Warren Buffett's 10 Step Investor Guide

For someone who has been aboard the Berkshire Hathaway (a diversified investment company with Warren Buffet as the Chairman and CEO) express since 1965, the cumulative outperformance has averaged 10.8% compound a year – or a 490,409% overall gain against 6,262% by the S&P 500.

So, every budding smart investor asks, how does the 80-year old Buffett and his even more venerable vice-chairman Charlie Munger achieve this high outperformance? Those seeking answers need only turn to Buffett’s 105 page 2010 letter to shareholders for a 10-point guide.

1. Investors shouldn’t sweat on year-to-year numbers. The normal measurement of time, observes Buffett, “is not synchronised with the time needed for either investment ideas or operating decisions to bear fruit.”

2. There’s a long-term correlation between earnings and share prices. For 40 years, the group’s compounded annual gains in pre-tax, non-insurance earnings per share has been 21% while the Berkshire stock price has risen at 22% a year: “Market price and intrinsic value often follow very different paths – sometimes for extended periods – but eventually they meet.”

3. Judging on the value of a share depends not only on “what do we have now?” calculations but also what Buffett calls the “what will they do with the money?” factor. Berkshire is a classic case: it boasts it has never paid a dividend or made a capital return but assiduously retains its earnings. This means, Buffett says, it needs good performance from both its current business and the more major acquisitions.

4. A smart investor is always searching for new opportunities. So stand by for more action, says Buffett: “We’re prepared. Our elephant gun has been reloaded and my trigger finger it itchy.”

5. Buffett always holds large cash reserves – and not just access to lines of credit. The company now keeps at least $US20 billion in cash to cover unexpected insurance losses and to use for acquisitions. (In 2008, it invested $US15.6 billion in 25 days of panic after the Lehman Brothers bankruptcy.) I also retained all of its earnings over 40 years, increasing its net worth from $US48 million to $US157 billion. “No other American corporation has come close to building up its financial strength in this unrelenting way,” Buffett says. 

6. Liquidity is important “as a condition for assured survival”. Buffett says that, while there is a minor cost in favouring cash rather than borrowings, “having loads of liquidity lets us sleep well”. This trait goes back to Buffett’s grandfather Earnest who, in the 1930’s put $1,000 cash in an envelope for each of his 5 children and urged them to keep it in a safe deposit box for an emergency.

7. Companies should assess the investment attractions of a business against opportunities available on the stockmarket. “Often businesses are priced ridiculously against what is likely to be earned from investment in stocks or bonds. At such moments we buy securities and bide our time,” he says.

8. Leverage can be lethal. “Some people have become very rich through the use of borrowed money. However, that’s also been a way to get very poor.” The danger, says Buffett is that leverage is addictive and, after profiting from its wonders, few people retreat to more conservative practices. He says “History tell us that leverage all too often produces zeroes, even when it is employed by very smart people.”

9. Berkshire has great managers. “They are not subjected to meetings at headquarters nor financing worries nor Wall Street harassment, “Buffett says, adding that “our trust is in the people rather than the process. A ‘hire well, manage little’ code suits both them and me.”

10. Investors who are patient will profit from companies which regularly increase their dividends. Buffett says when he first bought Coca-Cola stock in 1995, it paid $US88 million in dividends. Every year since, it has increased its dividend and in 2011 it will be $US376 million. Within the next 10 years, the dividends could double – and the annual returns could exceed the cost of the original investment. “Time is the friend of the wonderful business,” he says.

The following article has been sourced from the Weekend AFR 5-6 March 2011.

My thoughts - I use an investment method similar to that used by Warren Buffet. Click on Direct Share Investing - Warren Buffet Investment Method for more information.

Important Information

The above information provides an overview or summary only and it shouldn’t be considered a comprehensive statement on any matter or relied upon as such. The above information doesn’t take into account your personal objectives, financial situation or needs. It’s important for you to consider these matters before making any financial decision and I recommend you seek help from a financial adviser.