Warren Buffett's Golden Rule of Investing

Updated August 5, 2020
posted on 06-10-2019

In 1988, when Warren Buffett bought his first shares of Coca-Cola -- one of the world's most powerful brands -- they were trading for less than $45 per share.

Anybody who bought Coke in 1988 benefited from a timeless rule that wealthy, sophisticated investors hold sacred. In fact, Warren Buffett has made so much money with this idea that we've come to call it his "Golden Rule."

What is this rule of the wealthy? How did it make Buffett a seeming Midas, turning every investment he made into gold? And how can you begin using it to make a fortune in stocks?

Buy wonderful companies at wonderful prices and hold them forever.

Essentially, it means that once you've found a wonderful company to invest in, the price you pay and the time period you hold it for are the most important things to succeeding as an investor. If you buy a great company for a cheap or fair price, you'll make money with just about every investment. If you pay too much -- even for the best businesses -- you'll lose money.

Let's go back to 1988 and see how Buffett applied this rule to his Coke investment...

Even though Coke's shares were trading for 15.6 times earnings, the company's PEG ratio -- a more accurate measure of value that takes a company's future earnings growth into account -- was 0.91, indicating that Coke was trading at a bargain. (A PEG ratio under 1.0 is considered to be a good value. Anything over 1.0 is potentially overpriced.)

Two years after Buffett made his first investment in Coke, it was up more than 127%. Buffett could have sold his shares and pocketed his cash, satisfied with his big win, and no one would have complained. Doubling your money in less than two years is impressive no matter who you are.

But that's where the second half of the "Golden Rule" comes into play.

Buffett has never been shy about holding investments long term. He's fond of saying that his favorite holding period is forever. "Time is the friend of the wonderful company, the enemy of the mediocre," he has been quoted as saying.

Buffett knew Coke was a wonderful company -- he wouldn't have bought it in the first place if he wasn't sure of it. So even after watching Coke's share price soar over 100%, he wasn't ready to call it a day. 

Five years later, Coke's share price had doubled again. Ten years later, Buffett, along with any investors who purchased alongside him, had made more than a 1,600% profit

The money Buffett made from his 1988 investment was the direct result of paying a wonderful price to become a shareholder of a wonderful company.

The exact opposite happened to investors who bought Coke in June 1998, when shares traded close to $90. 

Investors who bought back then paid the wrong price -- and lost money. The stock was trading at 62 times annual earnings. It's PEG ratio was an astounding 3.57.

That's ridiculously expensive. If a PEG of 1 indicates a fair price, then a ratio of 3.57 is like paying $50 for a $15 steak. Nothing much changed about Coke's business during that time. It was still one of the world's most recognizable brands. It still sold soda all over the world. It still had high profit margins. But investors who bought shares in 1998 seriously overpaid. And they're still paying the price.

Nearly 14 years later, those investors haven't made a dime in Coke, one of the world's greatest companies.

I don't know about you, but I don't have the time or patience to lose money in what should be a "no-brainer" investment. I'd rather sleep well at night knowing that my wealth was steadily growing in secure, wonderful companies.

Today, Coke is trading for 19.5 times earnings (20% more expensive than its industry peers) and its PEG ratio is 1.8 -- a little overvalued for my taste. 

Fortunately for us (and Buffett), there are other wonderful companies trading for wonderful prices. In fact, Cisco (Nasdaq: CSCO), Visa (NYSE: V) and Disney (NYSE: DIS) all sport PEG ratios similar to Coke's in 1988.

The Investing Answer: Successful investors don't rack up win after win because they're the smartest guys in the room. They have simple, smart rules that they stick to every time. Buffett and his "Golden Rule" are no different. If you take his lesson to heart and pay wonderful prices for wonderful companies and -- this part is important -- hold them "forever," you'll start seeing long-term gains, too.