One of my favorite investing books is How To Think Like Benjamin Graham and Invest Like Warren Buffett, by Lawrence A Cunningham. One of the best pieces in the book looks at the principles applied by some of the greatest superinvestors of all time.

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Walter Schloss : How I Choose Value Investments In Stocks

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Here’s an excerpt from the book:

The best investors employ a mind-set that takes account of just a few things, but those things are indispensable. Every extraordinary investor follows Ben Graham’s first principle: The market does not perfectly price the business value of a stock. Warren Buffett takes that insight dead seriously by limiting his purchases to stocks that are way underpriced by the market. Both of these investment titans as well as Phil Carret emphasize the importance of avoiding bad deals, stocks that are way overpriced in the market.

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These investors and other greats, such as Buffett’s partner Charlie Munger, always remember that there are tens of thousands of investment options available to just about anyone. To opt for one requires a strong belief that the market is giving the best deal available compared to all the others. And opportunity does knock. One way to test opportunity is to take Loeb’s approach: always ask whether you would be comfortable committing a large portion of your resources to a single stock you are considering.

Buffett and other outstanding investors, including Peter Lynch, know that an intelligent appraisal depends on your ability to understand a business. This gives you a basis for gauging points all these top investors consider crucial, such as a company’s competitive strength, brand power, and ability to develop new products profitably.

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The investment giants (not monkeys) don’t worry much about whether their investments end up concentrated in certain companies. For example John Neff, the portfolio manager of the Windsor Fund from 1964 through 1995, generated returns exceeding the average by a steady 3% annually and did so while sometimes allocating as much as 40% of the fund into a single business sector. Buffett’s Berkshire Hathaway is a wonderfully diverse collection of outstanding businesses, but that diversity was an accidental by-product of the tremendous growth in the capital it deployed rather than a conscious effort to participate in lots of different businesses or sectors.

This cast of illustrious investors extends the commonsense understanding of markets and businesses to the analysis of business fundamentals. Chief among these factors are economic characteristics such as strong financial condition, earnings stability and growth, strong sales and profit margins, and large amounts of internally generated cash to fund growth as opposed to a continuing reliance on external financing sources.

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These investors also pay attention to the quality and integrity of management, looking for companies which consistently maximize the full potential of a business, wisely allocate capital, and channel the rewards of this success to shareholders. They emphasize the importance of exceptionally competent managers who own substantial amounts of equity in their own companies and can rapidly adapt to dynamic business conditions. They also believe that managerial depth and integrity include assuring good relations with labor and promoting an entrepreneurial spirit.

The hedge fund master George Soros summed it up well by saying that “the prevailing wisdom is that markets are always right; I assume they are always wrong.” The prevailing wisdom of market efficiency is one way to view markets. In this view, price changes are due almost exclusively to changes in fundamental values. Therefore, a diversified selection of stocks with different pricing behaviors compared to the overall market makes the most sense.

The contrary view says that lots of price changes occur for nonfundamental reasons. The goal here is to identify those companies whose prices are below their business value. This perspective calls for thinking about individual businesses rather than the overall market.

Article by Johnny Hopkins, The Acquirer's Multiple