BY DANIELLE TOWN & PHIL TOWN
Do you long for the day when you can work less and travel more? Do you fear that you’ll never have enough money to be able to retire? By following Warren Buffett’s approach to value investing, you can learn how to build an investment portfolio that will give you the financial freedom you need.
The key to Buffett’s approach is to look for companies that you can understand, that have an intrinsic and durable competitive advantage, and that have talented management. Then, calculate a good price at which to buy that company’s shares.
Value investing does involve diving into the sometimes-complex world of financial statements, but with practice, you can figure out which are the most important numbers on any company’s Income Statement, Balance Sheet, and Cash Flow Statement, and use them to decide whether a company meets your investment criteria.
Once you have calculated the right price for your target companies, wait until the share price falls to that level and then buy, confident in the knowledge that you have an anti-fragile portfolio that will not just give you a great rate of return but will also be able to survive the next – inevitable – market downturn.
Fear keeps most of us from controlling our own investment decisions but following Warren Buffett’s value investing approach can give you financial freedom. The key is to look for a handful of companies that will give you great investment returns over the long term. There are four simple rules to follow: pick a business you are capable of understanding; one with a durable competitive advantage; whose management has integrity and talent; and that you can buy for a price that makes sense. This way, you can build an anti-fragile portfolio that will not only survive the inevitable next market downturn but will thrive in the long term.
1. GETTING STARTED
Most of us yearn for some level of financial freedom, but are busy juggling work-life stress, paying off student loans, servicing a mortgage, and perhaps raising kids while pursuing a career. In the middle of all of this it’s tough to take the plunge and create your own investment portfolio. Many of us are too afraid of the risks involved in anything to do with the financial markets. However, with some education and practice it is possible to follow in the footsteps of Warren Buffett and his ‘value investing’ strategy.
In 1956 Warren started the Buffett Partnership in Omaha, Nebraska, investing his money and that of friends and family. Over the next fourteen years his investments averaged annual returns of 31.5%. In 1969 Buffett closed that partnership and put all his money in Berkshire Hathaway, a public company controlled by Buffett and his investment partner Charlie Munger. Berkshire buys the shares of publicly traded companies like Coca-Cola as well as entire companies like Geico. Now known as the Oracle of Omaha and the elder statesman of the value investing world Buffett’s strategy is simple: buy a wonderful company when it is a bargain and only when you are certain that it will be worth more in ten years than it is today; and hold onto it even if the price goes down.
THE PROBLEM WITH INFLATION
Recessions have taught us that the stock market is a fickle partner. For many of us, it is tempting to become a financial hoarder and put everything in the financial equivalent of ‘under the mattress,’ i.e., buy U.S. Treasury Department bills or T-bills, which are guaranteed by the federal government and considered as close to risk-free as it’s possible to get. Unfortunately, inflation happens. Inflation is a good thing in that relatively low and steady price increases lead to what economists call a virtuous cycle of rising production and demand, leading to higher wages and more consumption. Of course, a high rate of inflation is a bad thing – it devalues money so quickly that wages and jobs can’t keep up. However, even moderate inflation is bad for savers as it erodes the purchasing power of your money. The $100 you have today won’t buy you as much ten years down the road, when prices have gone up an average of 3.0% every year.
In fact, you have to earn at least a 3.0% return on your money every year just to stop its value from eroding. Stock markets typically rise with inflation as company revenue and earnings also rise. So, the only way to grow your savings is through investment.
FEAR OF THE MARKET
The problem with the stock market, of course, is that it goes down as well as up – and a lot of things can cause a stock price to fall. Women investors in particular tend to have a low risk tolerance, making many of them unwilling to invest in the market. It seems safer to pay a professional to manage your money for you – but, that money manager has to be paid whether or not they actually make money for you. If you learn how to practice value investing, you can manage your own money with confidence.
As you go through these steps you will progress from Unconscious Incompetence (you don’t realize how little you know), through Conscious Incompetence (you know what you need to do but don’t know how), to Conscious Competence (you know how to do this!), and finally to Unconscious Competence (you’re so good at this you don’t even have to think about it anymore). The key thing to bear in mind right now is that you won’t actually be buying anything until you’ve worked your way through all these steps and arrived at a level of Conscious Competence.
So, how much do you really need to invest? To figure this out, you need to understand how the market works, and what your investment number really is.
‘The market’ is short-hand for the many stock exchanges around the world. In the U.S., the best known is the New York Stock Exchange or NYSE. The concept of trading shares on the market has been around since the Dutch invented the idea in the 1600s, dividing up a corporation into fractions that can be owned. When you buy or sell a share on a stock exchange you are buying it from, or selling it to, another investor, not to the corporation itself. Today, a lot of the actual buying and selling is done electronically rather than in a Dutch coffee house, but the principle is the same.
A few hundred years after the Dutch created the first stock exchange, the British came up with the idea of the limited liability company – exactly what it sounds like, this is a corporate structure that limits the liability of corporate owners to the assets of the company, keeping their private assets safe. This is great for encouraging the kind of risk-taking needed for entrepreneurialism but can also lead to corporations with no sense of responsibility for their actions.
Another aspect of the stock market to bear in mind is that management has a lot more information about the company than do shareholders. Theoretically, the shareholders indirectly run the company by electing a board of directors; but in reality, this is at best arms-length control, with the board overseeing the major decisions and appointing executive officers to actually run the company.
About 85% of the money in the stock market actually comes from individual investors, ordinary people trying to build their nest eggs through 401k plans, IRAs, and insurance policies. However, most of this investment is done through proxies:
Mutual funds: A collection of stocks and bonds, chosen by a financial advisor who charges a fee whether or not they grow your money.
Market index funds: A market index is a group of stocks that tell us how the market is doing overall, e.g., the S&P 500 – five hundred stocks that indicate how the overall 6,000 or so stocks on the market are performing. Market index funds buy the stocks in the index to passively follow the market, charging a lower fee than an actively managed mutual fund. Buffett says this is the best option if you’re not willing to do your own value investing, but it also means you will only average a return of about 7.0% a year.
Exchange traded funds (ETFs): Another index tracking idea, but a fund that you buy and sell direct from a broker like an individual stock, the fees tend to be higher than for market index funds but lower than for mutual funds.
Robo-advisors: A computer program that offers the same kind of investment options as a human advisor, but at a lower fee.
All of these money managers charge you a fee to invest your money, whether or not they actually grow your savings; and, at best, most barely manage to beat the market average. If the market rises an average of 7.0% a year, but your money manager charges you 2.0%, the actual earning on your savings is only 5.0%. In other words, it gets even harder to beat the rate of inflation and build up your money enough to gain financial freedom.
On the other hand, studies have shown that Buffett-style value investing returns over 20% a year.
CALCULATE YOUR NUMBER
The first step to building your own investment practice is to write down what financial freedom means to you – perhaps the ability to work less, pay off your debts, travel, or just feel less stressed?
To figure out what you need to attain your own financial freedom, you just need to know four things: how much you actually need to spend every year; how many years you have left to build your investment total; how much you can afford to put into investments; and, based on these first three things, your required rate of return.
WHAT IS YOUR MISSION?
Given this asymmetry of information and the sheer number of publicly traded companies, how do you start to narrow your choices? Find your mission – what you really care about, the values that you want to bring to your investing practice. Take some time to come up with the list that defines your mission. Perhaps your focus is on treating employees well, not exploiting animals, supporting local communities, and so on.
The mission is the first step you will use in creating the story of a company you are considering investing in.
2. VALUE INVESTING
Charlie Munger laid out the basics of the value investing strategy in four simple principles, the things that must apply before putting money into a company:
It must be a business you are capable of understanding
It must have a durable competitive advantage
It has management with integrity and talent
You can buy it for a price that makes sense and gives a margin of safety
Before looking at each of these principles in more depth, we need to consider the way the market really works.
The Efficient Market Hypothesis or EMH assumes that people are rational actors who buy and sell a stock based on what it is worth, and that a stock’s price therefore reflects all available information at any given moment. EMH says that the reason professionals rarely ‘beat the market’ is because the price always adjusts as soon as new information is available.
And yet, the original Buffett Partnership had average annual returns of over 30%. One academic proponent of the EMH claimed Buffett was just lucky, like a monkey flipping coins. In 1984 Warren published his response, an article in the Columbia Business School magazine in which he pointed out that if you found a bunch of lucky monkeys that all came from the same zoo in Omaha, you’d be pretty sure you were onto something!
In fact, said Buffett, the market is far from efficient because investors can exploit gaps between price and value. What’s more, fund managers often buy and sell based on greed or fear, not on rational and fully informed decisions. In 1999 Yale economics professor Robert Shiller published the book Irrational Exuberance in which he showed that the market regularly behaves irrationally. Nassim Nicholas Taleb then weighed in with his book, The Black Swan, arguing that the market is neither random nor unbeatable; supposedly impossible Black Swan events actually happen quite regularly.
Additional academic research has shown that people tend to make decisions based on biases and emotions, not on rational pursuit of self-interest. In other words, EMH is wrong and value investing really does work.
Events happen – things that are unexpected, that affect the company or the whole market, but that are temporary and rectifiable. Thanks to the nature of their industry, fund managers react to Events – they cannot wait for months or even years for a company to recover. The key to value investing is that, thanks to your research into the company and the industry, you will know when something is a temporary Event rather than a terminal problem in a badly run company.
Bubbles and crashes happen in the market, and they can seem random and unpredictable. However, there are two good sources for market-pricing information that help the value investor to tell when the market is mis-priced.
Robert Shiller won a Nobel Prize for creating this indicator that shows how over- or under-priced the market is. Shiller calculates the cyclically- and inflation-adjusted earnings of the S&P 500 over the past ten years and divides that number into the total market price of the S&P 500. Over the past 140 years the average Shiller P/E is 16.4, so when the indicator goes much above (or below) this level it’s a sign that the market is badly mispriced. It’s only risen above this level three times: in 1929 it rose to 32, then the market crashed down 90%; in 2000 it reached 44, then the market dropped 50%; and by late 2017 the Shiller P/E had risen to 31, suggesting that it’s getting ready for another sharp fall.
Buffett says that the best measure of where valuations stand at any given moment is the ratio between the market as a whole and national revenue. The Federal Reserve Bank of St. Louis calculates one such ratio, colloquially known as the Wilshire GDP, which takes the capitalization of the Wilshire 5000 stock market index (i.e., how much the 5,000 companies in the index are worth) and divides it by the U.S. GDP. If the ratio is well below 100% then the market as a whole is underpriced; if it’s well over 100% then the market is overpriced. The index went over 100% in 2000 and again in 2008, and each time the market subsequently crashed. As of late 2017 the Wilshire GDP stood at an historic high of 155%.Taken together these two indicators say a correction is coming.
BE CAPABLE OF UNDERSTANDING THE BUSINESS
To reiterate, Charlie Munger’s first principle is to put your money into a business that you are capable of understanding. Note, this is not the same as saying you have to understand it right now, just that it is something you are capable of understanding in the future after putting in some work. That means, pick an industry that is easy for you to understand: what are you passionate about (like healthy eating, cars, snowboarding, etc.); where do you actually spend your money (which stores and services do you use on a regular basis); and where do you make your money (which industry are you involved in). Where these three things overlap is where you will find the industries that are the easiest for you to understand.
You can also get a sense of which companies to start researching by checking out what investment gurus such as Buffett, Munger, and others are buying. These investors only make their purchases public knowledge once a quarter, however, so you cannot just follow their investments without doing your own research to see if this is still a good buy for you. Warren Buffett’s annual letter to Berkshire Hathaway’s shareholders is also a great source of information about his thoughts and value investing. It’s also a good idea to start reading the Wall Street Journal business section on a regular basis.
3. THE MOAT AND MANAGEMENT
Charlie Munger’s second principle of value investing is to pick a company with an intrinsic, durable competitive advantage. Buffett calls this concept the moat: the competitive advantage that makes the castle/company near-untouchable by competitors. This is not the same as the company doing a good job in solving a particular problem or filling a particular need; it has to be something that is intrinsic to the business, and durable – so difficult or expensive to overcome that no competitor is going to try.
TYPES OF MOAT
There are a number of types of moat. A brand moat is something like Coke or Kleenex, where people think in terms of the brand name rather than the product. A switching moat is one where it is very complicated or expensive for a customer to switch away, like switching from Apple to Microsoft for all your operating systems; similarly, a network moat is something like Facebook, where the act of switching is not difficult but if you do so, you lose access to an entire network.
A toll bridge is when a company has a near or actual monopoly in its industry – this can be a moat created by government regulation or by geographic location. Proprietary secrets, such as patents or other intellectual property, are an effective moat. And finally, price can be a moat – when a company is the low-cost provider because it can make its product or service more cheaply than anyone else.
Take the case of Coca-Cola: it doesn’t really have a secrets moat any more, just a very strong origin story that perpetuates the idea of a secret recipe; it doesn’t have a switching moat or any kind of toll bridge; and it certainly isn’t the cheapest producer. What it does have, however, is a very strong brand moat. That brand moat may not be durable, given that sugary sodas are becoming unpopular in the U.S. and Europe; however, a little research reveals that Coca-Cola is busy buying brands associated with health and nutrition, like Honest Tea and Odwalla. That suggests a company that is preparing for the future – which may explain why Buffett owns Coca-Cola shares.
MOAT BY NUMBERS
Coca-Cola’s story gives a sense of what its moat is like, but the best way to really judge a company’s moat is by looking at some key numbers on its financial statements. All public companies have to file these statements according to a set of accounting principles (although there may be some variation in the precise terminology used).
The Income Statement shows the company’s revenue (how much it is making) and expenses; revenue minus expenses gives the company’s profit. The Balance Sheet shows what the company owns (assets), what it owes (liabilities), and what is left. The Cash Flow Statement shows what cash has been spent, on what aspects of the business, and what is actually in the bank account.
There are four key numbers in these statements that roughly predict how strong and durable the company’s moat might be:
Net Income: Also called Net Profit or Net Savings, this is on the Income Statement. It shows the company’s profit after all costs have been deducted.
Book Value + Dividends: Book Value (also called Equity) is on the Balance Sheet and Dividends (if there are any) are on the Cash Flow Statement. Added together, these two numbers show the value of the business if it were closed down, after all of its assets have been sold and before any dividends have been paid.
Sales: Found on the Income Statement, this number shows the amount the company earns from selling, i.e., its revenue.
Operating Cash: Part of the Cash Flow Statement, this shows the actual cash that the company receives from its business operations.
For a strong and durable moat, each of these four numbers should be growing at 10% or more every year. Periodic ups and downs are not a problem, as long as the trend over time is for steady growth. When there is a down year in any of the four numbers, check to see what the reason was and how quickly the company got back on track.
FIND THE WINDAGE RATE
Those four key numbers show how well the company did in the past; the next step is to figure out what you, the investor, think is a good overall growth rate for the company going forward. This is a judgement call based on your own research, akin to taking ‘windage’ into account when shooting a gun.
Most financial statements have three to five years of data in them; if you find the most recent 10-K (the annual company financial report, available on the company website) and the one from five years ago, you can figure out average growth rates for the four key numbers over, say, three- five- and ten-year periods. Combined with analyst predictions of how the company is expected to grow going forward and your own best guess, you can now come up with an overall growth rate for the company.
Charlie Munger’s third investing principle is to find a company whose management has integrity and talent. For most of us, this is something we have to glean through secondary sources. Look for articles on the CEO’s biography and management style and the story of the company founder. Look, too, for information about the board of directors and how they may have handled problems; and see if company founders or executives have large ownership stakes, i.e., are literally invested in the company’s long-term future. Parse the public letters to shareholders and any other public statements. Are they straightforward or do they seem to carefully conceal any real information?
In addition to these secondary sources, there are three key numbers that give insight into the quality of the company’s management.
RETURN ON EQUITY
This is calculated from the data in the financial statements: Net Income (from the Income Statement) divided by Equity (from the Balance Sheet). ROE shows how many dollars of profit a company generates with each dollar of shareholder equity. However, the ROE can be artificially inflated if the company borrows a lot of money; so, it has to be looked at alongside the other two key management numbers.
RETURN ON INVESTED CAPITAL
This is Net Income again, but this time divided by Equity-plus-Debt. As a value investor, look for a company with an ROE and ROIC at 15% or better every year for the past decade. Anything less than ten years and there isn’t enough history to show that the company is durable for the long haul.
Finally, look at the company’s level of debt; a quick way to determine this is to compare the ROE and ROIC; if the two numbers are the same, the company has zero debt. If the company does carry long-term debt, they should be able to pay it off with at most two years of earnings.
With all of this information, you are ready for the next step: starting to build a wishlist of companies.
BUILDING A WISHLIST
The only way to build the wishlist of companies you’re interested in, is to start diving in to corporate annual reports. They make for boring reading, but it’s the only way to start getting an in depth feel for their financial status and what makes them tick. Odds are, you’ll be able to tell within a few minutes of reading whether or not you are capable of understanding this company – if it’s too hard or just too plain boring, toss them on your reject pile.
Companies that have potential but just don’t seem exciting you can put in your ‘watching’ pile – get back to them later after you’re more adept at being a value investor. Very few companies will make it onto your wishlist, but that’s OK. Remember: you’re looking for a handful of companies that you are capable of understanding; that have durable moats; and that have management with integrity and talent.
Now, it’s time to tackle Charlie Munger’s final principle of value investing: finding the right price.
4. THREE WAYS TO CALCULATE PRICE
The short version of Charlie’s fourth principle is: figure out a reasonable price for this company’s shares, then wait until the price falls below that level. This is the point at which first-time investors may start to panic, thinking, “But this involves math! I can’t do math!” Yes, numbers are involved here but there’s little real “math,” it’s mostly a case of logical thinking.
In his 2014 letter to his shareholders, Buffett laid out the simplest way to put a price on a business: think about it like a real estate purchase. You know what the condo costs, what the neighborhood is like, and what the maintenance and yearly fees will be; and you know how much mortgage you can afford. With those numbers, you can figure out if this particular condo is the one you should buy. Pricing a company is no more complicated, once you know where to find the numbers and what to do with them.
Phil Town uses three different ways to price and value companies. By using all three, you can understand the company better and be confident that you have determined a good price to pay.
TEN CAP PRICE
The ten cap price is based on owner earnings; cap is short for capitalization. In his 2014 letter, Buffett describes using this method to pay for a farm in Nebraska and a building in New York City. A cap rate is the rate of return the property owner gets each year on the purchase price of the property. If you buy a farm for $500,000 and at the end of the year you have $50,000 in your pocket, then your cap rate was 10% – a ten cap. Buffett and Munger require a ten cap on their investments.
The formula is simple: owner earnings times ten. In his 1986 letter to shareholders, Buffett is characteristically blunt, calling owner earnings, “the relevant item for valuation purposes—both for investors in buying stocks and for managers in buying entire businesses.” Buffett notes in his 2014 letter that while real estate deals with a ten cap are pretty rare, they are much more common in the stock market, where traders react to short-term emotions like fear and greed and drive prices down.
Owner earnings is not a line on standard financial statements, but it is easy to calculate from those statements. Buffett’s formula is very simple:
Owner earnings = net income + depreciation/amortization – average annual capital expenditure
To calculate owner earnings, add together six numbers (even though some may be negative, add them; it’s an accounting thing). Net income is usually the very first line on the Cash Flow Statement. Right underneath is the entry for depreciation and amortization (a non-cash expense that takes account of the declining value of certain assets). Still in the same part of the Cash Flow Statement there will be lines citing net change in accounts receivable and accounts payable from the previous year – add those two numbers into the calculation, too. Next, add income tax paid, which can be found on the Income Statement. Finally, add maintenance capital expenditures – this number (which will be a negative one) may not be listed separately from total capital expenditures, so you’ll have to estimate the average annual maintenance cost, based on what you know about the business. Add these six numbers together and multiply by ten; now you have the company’s ten cap price.
PAYBACK TIME PRICE
This calculation is based on the company’s free cash flow and it does take growth into account. It calculates how many years it will take to get your whole purchase price back: free cash flow, grown by the compounded ‘windage growth rate’ for eight years. To calculate free cash flow, go to the Cash Flow Statement and add together the lines called ‘net cash provided by operating activities,’ ‘purchase of property and equipment’ (again, a negative number but you add it), and any ‘other capital expenditures for maintenance and growth’ (also a negative number).
Remember, you came up with the windage growth rate when you were researching the company’s moat and financial outlook. Now, compound that free cash flow every year by your windage growth rate, for a period of eight years. For example, say you have a lemonade stand with a free cash flow of $1,500 and you’ve decided it’s windage growth rate is 16%. Multiply $1,500 by 16% and you get $240; now carry the calculation forward, cumulatively for eight years. The result is a payback time price for the lemonade stand of $24,778 – if you pay that amount for the company today, in eight years you will have your whole purchase price back.
>Lemonade stand payback time chart from page 205<
MARGIN OF SAFETY VALUATION
This is based on earnings and is how you calculate the value of the company. You should only buy when the price gives you a margin of safety; the ten cap pricing method requires a high return so it requires a low buying price (a nice big margin of safety), while the payback time pricing method gets you your money back in eight years. Finally, you have to calculate a valuation method that has a margin of safety built in. This is a variation on what accountants call Discounted Cash Flow Analysis.
First, figure out what rate of return you need to get on your money every year, to make the investment risk worthwhile. A good rule of thumb minimum acceptable rate of return for stocks is 15%.
Decide what the price of the company should reasonably be in ten years: take the earnings per share (from the Income Statement) and multiply it by (1 + your windage rate), and do this ten times. The result is your future ten-year earnings per share.
Next, take your windage growth number and double it; compare the result with the company’s historically-highest price/earnings ratio (which you can easily find online). Pick whichever of these two numbers is the lowest and multiply your future ten-year earnings per share by this number. Now you know what the future price of one share should be, ten years from now.
Now, work backwards to find out what the price should be today, assuming a 15% rate of return every year. Take your future ten-year share price and divide it by 4; the result is today’s reasonable price for that company. Finally, take that sticker price and cut it in half: that’s your margin of safety.
>lemonade stand margin of safety calculation table from page 217<
After running these three pricing models, you may end up with three very different results. At this point, you make a judgement call on what you think is a reasonable price to pay, based on everything you now know about the company.
5. WRITE – AND INVERT – THE STORY
The final stage in preparing to take the investment plunge is to tell the story of why you should buy this company – and then invert it and tell the story of why you should not. Go back over all the work you have done up to this point and write up your investment story.
Do you understand this company and does it meet your mission-to-invest criteria? Does it have an intrinsic, durable, solid moat and are its big four numbers growing? What is your opinion of the management team? And, what is a good price at which to buy?
Next, list three great reasons to buy this company. Now, describe the Event (whatever it may be) that has led to this company being on sale. Are you confident that the company can recover from the Event in three years or less?
Now, invert the story. Come up with three good reasons not to buy this company and see if you can rebut each reason not to own. If you can’t, or you’re undecided, then this company gets taken off your wishlist. That may seem harsh after spending all this time building up your company profile and running all those numbers, but the intent here is to avoid an expensive mistake. Odds are you can use a lot of your background research on another company in the same industry; no investment research is ever a waste of time.However, if after all this you still really like this company, then it goes on your wishlist. Now, you just wait for the price to be right.
SETTING UP A BROKERAGE ACCOUNT
While you are waiting for the right time to buy into one of your handful of wishlist companies, set up a brokerage account at one of the online companies like TD Ameritrade or Schwab. This is no more complicated than deciding where to open a bank account.
When you are ready to make a purchase, you go to your account, type in the symbol for the company you want to buy and specify how many shares. The broker will likely ask for confirmation that this is a limit order – meaning the seller will sell it to you at the price you specify, or less. Investor guru Mohnish Pabrai has said that he never puts in a buy order when the market is actually open, because he doesn’t want to be focused on the day’s price fluctuations.
Whenever you do decide to buy, remember you have picked your buy price based on solid research; you will almost certainly not be able to predict the bottom of the stock price; and, you’re in this investment for the long term.
6. YOUR ANTIFRAGILE PORTFOLIO
The key to building a portfolio that will withstand the regular fluctuations of the market and one-off Events – an antifragile portfolio, to use Nassim Nicholas Taleb’s teminology – is patience. Think of yourself as a hunter stalking its prey, waiting for the price to be right on your handful of wishlist companies. Your companies all have durable moats, meaning they can not only withstand, but likely actually benefit from, Events. The companies are antifragile because they will come back stronger than ever. So, until the price comes down, wait in cash and be ready to take action when the chaos hits. Just don’t hesitate and think, “Maybe I should wait even longer for the price to fall even lower.”
So, how much to invest in each company? A good rule of thumb is to put 10% of your investment portfolio in each company, but that’s just a guideline. Either way, have a plan for what order you will buy your wishlist in if the whole market goes down at once. And, when it comes to deciding where to start, Buffett would say, “Buy your favorite,” because that’s the company you have spent the most time thinking about.
One of Buffett’s biggest secrets to lowering risk and raising overall return is buying companies that, over time, reduce the amount he has invested in them by sending him some of their free cash flow – in other words, dividends. Ideally, you will get all of your money back through dividends. However, companies are under a great deal of pressure to keep the dividends paying out, no matter what; and sometimes that is not the best use of their funds. Don’t buy based on whether a company pays a regular dividend, but rather on whether management is using its free cash wisely.
One tactic to use is to buy in tranches or slices. When your target company price hits your buying level, buy 25% of what your total purchase aim is for the company; when the price goes down more, buy the next 25%, and so on. This helps to alleviate your fear of what happens if the price keeps falling after you buy. Just remember that the aim is to buy and hold for the long term.
WHEN TO SELL
Do not plan on selling your company unless its story changes – perhaps its moat is breached by a fundamental shift in the industry, a major new technological invention, or management turning into traitors to the stakeholders (debt rises, ROIC starts dropping, etc.). The story inversion exercise that you went through before putting the company on your wishlist will give you clues as to what might wreck the company and cause you to sell.
Keep track of the company’s story through its annual report and shareholders meeting; regular reading of the business news; and periodic checks on what your favorite investment gurus are doing. Keep an eye on the overall market by checking the Shiller P/E and the Wilshire GDP. And finally, keep doing the research to find potential new wishlist companies.
As you start to build your investing practice, you will get more adept at doing the research, finding the information, running the numbers, and making decisions. You’ll start to see the world around you through the eyes of an investor, not just a passive consumer. You will gain new insights into your thoughts about money and new confidence in your ability to ride out the inevitable next market crash.