Warren Buffett is one of the greatest investors to have ever lived. Now known as the Oracle of Omaha, Warren Buffet came from modest beginnings to build a net worth of well over $84 billion, according to Business Insider.
With his vast wealth being built mostly in the stock market, it only makes sense that he’s viewed as one of the most successful investors of all time. But you may be surprised to find that Warren Buffett isn’t the kind of investor you might imagine, and that his footsteps will be hard to follow in unless you have a ton of money to start with.
Nonetheless, Buffet did find his success on Wall Street, and following his lead in terms of investment strategies and psychology will serve you well in your activities in the stock market.
Who Is Warren Buffett?
Most people have heard the name Warren Buffett and know him as a famous billionaire investor. However, there’s much more behind the name than someone who squirreled money away in the stock market to build his wealth.
Buffett had a relatively comfortable upbringing. His father, Howard Buffett, was an investor turned Congressman, and his mother, Leila Buffett, was a homemaker. His career started quite early, with him taking a job as a delivery boy for The Washington Post at 11 years old. Buffett also worked in his family’s grocery store and spent quite a bit of time at his father’s small brokerage, where he would watch what investors were doing and what they said.
With his pay, he purchased six shares of Cities Service preferred stock at $38 per share — three shares for himself, and three for his mom. The stock quickly fell to $27 per share, but even in his preteens, he decided not to sell. Once the stock got back to $40 per share, Buffett and his mother sold their positions, and Warren was hooked.
As a young investor, Buffett met Benjamin Graham, who took him under his wing. Now known as the father of value investing, Graham taught Buffett how to invest in undervalued companies that have a competitive advantage.
Throughout his career, Buffet has looked for intrinsic value that was hidden behind vast undervaluations — opportunities to buy a company worth $38 to $40 per share at $27 per share. He has held many seats on boards of directors for publicly traded companies and is a co-founder of Berkshire Hathaway, an investment firm with hundreds of millions of dollars in assets under management.
Buffett Doesn’t Just Buy Stock — He Owns Companies
Although just about every investor wants to follow in the footsteps of Warren Buffett, doing so would prove to be pretty difficult without plenty of money to start with.
You see, Buffett isn’t known for investing small amounts and simply riding stock prices on the way up. A $100, $500, $1,000, or even $10,000 stock position wouldn’t even scratch the surface of the investments Buffet makes.
Why does that matter?
Buffet is an activist investor. This means that he buys enough shares of the companies he invests in for it to make sense for the companies to give him an active role as a member of their boards of directors.
As a member of the board, Buffett becomes a key part of the decision-making process, helping to guide the companies he buys in the right direction.
Although the average investor can’t afford a seat on the board of directors of a publicly traded company, that doesn’t mean that you can’t learn from the Oracle of Omaha. All it means is that you need to set your expectations more realistically when following Buffett’s investing ideology.
Value Investing Isn’t Buy-and-Hold
One important factor you need to know about Buffett’s investment strategy is that he is a value investor. There’s a common misconception that Buffett follows a buy-and-hold investment strategy, and there’s a good reason for it.
Buffett once said, “If you’re not willing to own a stock for 10 years, don’t even think about owning it for 10 minutes.”
Sure, this quotation could insinuate that the buy-and-hold investing strategy is the way to go. However, actions speak louder than words, and Buffett’s actions in the stock market are those of a value investor. Buffett also understands what the companies he owns are worth and isn’t shy about getting out and selling a position when the time is right.
Value investors look for stocks that they’re willing to hold for the long haul. There’s no telling how long the investor will need to hold a value stock for it to grow to be worth its intrinsic value. However, the widely circulated Buffett quote doesn’t suggest that you should hold a stock that has climbed to fair market value or a higher price than it’s worth. Whereas a buy-and-hold investor might passively hang onto such a stock, a value investor would prefer to sell and take profits.
Key Principles of the Warren Buffett Investing Strategy
Although it’s unlikely you’ll invest enough in any company to get a seat on the board, there are six key principles of the Warren Buffett investing strategy that you can follow regardless of how much money you have to invest. Following these key principles will generally result in above-par returns in the stock market.
1. Know What You’re Investing In
Warren Buffett never makes a blind investment based on hype in the media or on social networks. Each investment he makes is highly calculated and in his areas of interest.
In fact, if you’re planning on investing like Buffett, you’ll invest in industries that aren’t just of interest to you, but that you know intimately. For example, if you’re a mechanic looking to build a nest egg, a strong place to start might be to invest in automobile-related stocks. On the other hand, if you’re a dentist, you might look for investments in a medical company developing a way to reduce pain after oral surgery without opiates.
Investing is a process that takes quite a bit of research. If you’re not interested in what you’re researching, you’re not as likely to do exhaustive research. But if you have an intimate knowledge of the industry you’re digging into, you know exactly what to look for when it comes to factors that drive success within the company’s industry.
2. An Investment Must Fit Into Specific Criteria
Even if Warren Buffet personally believes that a company he’s considering investing in will do well, he doesn’t risk his money or the assets under management at Berkshire Hathaway on anything that doesn’t fit into specific criteria.
When determining whether to invest in a company, Warren Buffett holds companies to the following criteria:
- The Stock Must Be Sensibly Priced. As a value investor, the first point of interest for Buffett is the value the stock comes with. Using various valuation metrics like the price-to-earnings ratio, price-to-book-value ratio, and price-to-sales ratio, the Oracle of Omaha makes sure he’s getting a good deal before he decides to buy shares.
- Management Must Be Quality. Buffett invests as much based on the management team as he does based on the company’s numbers. After all, even with the best product on the market, poor decisions made by a management team will result in significant declines. Before you buy shares in any company, it’s important to understand who’s running it.
- The Company Must Be Aggressive With Its Reinvestments. Buffett isn’t primarily concerned with earning dividends or income from his holdings. He sees aggressive reinvestments of net capital as a far more lucrative endeavor. In fact, he looks for companies like Amazon.com that — even with small margins — reinvest their earnings and generate a return on equity (ROE) of more than 20%.
- The Company Must Have Strong Earnings Power. One thing you don’t see much out of Buffett is an investment in any company that’s generating a loss. In order for Buffet or the management at Berkshire Hathaway to take notice, the company must be generating compelling profits.
Pro tip: Before you add any investments to your portfolio, make sure you’re choosing the best possible companies. Stock screeners like Trade Ideas can help you narrow down the choices to companies that meet your individual requirements. Learn more about our favorite stock screeners.
3. Look for an Economic Moat
Warren Buffett, like any successful investor, realizes that the success of any company is dependent on its ability to ward off competition. So it’s no surprise that the Oracle of Omaha often talks about an economic moat.
What is an economic moat?
Think of a moat around a castle during medieval times. Moats were vast bodies of water that surrounded the castle, warding off unwelcome guests and protecting the castle’s inhabitants.
That idea also works for businesses.
A company’s economic moat includes a strong brand, patents, and trademarks that keep competitors at bay. Should competitors decide they want to brave the moat formed by this intellectual property to take a bite out of the company, they will have to be prepared for the economic pain that will come as a result of expensive marketing or legal battles.
Before investing in any company, take time to research its intellectual property. Moreover, look for any attempts to infringe on that intellectual property by competitors and how the company you’re considering investing in reacted to it. Although intellectual property is great in and of itself, companies with a proven ability to ward off competitors in the courtroom generally have an economic moat that even the bravest competitors won’t want to fight through.
4. Cash Is an Investment
If Warren Buffet has cash in his pocket, it might just stay there. While he is a strong proponent of taking advantage of opportunities in the stock market, if there’s not an opportunity that currently fits into his criteria, he’s also happy to hold his cash.
There have been plenty of times throughout history that the value of cash has grown faster than the value of stocks. Moreover, liquid cash in your pocket gives you the opportunity to take advantage of strong opportunities in the stock market as they arise, rather than settling for a stock that simply won’t produce the returns you’re looking for.
As such, be highly selective in the investments you make. If you can’t find a stock that fits into your investing strategy, hold your cash; more opportunities will arise soon.
5. Don’t Set It and Forget It
Warren Buffet would never make an investment in a company and forget it for years. As a value investor, he is one of the most active investors on Wall Street today.
Any successful investor takes the time necessary to stay on top of their investments, rebalancing their portfolio as necessary. To do so, dig into your portfolio at least on a quarterly basis or on a monthly basis at best.
Look for any stock that has fallen out of your criteria as an investment. Maybe the value has grown to a point of overvaluation, the management team is changing for the worse, or a lawsuit took place and the company’s intellectual property didn’t hold up. If a company’s circumstances change and it no longer fits the value investing criteria, it might be time to sell it and look for the next opportunity.
Anything can happen in the market. Buffett pays close attention to his investments so he doesn’t miss anything. You should do the same.
6. Sell When Value Dissipates
The goal of a value investor is to find a discount on a quality stock. Once the stock is purchased at a discount, the investor patiently waits for the value of the stock to climb to a fair price.
You should have at least a rough idea of the fair market value of your investment based on your research prior to your decision to buy. Once that price is reached, there’s no more discount to be had. At this point, value investors generally sell their shares, earning a profit on the spread between the discount price at which shares were purchased and the fair price at which shares were sold. You can then apply your cash to invest in the next opportunity.
There’s No Shame in Index Funds
Investing like Warren Buffett is quite a bit of work. The amount of research that Buffett puts into his investment decisions should not be discounted. Buffett himself has made clear to investors that if you lack the understanding of the market needed to do quality research, or you simply don’t have the time to dedicate to the investing process, you should invest in index funds.
Index funds give investors access to a highly diversified list of stocks. These funds are designed to mimic the movement seen across entire indexes by purchasing shares of all the stocks in the index, such as all the companies listed on the S&P 500.
By purchasing shares in an index fund, you get wide exposure to the underlying index the fund is based on without having to research and select individual stocks. Exchange-traded funds (ETFs) and mutual funds are also strong investment-grade fund options that provide heavy diversification and access to entire sections of the stock market at a relatively low cost.
If you decide to invest in investment-grade funds, pay close attention to expense ratios, which reflects the cost of investing in a fund. The higher the expense ratio, the lower your returns. Many excellent broad-market index funds have expense ratios below 0.05%.
Everyone wants to invest like Warren Buffett. Although few have the investing capital required to buy yourself a seat on the board of a publicly traded company, there are several things that you can learn for the Oracle of Omaha.
In particular, the value investing strategy is a great way to go if you are willing to devote the time to research and have a solid understanding of the stock market. However, if that’s not the case, there’s no shame in investing in index funds and ETFs while you gain experience and earn market-average returns in the meantime.