People are always interested to hear what Warren Buffett has to say about the current state of the economy, but what everyone actually cares about is how he continues to achieve such amazing returns after all this time. Of course he’s always willing to impart pieces of his wisdom to the public, but sometimes they sound like cryptic messages from the future, while others are crystal clear to understand. Unfortunately, a conceptual understanding of what he says is very different than turning his thoughts into sound investment principles and actions. This is why we have pinpointed five easy Buffett investment principles, which build upon each other, that hopefully will help the everyday investor to achieve better returns.
1. Be a Bear Market Investor
Buffett is, in our opinion, a bear market investor; he has historically made some of his most successful investments and deployed the greatest amount of capital specifically during bear markets. Think for one moment about how well a portfolio would do if a good chunk of its assets were consistently invested only during bear market periods, and that during bull markets capital was deployed much more sparingly. It’s not hard to understand that it would probably do much better over the long term with this general mindset. This is due to the fact that investments would be made more often when stocks are trading at depressed prices. Below is an example of Buffett being a bear market investor:
Investment: PetroChina (PTR)
Investment Date: 2002-2003 (Dot.com crash/recession period)
Total Capital Invested: $488 Million
Holding Period: 6 Years (Sold in 2008)
Capital Received from Sale: $4 Billion
Total Return: 819.67%
Annualized Return on PTR: 136.66%
Most investors were obviously not looking at investing in a Chinese state-owned oil company after the dot.com crash -- or anything else, for that matter. Still, this simple investment principle is no different than if a person only bought clothes when they were on sale at a department store. He bought a great company when it was on “sale” because he realized that the intrinsic value of the company never changed; just the price tag on it. Remember, a great company generally only goes on “sale” during a bear market -- so when there is fear in the streets, it’s time to go shopping.
2. Invest in What the World Needs
During the last recession, investors hated Goldman Sachs (GS), Burlington Santa Fe Rail (BNI), and General Electric (GE) equally. Investors crushed their respective stock prices based on illogical fears, emotional hatred, and very little analysis. Putting personal opinions aside, GE, BNI, and GS are all marble pillars of the U.S. economy. Buffett always invests with objectivity, and that’s why he bought shares in each of these firms. In particular, he bought the remaining shares of Burlington Santa Fe and folded them into Berkshire Hathaway (BRK.A). One man’s “trash” was definitely Buffett’s treasure. The takeaway point here is that Buffett went into heavily distressed industries that were crucial to the U.S. economy recovering and then bought the best in breed.
3. Fundamental Analysis and Due Diligence
The Oracle of Omaha is constantly quoted for saying “I only invest in what I understand.” As simple as this sounds, it actually goes over the heads of about 80% of investors. What he means here is that he spends a good portion of time educating/doing due diligence for himself about industries that he is interested in but potentially unfamiliar with. This includes taking time to understand the industry as a whole, how it fits into the world economy, and the company itself. We doubt he was a chocolate connoisseur before or after he bought See’s Candy, but either way, he knew what he was buying because he did his due diligence.
As an investor, he is probably one of the few who still directly requests the financial statements from firms he has an interest in. Everyone can call Buffett a “value investor” till they’re blue in the face, but he is a fundamental analysis investor at the end of the day. We have little doubt he goes through every number and checks every financial statement ratio in the book to find potential “hidden value.” He is even known to go through the granular footnote details for assumptions and/or additional information about inventory classification.
Doesn’t doing all this due diligence and research take time though? Yes, of course it does. Still, this is what he does in order to beat the market. He realizes and understands that most investors won’t take the time to do this consistently. Imagine how successful anyone could be at anything if they knew exactly how much effort they needed to give in order to outperform the competition. When it comes to investing, Buffett knows exactly how much effort he has to put forward.
This may all sound boring so far, but becoming the third-richest billionaire in the world by investing in names like Coca-Cola (KO) is not. He may like the taste of a Coca-Cola soda, but we doubt he would have invested in the company if it were short on cash, up to the eyeballs in red, and leveraged to the hilt with debt and with no hope of being able to pay it back. When he invests in a company, he knows it and its industry inside out. The time involved with principle three is substantial -- but so is the potential payoff.
4. Pricing Power beats Sound Management
The pricing power of a firm generally holds more value than does sound management, plain and simple. Further, it reduces the risk that a firm will underperform longterm should key personnel leave. Do you agree? Well, Buffett certainly does; he was quoted saying the following in two separate, recent interviews:
- "The single most important decision in evaluating a business is pricing power …. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.” (For more, see here.)
- “The extraordinary business does not require good management.” (For more, see here.)
His argument here makes sense and we are happy to follow this principle without question.
It’s true that Rome wasn’t built in a day, but sometimes it’s tough to remember that. Buffett understands the power of patience, and that is why he remains bullish over the long term. The rules are no different for anyone else, in that if an investor follows all the other principles then all that is left for him to do is be patient enough to wait and watch hard work pay off.
The Oracle of Omaha will always be bullish long term because he follows these principles without fail, in our opinion. With these five simple principles he has consistently outperformed the market and continues to see the investment landscape differently than almost everyone else.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.