Join our community of smart investors

How to invest like Warren Buffett

'By following 10 investment rules it's possible to prosper from the highly successful techniques used by the greatest investor of all-time.'

There is no question in my mind that Warren Buffett is the greatest investor of all time. The sage of Omaha, as he is widely known, enjoyed a privileged start in the finance world as his father Howard Buffett ran a stockbroking house and encouraged his son's interest in the markets.

Moreover, having studied economics at Columbia Business School, Warren Buffett was taught by one of the greatest investors of all time - Benjamin Graham, the father of value investing on whose works I based the criteria for my annual bargain shares portfolios in Investors Chronicle. If that was not enough of a head start in his investment career, Warren Buffett was fortunate enough to work with Mr Graham, too.

Still, he had to put his investment knowledge and skills into practice. On this score, Warren Buffett's Berkshire Hathaway investment vehicle has proved itself to be the most successful investment company of all time. In fact an investment in Berkshire Hathaway has returned an incredible 586,817 per cent increase in book value over the 48 years since its inception and until the end of 2012. That represents a compound annual growth rate of 19.7 per cent a year, more than double the annualised total return of 9.4 per cent on the S&P 500 over the same 48-year period.

And Warren Buffett has been handsomely rewarded for his shrewd investments, too. In fact, with a net worth estimated by Forbes of $58.5bn (£35.8bn), he is one of the richest men alive. There are some valuable lessons to be learned for all of us from the stock picking guru.

Create a margin of safety

Warren Buffett and his right-hand man, Charlie Munger, the vice chairman of Berkshire Hathaway, have succeeded in generating these eye-watering returns because they have adhered to strict rules when assessing any potential investment.

The most important of these is to create a margin of safety in the price you are willing to pay for a company's shares, and to be patient until the market is willing to offer you that price. Even if a potential investment ticks all the right boxes, there is one thing worse than not being invested. That's being invested at the wrong price which is why it pays to be patient and only purchase shares in a company when the future potential return embedded in the share price is satisfactory for the risk being taken. Frankly, if you are a long-term investor then you can afford to wait for the market to provide you with the optimum buying opportunity, and at the price you are prepared to pay. That's what Warren Buffett does.

Invest for the long term

Part of the reason for the incredible annualised growth rate posted by Berkshire Hathaway is down to the benefit of compounding. To illustrate why, consider the following two examples.

Let's assume you are a buy-and-hold investor and hold a portfolio for 10 years, which grows at a rate of 20 per cent a year. Within four years, it will have doubled in value; within six years it has trebled and by the end of the 10th year it has increased by 519 per cent. That's the benefit of compounding. At the end of the 10th year you sell up and pay capital gains tax on the proceeds at 28 per cent. So, an initial £10,000 investment has increased in value to £61,900, of which the tax man will take a £14,500 slice of the £51,900 gains. That leaves you with a cash sum of £47,400 after 10 years.

Alternatively, let's assume you are a short-term investor and manage to make the same 20 per cent a year return on your capital. However, at the end of each tax year, the taxman takes his 28 per cent slice of your realised capital gains. This means that after one year your £10,000 starting capital will have grown to £12,000 as before, but of this £560 is passed straight over to the tax man. Repeat this process over a 10-year period and, at the end of the 10th year, the £10,000 original investment has turned into a cash sum of £38,400 after all taxes are paid. That's £9,000 less than a long-term investor has made, which is a sizeable sum on a starting bank of £10,000.

Furthermore, the longer the timeframe, the bigger the difference in the final portfolio value of a long-term and short-tem investor. In other words, investing for long-term gains pays the greatest rewards.

Don't ignore dividends

Warren Buffett may have made a near 20 per cent annual gain on his portfolio over the past five decades, but the mere mortals among us are more than happy generating a return of 12 per cent a year over the long run. With the benefit of reinvesting dividends, this translates into a total return of 1,600 per cent over a period of 25 years. But if the starting yield on the portfolio is 4 per cent, this means a third of the targeted annual growth rate is in the bag from the start. Moreover, dividends grow over time and can be reinvested to mitigate risk.

This is why many of the companies I highlight in my investment columns are decent dividend payers. It also explains why you are better off investing in higher-yielding shares for the long run than low yielders. In fact, according to the Credit Suisse Global Investment Returns Handbook, in collaboration with the London Business School, the difference between the annual total returns on the highest yielding shares (10.9 per cent), and lowest yielding shares (7.8 per cent), on the London stock market has been on average 3.1 per cent a year since 1900. That may not sound much of a difference, but with the benefit of compounding, a portfolio of high-yielding shares would be worth more than double that of the low-yielders after 25 years; treble the value of the low yielders after 40 years; and four times larger after 50 years. That's why dividends are so important.

Target quality companies

Given the choice between selecting a good-quality company rated on a relatively attractive valuation to its historic average, and one with an impressive long-term track record, or a lower-quality company priced on a sub-market earnings multiple, I will always opt for the former. That's because investors are more inclined to pay premium ratings for quality companies. In turn this offers potential for share prices of good-quality companies to recover to (and above) their long-term average earnings multiple. So on a risk-adjusted basis the odds of a favourable outcome are far better.

It also helps explain why consumer monopolies are very much Warren Buffett's bag. These are companies with substantial pricing power, partly through strong brand recognition or significant intangible, but unrecognised value. They also have predictable products, which support growing earnings and cash flow. Berkshire Hathaway’s investments in Coca-Cola and consumer products manufacturer Johnson & Johnson are prime examples of corporations with durable competitive advantages.

Avoid 'value traps' and spread risk

Some companies are lowly valued for a variety of reasons and not just because they carry more risk than other companies. For instance, they may not be run for the benefit of outside shareholders. As a result investors are simply not prepared to value these companies on anything other than sub-market and sub-sector earnings multiples. That's why it's important to carry out risk assessments on companies before you invest to get a picture of the type of investment you are taking on. Rest assured other investors will be.

There are a variety of different risks embedded in the valuations of companies. It therefore pays to spread the risk of the holdings in your portfolio. To do this you should consider the level of risk you are taking on in specific key areas including market risk, economic risk, liquidity risk, distress risk and volatility risk. The idea is to minimise the total amount of risk embedded in each shareholding so that on average your portfolio is less volatile and less exposed to large amounts of risk in any one of these five areas.

Never be a forced seller

Warren Buffett is never a forced seller. That's because Berkshire Hathaway uses leverage sparingly. In the business principles outlined in the company's owner's manual, the greatest investors of all-time states: "We use debt sparingly and, when we do borrow, we attempt to structure our loans on a long-term fixed-rate basis. We will reject interesting opportunities rather than over-leverage our balance sheet. This conservatism has penalized our results but it is the only behavior that leaves us comfortable... We would never permit trading a good night's sleep for a shot at a few extra percentage points of return." I could not agree more.

Avoid companies diluting shareholders' interests

Berkshire Hathaway only issues stock when it receives as much in business value as it gives. So if a company you follow, or are looking to invest in, is diluting its earnings per share by making an acquisition or issuing equity for any other reason, always ask yourself how the board intends to create value for shareholders in the long run.

Similarly, given the choice, I prefer to invest in companies with conservative accounting policies as the hidden value in the accounts will at some point reveal itself in the future.

M&A pays

Over the years, Warren Buffet has made attractive returns by playing the merger arbitrage game and taking advantage of the valuation difference between the market price of a share and the price a takeover is likely to be executed at. Of course it's critical to ascertain how long the deal will take to close, and the probability of it completing in deciding whether the risk is worth taking on. But the annualised gains can be substantial.

Think like the owner

Warren Buffett believes shareholders should consider themselves as owners of a company instead of thinking they are buying just a share of the enterprise. This has implications on the way you view management and their asset allocation decisions.

Ultimately, the end game is to generate the maximum rewards for shareholders, and that aim should never be overlooked. According to Mr Buffett management should first examine reinvestment possibilities offered by its current business - projects to become more efficient, expand territorially, extend and improve product lines or to otherwise widen the economic moat separating the company from its competitors. The next step is to search for acquisitions unrelated to the current businesses. The third use of a company's funds - stock repurchases - is deemed sensible when its shares sell at a meaningful discount to their intrinsic value. This is an incredibly useful exercise to undergo when making your decision to invest as you can make a considered judgment as to whether directors are acting in your best interest.

Average up winners

Berkshire Hathaway's 'Big Four' investments - American Express, Coca-Cola, IBM and Wells Fargo - paid out a total of $1.1bn in dividends to the company out of net earnings of $3.9bn. But that is only the part of it because the other $2.8bn of earnings is every bit as valuable to Berkshire Hathaway. The earnings that the four companies retain are often used for share repurchases - which enhance its share of future earnings - and also for funding business opportunities that are usually advantageous.

In fact, Berkshire Hathaway's investment team were so convinced of the future valuation creation that it increased its ownership interest in each company last year. That’s why I am never afraid to average up winners and repeat buy recommendations when I believe the scope for medium-term gains still holds.

Finally, due to unprecedented demand, my new book, Stock Picking for Profit, has sold out and is being reprinted for delivery the week beginning Monday, 6 January 2014. As a special promotion to IC readers, the first 100 pre-orders for the book placed online with YPD Books and quoting offer code ICOFFER will receive complimentary postage and packaging. The book can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213. The book is only being sold through YPDBooks and no other source. It is priced at £14.99, plus £2.75 postage and packaging. Telephone orders will continue to incur the £2.75 charge.

 

MORE FROM SIMON THOMPSON ONLINE...

Since the start of December I have published the following 20 articles on the following 31 companies or trading strategies:

PV Crystalox Solar ('Cash rich and undervalued', 2 Dec 2013)

Pilat Media Global ('Bumper upgrades for software maestro', 2 Dec 2013)

Housing market ('Allaying fears of housing myths', 3 Dec 2013)

Dragon Ukrainian Properties ('Ukrainian nightmare tames the dragon', 4 Dec 2013)

Conygar ('A smart regional property play', 4 Dec 2013)

Sutton Harbour ('Small cap value plays', 5 Dec 2013)

Crystal Amber ('Small cap value plays', 5 Dec 2013)

API ('Small cap value plays', 5 Dec 2013)

Greenko ('Fair wind', 6 Dec 2013)

Bezant Resources ('High risk, high reward resource play', 9 Dec 2013)

Thorntons ('A rating too sweet?', 10 Dec 2013)

KBC Advanced Technologies ('Fuelled for more growth', 11 December 2013)

Terrace Hill (‘Property play fully valued’, 13 December 2013)

Moss Bros (‘Dressed for success, 16 December 2013)

Inland, Terrace Hill, Daejan, Raven Russia, Mountview, Town Centre Securities, Bellway, Jarvis Securities, Air Partner, Thalassa, Pilat Media Global, NetPlay TV, 32Red ('Seeking safety and income at a reasonable price', 17 December 2013)

Polo Resources ('Polo awaits farm-out deal', 18 December 2013)

Raven Russia ('Preferential treatement for Raven Russia', 18 December 2013)

Aurora Russia ('Deep value in Aurora', 18 December 2013)

WH Ireland ('Broking for more success', 19 December 2013)

Safestyle ('Window of opportunity', 23 December 2013)