Warren Buffett's Stock Formula

The purpose of this article is to inform its readers about the Investment Philosophies of Warren Buffett and Charlie Munger, one of the greatest investment partnerships in the history of investing. I hope to explain the simple ideas portrayed in the video (interview with Charlie Munger; below) in an effort to help readers use the ideas in their own investment decisions:

Stock Formula Video

I recently wrote articles on Benjamin Graham, the mentor and teacher of the great investor Warren Buffett, and on how to Value Invest, established by this partnership. Following these articles I felt the need to outline the philosophies of Buffet and Munger, the partnership that turned Berkshire Hathaway into a $50 billion business. The video contains an interview with Charlie Munger explaining four simple principles used in the investment decisions of himself and Buffett.
Interestingly, Buffett has noted in the past that one of the reasons people aren't able to replicate his success is because, ironically, people think that investing has to be complicated. Munger and Buffett demonstrate that good stock picking does not have to be a difficult process.

The four steps to a good investment:

  1. Understand the business - It is very clear that you should never invest in anything that you don't fully understand. This is why Buffett and Munger never followed the trend of the dotcom boom in the late 90s, investing in Web based companies. The partnership stuck to businesses that they actually understood. If you can't explain to another person exactly what it is about the business that attracted you to investing in it, then you do not understand your investment. This means that you would never invest based on a suggestion or tip from someone else as investing requires fully understanding, YOURSELF, not just going on what someone else has said.
  2. Sustainable Competitive Advantages - Investing in a business that is doing well currently, is relatively easy. Investing in a business that will continue to do well in the future is hard. Buffett explains that you should be willing to hold the company for an infinite time horizon. This requires finding a business that invests a reasonable amount in R&D, keeping itself ahead of the competition through its innovation rather than through forced barriers to entry. Buffett and Munger look for business that have a long track record of paying increasing dividends over a decade or more. This demonstrates a business that has established itself into a market and is a business that makes its investors more money in the long run.
  3. Able and Trustworthy Managers - Check the track record of Managers. Who did they work for before? How did they do? How many shares do the managers own in a business? Read the Chairman's Letter in an Annual Report carefully. It can reveal how the company is really doing.
  4. Bargain Price (Margin of Safety) - As Munger puts it, even if you find a great business, you don't want to pay any more than you have to for it.  Getting a fair price that offers a margin of safety on your investment is important. My previous post on Value Investing should help explain how to make sure you are giving yourself a large enough margin of safety by buying undervalued shares.
As you can see the four steps to picking great stocks are fairly straightforward. However, they require a large amount of patience and a cool-head to be calm and considered in your own conviction. I believe that these are the attributes of a great investor and I shall write more about these in a future post.

Is making a good investment really this simple? What experiences have you had that would support these ideas or suggest otherwise?

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Taline said...

I was an investment banker in my previous career so I feel that I can qualify to speak on the matter. Well, I do agree with Buffett on this one with a simple twist. It is easy to use this method to earn an average rate of return.

Who wants that?

For a rate of return usually above 10%, I'm afraid this method is a bit too simple and misleading. If it really were that easy, there would be many more Warren Buffett's out there.

Mr. Moneybanks said...

Hi Taline.
I don't think there's anything wrong with gaining 7%-10% per year in the stock market, better than losing money.
As for gaining returns well above 10%, this requires (unless you are as astute as Buffett) taking on a lot more risk.
So I think I and many readers would be more than happy with a steady return of 7%-10% plus dividends, so "who wants that?", I think based on most people's risk profiles, most people want it.
What do you think?

Rob said...

@Taline - but how many company's really have a true sustainable competitive advantage, great managers and are available at a bargain price; some come close, but to fully achieve all those requires something very special. I don't think the problem is that those company's won't give enough of a return, it's just that finding a company truly great on all these points is nigh on impossible.

Taline said...

I should have been more clear. I really don't think you can achieve a 10% rate of return with his method. If you achieve 7%, then factor in inflation (National 2011 inflation was 3.2) then you really aren't getting much for your money. It is however better than any savings, and most CD's

Rob - good point...but they are out there.

You guys should read my "Real Estate or Stocks" article. I exmplain in detail why one investment is better than the other comparing rates of return. If you do, let me know what you think :)

Mr. Moneybanks said...

@Rob - I think I agree with Taline, there are always companies out there. It just takes time and effort to find them.

@Taline - Will have a read, thank you

Rob said...

If I didn't think I could find them I wouldn't be talking right now. The fact they are nigh on impossible to find, just makes finding them all the more exciting. It's a tough goal to achieve, but anyone that tells you Buffett can't be replicated is wrong... you just need to really want it and to be able to learn from some very tough lessons.

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