3 Things To Remember If You're Going To Follow Warren Buffett

Includes: BAC, BRK.A, BRK.B, GE, GS, IBM, KO, WFC
by: Tim McAleenan Jr.

For two primary reasons, many investors keep tabs of the buy and sell decisions of the investment portfolio of Warren Buffett's Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B). One of those reasons, of course, is the long-term excellent performance of Berkshire (over 20% annual compounding since Buffett took over, although long-term returns have gradually diminished as Berkshire continues to grow larger), and the other is that most of Buffett's billion-dollar common stock purchases over the past fifteen years have tended to be of a more long-term nature; that is to say, he doesn't usually hop in and out of a billion-dollar stock position from quarter to quarter. With this in mind, many investors look to Buffett for investment ideas in an attempt to mimic the returns of the Berkshire Chairman and CEO. However, I do think there is a right way and a wrong way to do this-not every stock associated with Buffett's name should necessarily be added to the "buy" list for investors. I think there are three considerations in particular that investors ought to take into account when thinking about trying to echo Warren Buffett:

1. Only consider Buffett's common stock investments. I think it can be quite misleading when some headlines treat Buffett's deals with General Electric (NYSE:GE), Goldman (NYSE:GS), or Bank of America (NYSE:BAC) as an endorsement for investors to look to buy the shares of one of those companies. Buffett received preferred deals that limited his downside and greatly enhanced his upside with each of these investments, and these Buffett investments are not available to us as investors, so it would be foolish to pursue something on an apples to oranges basis when Buffett is not engaging in the same risk/reward scenario with GE, GS, and BAC as common stock investors. If you're going to try and follow Buffett, you want to do it when the plane is as equal as possible, rather than when the terms of the deal grant Buffett a significantly reduced downside.

2. Look to Buffett's "Best Ideas." Buffett has three investments that are worth over $10 billion. They are Coca-Cola (NYSE:KO), Wells Fargo (NYSE:WFC), and his newly initiated stake in IBM (NYSE:IBM). Each of these three companies is worth looking at since they are Buffett's most substantial bets and most likely represent his "best ideas" among mega-cap American corporations. I included a chart that demonstrates the ten-year earnings growth of each of these holdings.

In terms of moats and long-term competitive advantages, investors could easily use Buffett's own words to apply the "Peter Lynch Crayon Test" to each of these three main holdings. Coke has a very strong brand name and ability to sell syrup concentrates all over the world for much more than the fraction of the production costs-as Buffett once famously said, "If you gave me a $1 billion and asked me to displace Coca-Cola, I'd tell you that it couldn't be done.

In the case of Wells Fargo, Buffett has repeatedly mentioned that he is a fan of the business model-Wells Fargo is the low cost producer in the lending industry, and Buffett has repeatedly mentioned how this creates "rich get richer" type of phenomenon over time-as Wells Fargo continuously leverages its low-cost business model, it further cements itself as the low-cost leader, enhancing its competitive advantage.

And as for Buffett's recent investment in IBM, he mentioned that "no one in the IT Department ever gets fired for going with IBM." Buffett also noted that the relationship between a company and its service provider is somewhat fixed-that is to say, IBM would generally have to do something wrong to lose a customer-companies don't usually hop from service provider to service provider in the hopes of saving a few bucks, and IBM's status as the premier brand-name in the industry contributes to a moat substantial enough for Buffett to pour $10 billion into for a 5% stake of International Business Machines.

3. Pay Attention to Buffett's Price! There is a big difference between thinking that now is the time to add an investment to your portfolio and thinking that it is intelligent to keep a stock holding in your portfolio. Coke has been trading around $70 per share the past couple of months-while investors can extrapolate from Buffett's investment portfolio that he obviously thinks that Coca-Cola is a fantastic business, we cannot determine whether he thinks it's a good investment at this price. In the case of Wells Fargo and IBM, Buffett was adding to his Wells position this past year (and paid around $28 per share), and while we're still waiting for the dust to settle and for the specific details of the IBM purchase to emerge, we can make the likely ballpark estimate that Buffett paid in the low $160s per share for his IBM stake. This enables us to more evenly compare the playing fields between us as investors and Buffett-that is to say, every dollar that we pay over the low $160s for a share of IBM, we are diminishing our potential returns and reducing our margin of safety compared to the investment's performance in the Berkshire portfolio. If we pay sharp attention to the differences between Buffett's established price and that of our own, we can decrease the likelihood of seeing a particular investment perform fantastically for Buffett while turning out as a dud for us.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.