the business. Warren Buffet and Uber were in the news recently because the two sides could not make a deal to each party’s liking. Warren did not invest more than $1 billion into Uber! Would Uber Management take your call?
#3 – Margin of Safety – Pay less for a company then your valuation price
Price is what you pay. Value is what you get.
So what valuation method do you use? The Dupont System to analyze the return on equity? Or maybe you prefer a model that takes into account a company’s expected return such as the Capital Asset Pricing Model or the Security Market Line? Maybe you believe a company is only as good as its future income stream, so you use a discounted cash flow model such as the dividend discount model. If you have no idea about anything in that last few sentences you are not alone, and you will not likely get an analyst job at a Wall Street firm making a nice six figure income!
More important to this article, not only does Warren Buffett understand all of these methods but he has worked with other geniuses to create their methods of evaluation. One of my favorite old commercials was the be like Mike from Nike. One could be just like Michael Jordan if they wore Nike shoes. To this day Nike stills sells a lot of “Jordan’s” but there is only one Michael Jordan, just like there is only one Warren Buffett!
Three Simple Wealth Building Tips for Us Regular Folk
#1 – Buy an Index Fund or ETF – A cheap diversification strategy
Rather than having all the risk of one stock investment: the risk if something should happen to only your stock plus the risk of the stock market in general. An index fund eliminates (diversifies away) the company risk leaving you with general stock market risk.
When buying anything, cost matters and index funds/ETFs generally are less expensive than actively managed funds/ETFs. Their passive style keeps the trading cost within the fund or ETF to a minimum, and you don’t have to pay a manager, so your administrative cost should be negligible.
Think of cost as a hurdle. The more you pay, the higher the hurdle your money needs to jump before you make any money on your investment. For example, if your return is 5% and the total cost (seen and unseen) of the investment is 2%; the fund/ETF made 7%, but you netted 5% because the investment cost you 2%. If the expenses were only .06%, (many index funds/ETFs charge between .03% to .20%), then your return would have been 6.94%.
I would rather make 6.94% than 5% for owning the same thing! Cost matters
#2 – Do the DRIP – reinvest your dividends
Free money: Who does not love free money! That essentially is what a dividend is to you. A dividend refers to a stock’s payment to its shareholders, expressed in terms of yield which is a percentage of the stock’s current price.
The SPDR S&P 500 ETF (SPY) pays an annual dividend yield of around 1.80%. If you own the ETF for the full year, you will receive an additional 1.80% return on your investment. With this 1.80%, you can receive the money or reinvest it. The name of the game when investing is accumulating as many shares as you can. When you reinvest your dividend, you are using the money, not out of your pocket, to buy more shares.
Doing the DRIP also helps to lower your potential taxes, but that is for a different post.
#3 – Always have a Dollar Cost Averaging Strategy Working – buy every month no matter what
People can talk about all the superior investment strategies and math know how they want, but for me, merely buying an investment every month still is the best use of an irrefutable math principle.
Everyone knows that the key to successful investing is Buy Low: Sell High. Oddly enough, our emotions tend to lead us to do just the opposite. When the stock market is going gangbusters, everyone wants in, but when the market is losing money hand over fist, most people buy nothing.
Dollar Cost Averaging forces you to employ the correct behavior. When the market is going gangbusters, your monthly money buys fewer shares because the price is too high and when the market is in free fall your monthly money is busy buying up shares at the reduced price. The most important thing when you are still in accumulation mode is to acquire as many shares as you possibly can. It sure is easier to acquire more shares when the price is low.
Remember, The number of shares x Price = Wealth
You have zero control over the price of an investment, but you can control the number of shares you obtain. Dollar Cost Averaging is the most proven method to accumulate shares over time in any investment.
For example, I save our family vacation money, every paycheck, through a dollar cost averaging arrangement into an EFT which cost .03%. All dividends are reinvested, and this strategy has not cost us a trip to Disney World yet. I hope this helps!