Warren Buffett's approach to investing has obviously worked. Waiting for historic opportunities to buy great companies with high margins of safety results in phenomenal investing results. Here's a summary of some of the things Buffett looks for, and what he is missing.
Warren Buffett's Approach
- A business with great long-term prospects. Starting at the top, this usually advocates a best-in-industry company. One that has great margins, but not only that. These margins have to be sustainable, which means an economic moat. There has to be a reason that these margins won't erode over time as competitors start to attack the firm's profitability. Economic moats can come from sources such as a strong brand, corporate culture, or economics of scale. A great example of this is one of Buffett's most profitable investments: Coca Cola (KO). Coca Cola has all of the moat-creating things listed. Its brand is known world wide. No one at McDonald's orders a soda. They order a Coke. Coke has entered the common vocabulary of our country. Coke has aligned its managers' interests with shareholders' through equity compensation, and its board has been with the company through good times and bad. Finally, Coke is a huge firm. It holds significant weight when making agreements with retailers, and thus keeps costs low. This has resulted in industry-beating margins that haven't deteriorated at all over the last decade.
- A business with great management. Investing must be viewed as buying as opposed to starting a business. In this sense of the phrase, stock investing is having a money manager. Someone else is managing the everyday operations that determine how your capital is allocated. This management must meet two massive criteria: They have to have their hearts and their minds in the right place. Their hearts must be aligned with shareholders' by being one of the shareholders. At the end of the day, management can't be assured to act in the shareholders' interests unless they're shareholders themselves. This also flows over into a mindset of maximizing returns on capital and constantly cutting costs. Even if managers have the right intentions, they have to be smart enough to put their intentions to work. Here is where the line becomes drawn between me, you, and Warren Buffett. When he makes an investment, he is welcomed in the corporate boardrooms of perspective investments. You and I aren't so lucky. Looking at company reports and compensation policies can often reveal a lot about corporate governance.
- The last major thing Buffett looks for is a margin of safety. This concept was identified by Benjamin Graham as the way to make sure that our mistakes as investors don't destroy our returns. This is achieved by buying companies that satisfy numbers one and two in this article at significant discounts. Buffett, like many investment professionals, uses his own calculation for what has been deemed "owner earnings." It is something along the lines of this:
+Depreciation, depletion, amortization, and a few other non-cash charges
-Necessary Capital Expenditures in order to maintain a competitive business
Lucky for those of us who can't spend our days making these calculations, there is a similar accounting metric: free cash flow. Free cash flow is calculated as such:
-Changes in Working Capital
This is a longer-term profitability metric, as it is more concerned with long-term earnings potential created by capital expenditures than top-line growth over the coming few years. This is the major valuation metric that has been utilized by Buffett since his departure from Ben Graham's Net Asset Value investing.
Buffett sat on Billions of cash for years, and when the recession struck he suddenly found great companies that had just started trading at prices that granted a margin of safety, and he went on a buying spree.
The Individual Investor
Believe it or not, the individual investor has some significant advantages over Warren Buffett, despite the obvious disadvantages.
1. The first advantage of the individual investor is that he or she is not limited to huge, and thus long-term buying and selling.
Graham identified three types of stock trading: unintelligent speculation, intelligent speculation, and investment. Unintelligent speculation is little better than gambling, and should never be done. It does not create a margin of safety, and it will likely destroy investor's capital. Intelligent speculation is short-term investing or trading based upon fundamental or technical analysis with proper risk-to-reward calculations done and operated upon before the trade is made. Investment is described above in Warren Buffett's approach.
The sheer scale of Warren Buffett's investments make short-term intelligent speculation unfeasible. This is the individual investor's first major advantage. Intelligent speculation, based on long-term technical analysis along with in-depth fundamental analysis can yield some great multi-month investments.
A combination of technical and fundamental analysis led me to America Pacific Corporation (APFC) as a value play in mid-August. The return was 25% over a few months. American Pacific is not a company that I would want to own for years, but for a few months it was a great investment. It was trading at a significant discount to book value and future earnings, and the proven track record convinced me that it wasn't going anywhere.
My time horizons for my current holdings aren't forever either. I would like to own GMX Resources (GMXR) at least until it returns to profitability in 2013. I would like to hold NRG Energy (NRG) and Navigant Consulting (NCI) until the economy recovers completely and these firms are fairly valued, but not forever. None of the companies I own right now pass test number one, and GMX Resources doesn't pass number three either [see above numbers]. These are not investments for decades, they're investments for a few years.
Warren Buffett can't make these types of investments. Buffett can't logistically manage moving his money around with this agility, and the result is a huge waste of capital. Over the last decade, Berkshire Hathaway (BRK.A) has been sitting on an enormous amount of cash: in the billions of dollars. This has ranged from 44 Billion to 5 Billion over the last decade that Berkshire hasn't been able to put to good use.
2. The individual investor's second advantage is his or her ability to buy small-caps.
Warren Buffett would never bother buying GMX Resources. The amount of effort it would take to determine the industry-leader in natural gas E&P small-caps would take way too much effort for an investment that would amount to 0.1% of Berkshire's capitalization. Buffett is thus limited, simply by time, to investing in mostly large caps. Large caps have inherently lower growth prospects. Large companies are large because growth has already blessed them. Smaller companies have (potential) growth ahead of them.
Warren Buffett got where he was by doing his legwork. Now his legwork involves getting to know his companies, and occasionally finding a big new investment. The individual investor, with anywhere from a few hundred to 10 or 15 million to invest, can move with agility in and out of high-potential small and mid caps within a few months or years. The key is to capitalize on this advantage that the individual has over the institution.
Disclosure: I am long GMXR, NRG, NCI. A close family member of mine owns shares in BRK.B. I owned shares of APFC intermittently from August 13th, 2010, until November 1st, 2010.