In the recent past, 2011 to be precise, this was once again evident in his massive purchase of IBM shares. In an interview with CNBC, he explained that IBM’s moat was the strength of its brand name and the stickiness of the customer relationship with the company. Buffett was of the opinion that IBM was less a pure tech company than a services company that helps IT departments do their job better. He went around to all his companies to see how their IT departments functioned and why they made the decisions they made. He came away convinced of the position that IBM holds within IT departments and why they hold it.
But it was more than that. Buffett confessed to reading the annual report of IBM every year for 50 years but was completely sold out on the latest (this was in 2011) which laid out a 5-year road map till 2015. He also held the financial policies of the management in high esteem and the way it contributed to shareholders wealth.
So what does Buffett look at when buying a stock?
(a) One that he understands
He stayed away from internet and dot-com companies because he did not think it possible to value a company that does not make money, has no competitive advantage and an uncertain future.
(b) High ROE
Return on equity, or ROE, is one of the more commonly used ratios for determining how well a company can use capital. Buffett likes companies with a high ROE while employing little or no debt. According to him, good business or investment decisions will eventually produce quite satisfactory economic results, with no aid from leverage.
(c) Favourable long-term prospects
Buffett ignores short-term swings in revenues and gravitates towards companies that have moats that allow it to earn high profits consistently.
In his 2007 letter to shareholders, he stated that a truly great business must have an enduring moat that protects excellent returns on invested capital. A barrier such as a company being a low-cost producer or possessing a powerful world-wide brand is essential for sustained success. Just as a moat around a medieval castle kept the castle safe from intruders, an economic moat around a company keeps the company safe from competitors and other profit-draining forces.
(d) Operated by honest and competent people
According to Buffett, it is hard to overemphasise the importance of who is CEO of a company. He looks for able and trustworthy management after all management’s capital allocation decisions can lead to the enhancement or erosion of an economic moat. “Over time, the skill with which a company's managers allocate capital has an enormous impact on the enterprise's value. “
(e) Available at a very attractive price
In his 1992 newsletter, he explained this parameter.
“We insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.”
In other words, margin of safety is the gap between price and value. “Price is what you pay, value is what you get.”
In terms of investor behaviour, there are 3 important lessons a value investor can learn from Buffett:
- Do not let the market make decisions for you.
“The market is there to serve you and not instruct you. It is not telling you whether you are right or wrong. The business results will determine that.” That is why Buffett picked Coca-Cola shares in 1988 even when many analysts thought the stock was over-valued. He believed he was buying Coke at a discount compared to a reasonable valuation of the company and its prospects. “Buy based on how businesses behave, not people.”
- Stay in for the long haul.
On a number of occasions Buffett has referred to himself as a "Rip Van Winkle" investor, an investor whose “favorite time frame for holding a stock is forever.”
A harmful temptation for individual investors is buying and selling too frequently. If you own high-quality assets, let the companies' business strength and growth reward you through buybacks, dividends, purchases of other companies or internal growth. It is not necessary to constantly trade your holdings to have good investment success.
“Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”
In 1973, Buffett invested $10.6 million in the Washington Post Company. By the next year, his investment sank to a market value of around $8 million. But Buffett was unfazed. In his 1985 letter to shareholders, his calculations revealed that the investment was worth $221 million.
The lesson he learnt as an 11-year old served him well.
