Warren Buffett Describes How To Pick Stocks

Warren Buffett
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Warren Buffett is the greatest investor alive today. After starting with a strategy based on value investing, Buffett’s investing has developed over the years to a more quality-based style, a change that’s produced huge returns for both himself and investors of Berkshire Hathaway.

Buffett wasn’t born with all of his investment acumen. Over the years his strategy has developed and changed with experience into what it is today.

“In my early days as a manager I, too, dated a few toads. They were cheap dates – I’ve never been much of a sport – but my results matched those of acquirers who courted higher-priced toads. I kissed, and they croaked.

“After several failures of this type, I finally remembered some useful advice I once got from a golf pro (who, like all pros who have had anything to do with my game, wishes to remain anonymous). Said the pro: ‘Practice doesn’t make perfect; practice makes permanent.’ And thereafter I revised my strategy and tried to buy good businesses at fair prices rather than fair businesses at good prices.” – Berkshire Hathaway 1992 letter.

To put it another way, Buffett started his career investing with traditional value metrics, such as P/B and P/E and then the morphed into a strategy based on cash flow calculations:

“The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset. Note that the formula is the same for stocks as for bonds.”

Cash flows are king, and that’s the case whether the business is growing or not:

“The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase – irrespective of whether the business grows or doesn’t, displays volatility or smoothness in its earnings or carries a high price or low in relation to its current earnings and book value.”

The best companies to own are the ones that produce the best returns with the least capital:

“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return.”

But how can you be sure that your calculations are correct? The best solution is to really get to know the businesses you own:

“First we try to stick to businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change, we’re not smart enough to predict future cash flows. Incidentally, that shortcoming doesn’t bother us. What counts for most people in investing is not how much they know but rather how realistically they define what they don’t know. An investor needs to do very few things right as long as he or she avoids big mistakes.”

And the second solution is to acknowledge that your calculations will never be 100% spot on, therefore, it’s key to always invest with a margin of safety:

“Second, and equally important, 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.”

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