We select our marketable equity securities in much the same way we would evaluate a business for acquisition in its entirety. We want the business to be:
One that we can understand,
With favorable long-term prospects
Operated by honest and competent people
Available at a very attractive price
We ordinarily make no attempt to buy equities for anticipated favorable stock price behavior in the short term. In fact, if their business experience continues to satisfy us, we welcome lower market prices of stocks we own as an opportunity to acquire even more of a good thing at a better price.
Apart from the first and last criteria of “large purchases” and “an offering price”, this is just the same list as Berkshire’s Acquisition Criteria for purchases of private companies that I presented first.
Let’s beak it down.
Warren Buffett’s 4 Principles
Indeed, these “4 Principles” as I call them are pure Buffett, and succinctly summarize some of his core beliefs inherent in many of his most popular quotes:
A business we understand: Invest within your circle of competence
What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.
With favorable long-term prospects: Our favorite holding period is forever
Time is the friend of the wonderful company, the enemy of the mediocre.
Operated by able and trustworthy management: Reputation is your most important asset
It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently.
Available at a very attractive price: Intrinsic value and a margin of safety
Long ago, Ben Graham taught me that ‘Price is what you pay; value is what you get.’ Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.
Principles #1, #3, and #4 are simple to grasp: Stick with what you know, find good & honest managers (but not ones that are solely responsible to the success of the business), pay less than the value you’re receiving.
But what about Principle #2? What does Buffett mean by “favorable long-term prospects” and how can we determine if a company meets this criterion?
The answer to this question comes down to whether the company has an enduring “moat” that will protect its “castle.” In other words, does the company have some long-term competitive edge that will allow it to continue to earn high returns on its capital?
How Can You Apply Buffett’s 4 Principles to Your Own Investing?
1) Stay Within Your Circle of Competence
What industries and companies do you understand? For example, Apple, Kellogg, and John Deere have easy business models to understand and operate in relatively straightforward industries. Think you want to invest in that hot tech start-up that facilitates the creation of backward overflow synergies?
Unless you have specialized industry expertise and know what that means, or you take the time to carefully study the company and industry first, you better stay away.
2) Look for Companies with Favorable Long-Term Prospects
What is your company’s long-term competitive advantage? Does your company have a very wide and very sustainable “moat” that will protect its “castle” for years to come? Or will the company constantly have to re-dig its moat every year?
3) Evaluate Top Management for Honesty and Competence
Has the company or any of its executives been involved in fraud at any point in time? Is there “key man” (or key woman) risk? What would happen if the CEO or founder of the company left?
4) Is the Stock of the Company at Least Reasonably Priced?
What is the price of the company on the stock market and what do you think the intrinsic value of the company actually is? Is there a margin of safety, i.e. is the stock trading at a discount?
And that’s all there is to know. If you adhere Buffett’s four simple principles, they will guarantee you prosperity in your investments. If you are curious to know in more detail about value investing, you can download my free E-book. Full of wisdom from Warren Buffett, Charlie Munger, and Benjamin Graham, it will propel you to investment success.
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