"It's far better to buy a wonderful company at a fair
price than a fair company at a wonderful price."
If you can grasp this simple advice from Warren Buffett,
you should do well as an investor. Sure, there are other
investment strategies out there, but Buffett's approach is
both easy to follow and demonstrably successful over more
than 50 years. Why try anything else?
Two words for the efficient market hypothesis: Warren
Buffett
An interesting
academic study(PDF
file) illustrates Buffett's amazing investment genius. From
1980 to 2003, the stock portfolio of
Berkshire Hathaway beat the S&P 500 index
in 20 out of 24 years. During that period, Berkshire's
average annual return from its stock portfolio outperformed
the index by 12 percentage points. The efficient market
theory predicts that this is impossible, but the theory is
clearly wrong in this case.
Buffett has delivered these outstanding returns by buying
undervalued shares in great companies such as Gillette, now
owned by
Procter & Gamble . Over the years,
Berkshire has owned household names such as
Nike (NYSE: NKE),
Home Depot (NYSE: HD), and
Washington Post (NYSE: WPO).
Although not every pick worked out, for the most part
Buffett and Berkshire have made a mint. Indeed, Buffett's
investment in Gillette increased threefold during the 1990s.
Who'd have guessed you could get such stratospheric returns
from razors?
The devil is in the details
So buying great companies at reasonable prices can
deliver solid returns for long-term investors. The challenge,
of course, is identifying great companies and determining
what constitutes a reasonable price.
Buffett recommends that investors look for companies that
deliver outstanding returns on capital and produce
substantial cash profits. He also suggests that you look for
companies with a huge economic moat to protect
them from competitors. You can identify companies
with moats by looking for strong brands that stand alongside
consistent or improving profit margins and returns on
capital.
How do you determine the right buy price for shares in
such companies? Buffett advises that you wait patiently for
opportunities to purchase stocks at a significant discount to
their intrinsic values -- as calculated by taking the present
value of all future cash flows. Ultimately, he believes that
"value will in time always be reflected in market price."
When the market finally recognizes the true worth of your
undervalued shares, you begin to earn solid returns.
Do-it-yourself outperformance
Before they can capture Buffett-like returns,
beginning investors will need to develop their skills in
identifying profitable companies and determining intrinsic
values. In the meantime, consider looking for stock ideas
among Berkshire's own holdings.
It's clear that Buffett believes health care is an
attractive sector. In the second quarter, he boosted
Berkshire's stake in
Johnson & Johnson and opened a position
in
Becton Dickinson (NYSE: BDX), a New
Jersey-based company that manufactures medical supplies,
devices, and diagnostic equipment.
Becton possesses many of the familiar qualities that
characterize a typical Buffett investment: tenured
management, a strong balance sheet, and plenty of recurring
free cash flow. And trading at just 14 times earnings, it
certainly looks cheap at first blush –
another hallmark of Buffett's buys.
Might diagnostic dynamos
LabCorp (NYSE: LH) and
Quest Diagnostics (NYSE: DGX) be next on
Buffett's shopping list? We'll have to wait until Berkshire
files its next Form 13-F to know for sure. Continued... |