The Warren Buffett the world has come to know is a plain-spoken, avuncular figure who seems more at home at a Dairy Queen in his hometown of Omaha than in a boardroom in midtown Manhattan. Think popcorn's Orville Redenbacher, not Wall Street's Gordon Gekko.
And that same homespun charm extends to his investing persona. Indeed, the mystique of Buffett is that this small-town stock picker managed to become America's second-wealthiest man largely by keeping things simple and sticking to his knitting. In Buffett-speak, he stayed within his "circle of competence." For instance, in the late 1990s, Buffett avoided the technology sector altogether, saying, "It's beyond me." But the man who downs five Cherry Cokes a day seems at ease investing in Coca-Cola (Buffett's Berkshire Hathaway owns $9.7 billion in Coke stock).
Yet in reality, Buffett's approach to picking stocks—and businesses to buy outright—has always been far more complicated than Buffett's public image as a "buy 'em at a big discount" value investor lets on. That's because Buffett has never been afraid to deviate from the classic definition of value investing.
As a graduate student at Columbia University in the early 1950s, Buffett learned value investing at the feet of Benjamin Graham, whose 1934 Security Analysis (written with David Dodd) is a value-investing bible. Like Graham, Buffett believes the best way to build a portfolio is to look for stocks trading at discounts to their true worth. Simple enough. But Buffett has made "some adjustments to the teachings of Ben Graham," says Jean-Marie Eveillard, a famed value investor who heads the portfolio management team at First Eagle Funds in New York. Eveillard adds that "there are a few Buffett pronouncements where Ben must be turning over in his grave."
Graham, for instance, never cared much about the quality of the stocks he invested in as long as they were trading at a deep discount to their "intrinsic" value (based on a company's assets and other considerations, as opposed to a stock's market value). Graham described himself as a "cigar butt" investor—willing to buy stocks that Wall Street tossed aside if they had a puff or two of value left in them.
For his part, Buffett is much more concerned about the quality of the companies he searches for in Wall Street's bargain-basement bin, which may explain his reported recent investment in Kraft Foods. "Buffett has said that he would rather own comfortable businesses at a questionable price rather than questionable businesses at a comfortable price," Eveillard says. Or as Buffett has put it: "It's far better to own a significant portion of the Hope diamond than 100 percent of a rhinestone."
Many of today's value managers have come around to Buffett's thinking. "Graham and Dodd wrote the bible of value investing, but there've been other people since who've interpreted that bible," says David Winters, founder of Wintergreen Advisers in Mountain Lakes, N.J. "And Buffett's interpretation has been globally the most influential."
What other attributes define the Buffett school of value investing—and might make you a better stock picker? Here are a half dozen that any do-it-yourselfer will find valuable:
Make money by not losing money.
It's an oft-quoted Buffettism: "The first rule of investing is don't lose money; the second rule is don't forget Rule No. 1." Buffett's greatest achievement may be that between 1965 and 2006, through three bear markets, Berkshire Hathaway lost value in only one calendar year, 2001. Even then, it still bested the Standard & Poor's 500 index.
Buffett understood this math foible: If you start with a dollar and lose 50 percent of your money, you'll be left with 50 cents. But then it takes a 100 percent return just to get back to your original dollar. So it's best not to fall into a hole.
Don't get fooled by earnings.
Buffett has noted that "most companies define 'record' earnings as a new high in earnings per share." But he says the fact that earnings per share are rising in itself tells you little, because it does not take into account how much shareholders have invested. The more that shareholders invest in a company, the greater its earnings should be.
That's why Buffett favors a different measure of profitability—return on equity. ROE is calculated by taking a company's net income and dividing it by shareholders' equity. Since ROE measures profits as a percentage of what investors actually own, it reveals how efficiently a company's profits are growing.
It's unclear if Buffett demands a minimum ROE among his stocks, but some of his value-investing disciples look for companies with a return on equity of at least 15 percent. Within Buffett's basket of publicly traded stocks, his top holding, Coca-Cola, sports an ROE of greater than 30 percent, Anheuser-Busch tops 51 percent, and American Express 37 percent.
Look to the future.
They don't call Buffett the Oracle of Omaha for nothing. While Graham was always reluctant to predict the health of a business, Buffett makes a conscious attempt to identify companies with a good chance of continuing their success 25 years into the future. "Buffett talks a lot about looking through the front window and not through the rearview mirror," says John Rogers, chairman of Ariel Capital Management in Chicago.
Buffett peers into the future partly by attempting to calculate the current value of a company's expected future cash flows. It's his way of assessing a company's intrinsic value. Then Buffett looks for companies selling at a deep discount to that value. Often, Wall Street—or "Mr. Market," as Buffett says, echoing Graham—realizes its error only after Buffett steps in. For example, Burlington Northern and Union Pacific, two plodding railroad stocks that Buffett recently disclosed owning, saw their shares shoot up more than 18 percent and 34 percent, respectively, so far this year.
But he also has admitted that "anyone calculating intrinsic value necessarily comes up with a highly subjective figure that will change both as estimates of future cash flows are revised and as interest rates move." Some investors use Buffett-inspired Web calculators to try to emulate the Oracle, including Stick with companies with wide "moats." Since it's risky to predict the future, Buffett always talks about favoring companies with wide "economic moats." This doesn't necessarily mean that a company has to have a lock on a product or a market. Coca-Cola, for instance, certainly has competition. But Buffett always looks for companies with long-term competitive advantages that make forecasting safer.
A big reason that Buffett avoided technology stocks in the late 1990s was that he could not identify any firms with a wide enough moat. So when Buffett said the tech sector was "beyond me," he wasn't claiming ignorance. What he really meant was that technological advances in this sector were coming so rapidly that it was impossible to gauge with any clarity which companies and platforms would have a competitive advantage 18 months down the road. This would explain why even blue-chip companies like the networking giant Cisco Systems or the microchip manufacturer Intel never made it into Berkshire Hathaway's portfolio even after their shares took a big hit in the 2000 bear market.
When you bet, bet big.
Most value investors are conservative by nature. The average manager of a value stock fund spreads his or her bets among 146 different stocks, according to fund tracker Morningstar. Not Buffett. The $62 billion that he has invested in publicly traded stocks is concentrated in only about 45 names.
His strategy is even more aggressive than this statistic would suggest. His top 10 stock picks account for a stunning 90 percent of his publicly traded portfolio. "This concentration is consistent with what Mr. Buffett has said in the past: 'Don't swing a lot, but if you do swing, swing for the fences,'" says Justin Fuller, a Morningstar senior equity analyst. Or, asks Bruce Berkowitz, comanager of the Buffett-loving Fairholme Fund in Short Hills, N.J.: "Why in the world would you want to invest in your 30th-best idea, as opposed to your best idea?"
Of course, this type of thinking takes moxie. You have to be totally confident that your best ideas will outperform the field. In the right hands, though, this risky approach can work: A quick analysis by U.S. News using data from Morningstar shows that value-oriented stock funds with fewer than 50 stocks have outperformed the average value portfolio with more than 50 holdings over the past one-, three-, five-, 10-, and 15-year periods.
Don't be afraid to wait.
If you take big swings in the stock market, as Buffett does, there's a big risk of striking out. Buffett's rule: Don't swing that often. And don't swing at bad pitches.
Buffett has quoted legendary Red Sox slugger Ted Williams: "To be a good hitter, you've got to get a good ball to hit." And until Buffett gets such an investing pitch, he's more than willing to hold cash. "He's understood something that people don't appreciate: Having large amounts of cash doesn't have to hurt your performance," Berkowitz says. "Cash can be a strategic asset." Cash currently represents more than 18 percent of Berkshire Hathaway's investment allocation, according to Morningstar, versus just 4 percent for the typical value stock fund.
This doesn't mean that Buffett doesn't want to maximize his gains at all times. Like Gordon Gekko, he believes "greed is good." But like the quintessential value investor he is, Buffett believes that you have to be patient when exercising that greed. As he has often said, "Be greedy when others are fearful and fearful when others are greedy."
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