Invest Like Warren Buffett: How To Think Like The Oracle Of Omaha

The Legend Of Buffett

Warren Buffett is one of the biggest names in finance – and for good reason. He amassed an $80 billion personal fortune thanks to his investments, making shareholders in his holding company very rich in the process. A share in his firm, Berkshire Hathaway, traded at $290 in 1980: today, that same share is worth over $300,000. Fortunately for us, Buffett has always been candid about how he invests, which means you can learn to invest like him. Interested? Read on...

Who is Warren Buffett? Before the octogenarian got his tentacles into everything from Apple to Wells Fargo, Warren was born in 1930 in Omaha, Nebraska. His father, Howard Buffett, was a broker and Warren took to money-making from an early age. The post-war teen fixed up an old pinball machine and struck a deal with a local barber to keep the machine in his shop. Soon Buffett and his partner had enough to buy more pinball machines and build a small empire. The early taste of business success was intoxicating.

Buffett read Ben Graham’s book The Intelligent Investor at 19 and immediately decided he would work for Graham. He enrolled at Columbia University, where Graham taught, to get his attention. Denied a role, Buffett worked at his father’s investment firm for a few years before Graham eventually relented and employed him. Graham had a huge impact on Buffett’s philosophy in possibly the most formative job in Buffett’s career.

In 1956, Buffett struck out on his own, starting the investment partnership which would become Berkshire Hathaway: the seventh most valuable company in the world.

Why should I know this? Buffett’s investment decisions have been hugely influenced by his life. Pinball wizardry taught Buffett to reinvest earnings in businesses when that will increase returns over the long run. His first investments in stocks as a child aged 11 in 1942, where he lost out on big profits because he sold too soon amid World War Two, taught him to buy and hold. And the finer points of his investment ideology (often termed “value investing”) come from his mentor Ben Graham.

The provenance of Buffett’s ideas is the key to his mindset today. And by understanding that, you can attempt to invest like him. By following in his footsteps, you could make a lot of money yourself. In this Pack we’ll give you the highlights of Buffett’s writings, picking out his practical wisdom that you can use in your own financial decisions. Now: it’s time for you to consult the oracle.

Buffett's Philosophy

What is Buffett’s investment philosophy? Warren Buffett is a “value” investor: he looks for businesses with a price tag less than their actual value. Value lies in assets, a strong expectation of good earnings in future, and management that is competent and trustworthy. He then either buys the entire company (if it’s affordable) or buys a significant stake and holds onto it, often forever.

But Buffett wouldn’t call himself a value investor: he thinks all investing should be like this. And he abhors trading – he would say that buying shares simply because you think their price will rise in the short term is speculation, not investing.

Isn’t this obvious? Not really! It was trendy to teach “efficient-market theory” (EMT) for much of the 20th century. EMT holds that markets are perfectly efficient, with all information about a company’s value factored into its stocks – so a stock’s current price exactly reflects the true value of a company. But EMT is incompatible with Buffett’s evidently successful strategy since you would never find a company trading for less than its value.

Buffett agrees prices may often be rational. But that’s a far cry from them always being rational. He points to his and Ben Graham’s investing record as evidence of the ability to find prices below a company’s value – and the falsity of EMT. Proponents of EMT, however, would say Buffett has just been lucky. Very, very lucky.

How does Buffett approach investments? In the same way he’d size up an acquisition, and he repeatedly reminds investors they are the owners of companies. He’ll try to understand the underlying mechanics of the business as best he can so he can find bargain prices. So how does the Oracle of Omaha divine value? Read on to find out!

How Buffett Picks Investments

How does Buffett find investment opportunities? To find good companies, you should rigorously evaluate them through an understanding of their business and market. Buffett stresses knowing your “circle of competence”: the area in which you make good decisions. For example, he won’t invest in the technology sector because he doesn’t think he’s able to make good decisions about which companies will exist in 20 years. Your area of expertise might be small and that’s fine: what really matters is that you stick to investment decisions in that area.

And how does he value a company? Buffett uses a definition of valuation adapted from the American economist John Burr Williams. In Buffett’s words:

He looks for companies with great prospects for future earnings – though establishing that isn’t easy.

How does he do it? There are a few factors Buffett uses to judge a company’s future. If the company has performed consistently well with high profit margins and minimal debt then that bodes well. He also looks for companies with defensible competitive advantages – he calls them “moats” – as these keep a company afloat ten, twenty or even fifty years from now (with Buffett’s nigh-on permanent investing horizon, that’s particularly important). The other main thing he looks at is the company’s management – more on that in the next session.

So if he finds a good company, he invests? Not always. Market prices are equally important. Once he calculates a company’s value, he wants to buy shares at a price significantly less than that value. He requires a “margin of safety” gap between the actual value and trading value to justify the risk of owning the company. If the company is trading just 1% below its value, it might not be worth the risk. For Buffett, no deal is better than a bad deal.

Because he’s looking for irrationally low prices, Buffett is a big fan of two traditional terrors: falling prices and high volatility. Falling prices create opportunities for bargain buying. And volatility means prices are flying around so there’s a greater chance the wrong price is attached to the stock.

Buffett's Ideal Manager

One recurring theme in Buffett’s writings is the importance of good managers. He’s not shy about slating major CEOs he doesn’t think are good enough. And good managers are a requirement for any business he invests in, particularly if he’s acquiring the company outright.

How does he find good managers? Buffett wants a manager with the mindset of an owner. He needs them to be looking out for shareholders, not themselves, and to think with long-term horizons. When he acquires a company, the managers are told to treat the company as if it’s their only asset, one that they have to hold onto for a hundred years.

Buffett looks for signals that indicate managerial qualities. If a company’s accounting is somewhat suspect or overly complicated, that’s a bad sign.

The same goes for a manager’s public statements: Buffett values clear and candid discussion of a company over insubstantial corporate jargon. He thinks it indicates trustworthiness:

His managers should be realistic in their goals for the company, too. He thinks CEOs shouldn’t predict growth rates, and he suspects those that regularly boast about their earnings success. It’s very hard to achieve consistent high growth and companies that claim to be achieving it may be hurting parts of their business to hit ambitious targets.

Finally, he demands managers avoid the “institutional imperative”: the disease afflicting big companies that makes them averse to change and wasteful with money. This can be a death knell for firms, so managers that sustain a culture opposed to this are a good bet.

Ultimately, Buffett goes into business “only with people whom I like, trust, and admire”. He may have a leg-up over you seeing as he actually meets CEOs he invests with. But you can make a stab at the same thing: many CEOs have a public profile and you can read their statements and interviews to get a feel for the person holding your money.

Practical Advice

What does Buffett think I should do with my cash? For one thing, don’t hold cash. He calls currency-based investments “among the most dangerous of assets” because inflation erodes currency’s value over time. To stay as wealthy as you are today, you need an investment that generates a return greater than inflation.

The easiest (and perhaps best) option is to own a low-fee index fund, Buffett says. With the chance to benefit from overall growth of the stock market you’ll probably do alright in the long run.

But Buffett maintains that if you’re smart and have the time to do research, it’s perfectly possible to build a portfolio of stocks yourself. And unlike most financial gurus, his mantra is not diversification.

Here’s his logic: evaluate companies within your circle of competence and find the few (five to ten) you think are best. Then pile significant amounts into each. Putting money into other companies you’re less confident about doesn’t make sense to Buffett.

Concentrated portfolios actually decrease risk, he says, because you think much more carefully about the businesses you invest in and are less likely to make a mistake. And “an investor should ordinarily hold a small piece of an outstanding business with the same tenacity that an owner would exhibit if he owned all of that business” – approach each investment decision as if you’re buying the whole company.

Once you buy in, Buffett advises you hold for the long term, ignoring fluctuations in market price (although it’s all you can eat for Buffett when prices are low, with more poured into his favourite companies). Do that consistently enough and you’ll hopefully see good returns.

Buffett’s philosophy isn’t particularly complicated, and there’s loads to learn from his slightly contrarian approach. Who knows: maybe following his advice will turn you into the next Warren Buffett.

Note: all quotations in this pack are from The Essays of Warren Buffett, edited by Lawrence A. Cunningham.