In 1962, a successful young fund manager began buying a sleepy New England textile firm, even though the U.S. textile industry was in a decline -- losing out to cheaper foreign competition. A small textile company with a few plants in Massachusetts certainly showed little growth potential or future, and hardly sounds like the ideal launch pad for the man that would become the world's most successful investor.
But that manager was 32-year-old Warren Buffett, and the textile manufacturer was Berkshire Hathaway (NYSE: BRK-A). By 1965, Buffett had taken total control of the company and replaced management. You see, Buffett wasn't interested in the textile business itself, but was instead interested in the firm's cash. Berkshire generated copious free cash flow and had plants, equipment and land that could be liquidated to provide even more cash.
With this in mind, Buffett dissolved his investment partnership and began to invest Berkshire's excess cash flows, offering his investors a stake in Berkshire in lieu of their previous fund holdings. Investors who took that deal were amply rewarded. Buffett's book value returns have been nothing short of legendary, averaging over 20% annually since he took over Berkshire's reins.
As our chart illustrates, $10,000 invested in Berkshire from 1965-2008 would be worth more than $36 million, against less than $430,000 for the same sum invested in the S&P 500. That's more than a +362,000% gain.
Why Buffett's Performance Is Important
Berkshire's performance is proof of the wisdom and value of Buffett's approach. Not surprisingly, dozens of books have been written on the subject, probing virtually every aspect of the Oracle's biography and all of his legendary investment decisions. Of course, it's impossible to neatly distill all of his wisdom into any book or article.
But Buffett's investing methodology is far from a total mystery. Each year, Buffett pens a lengthy letter to shareholders for the firm's annual report; these letters explain the rationale for Berkshire's investments and have contained countless pearls of investing wisdom over the years. And of course, Berkshire is a publicly traded company; the firm must disclose Buffett's investments. These too offer a look at the types of stocks that interest Buffett. Finally, Buffett has made no secret of the people that have influenced his style, including Benjamin Graham, the father of value investing. With these ideas in mind, we decided to dive into Buffett's investing style and let you know exactly what he looks for in an investment -- and how he led Berkshire to a +362,000% gain.
Margin of safety and intrinsic value are concepts Buffett learned under Graham's tutelage. Intrinsic value refers to the total value of a firm's assets and current and future earnings. Clearly, calculating intrinsic value is not an entirely straightforward process and different analysts will arrive at very different conclusions as to a firm's true value.
What Guides Buffett's Investment Choices
Buffett looks for the potential for growth, which means looking beyond tangible goods. For example, many key Berkshire businesses -- notably insurance -- can't really be valued based on physical assets alone.
Buffett, like Graham, looks for companies trading at around a -25% discount to his calculation of their value. The Margin of safety goes back to Buffett's core belief that he'll only invest in companies when he feels assured of a relatively low-risk return on his investment.
Warren Buffett has always preferred to invest in companies and industries he understands well. After all, if you can't understand how a business makes money and what sort of markets it's involved in, how can you possibly understand its true value?
A quick glance at the list of companies Buffett has purchased over the years shows that most are in straightforward industries -- Coca-Cola (NYSE: KO), See's Candies, and Dairy Queen are some classic examples.
But don't assume that Buffett is just some investing dinosaur who invests in a bunch of readily understood consumer stocks. Perhaps Berkshire's most important single industry group is insurance; the company owns GEICO and General Re and remains one of the world's largest insurers. You may think that insurance is a rather complicated business, but it too fits with Buffett's investing mantra. Buffett spent years studying the insurance industry so he understands it better than most insurance executives.
Buffett has alluded to the concept of an economic moat on several occasions in his annual letters to shareholders. Medieval castles often had moats -- a water-filled canal encircling the castle. This water made it tougher to lay siege to the castle. Attackers would have to swim or otherwise cross the moat before getting near the castle's walls; this slowed the would-be conquerors down and gave the castle inhabitants time to defend themselves.
In today's highly competitive economy, companies are not unlike medieval castles. A successful company that manages to earn sizable profits will undoubtedly attract competitors. If those competitors are successful in gaining market share, then they'll erode the profitability of the original business.
The most successful firms are those that boast some sort of sustainable competitive advantage -- an advantage that's difficult to copy or emulate. These firms are able to maintain their success despite the inevitable attacks from competitors.
If there's one single financial statistic that's more often associated with Buffett than any other, it's return on equity (ROE).
The calculation of ROE is simple, and it's quoted on just about every financial website. Simply divide a company's net income -- the sum remaining after all expenses have been met -- by shareholder's equity. This ratio measures how much profit a company produces relative to shareholders' investment in the firm. In other words, ROE answers one critical question: How much money does a firm make for its owners?
But don't assume that you can just run a screen for stocks with very high ROE and invest like Buffett. You must look for a stable or rising ROE over time. If a company has a particularly strong year, the net income figure can be inflated and that can cause ROE to look very big. Such one or two-year blips have a tendency to fade quickly once the business environment becomes less favorable.
Truth be told, we aren't likely to replicate Buffett's amazing gains, but by learning more about his techniques, we can become better investors.