While there are many books, gurus, and websites telling investors that “that you too can invest like Warren Buffett” …the sad truth is—you really can’t.
The average investor can’t be like Buffett; he is extremely intellectual, his IQ is off the charts, Charlie Munger said, “The man is a learning machine.”
So how can stock investors be more Buffett-like?
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I asked this question to Alice Schroeder, author to The Snowball: Warren Buffett and the Business of Life, when I interviewed her in April 2010. Schroeder was the only author given complete access to Buffett’s family, friends, and business associates.
Schroeder shared the three Buffett-like investment principles that the average investor can use—handicapping, compounding, and margin of safety:
Warren has his own way of explaining things, but handicapping to me is all of the different things that determine whether you should even be thinking about an investment and then all the details that prepare you to value it.
And so you start with whether it’s within your circle of competence, does the business have some cataclysmic risk factor out on the tail that makes you not want to even touch it, for example, asbestos was something like that for a lot of companies for a while.
You should be looking at the management, are they evil or are they shareholder-oriented? Is the product likely to become obsolete easily? Is it a fashion business, which is bad? Does it have a rational competition? Is it a commodity? Are there hidden assets or liabilities? Do they have legal problems? How do the cash flows work? Is it a capital-intensive business or a cash flow generator? Is it a fundamentally good business?
These are all things that require a great deal of thought, but what you’re doing is you’re putting together brick-by-brick a picture if you were to invest in this business, what are the odds in your favor of being right.
And they are ultimately going to be the inputs to the valuation as well, but what you’re really doing is figuring out the odds that this will be a successful investment. The moat is kind of a broad, generic term that Warren uses to cover a lot of these concepts and the circle of competence. But what they’re really about is stacking the odds in your favor as an investor.
Compounding is much more straightforward. I think people should spend a lot more of their time on the handicapping aspects. Compounding, we all know what estimating future cash flows means in theory. I think people spend way too much time worrying about things like what interest rate to discount at.
You know, (a) you can’t go too far wrong if you get the margin of safety right, and (b) you know, if you do relatively straightforward valuations based on price earnings ratios and make sure that you understand the earnings yield of a company, you will not make mistakes.
You will – if you have a company and you’re confident of the earnings then you can put a low PE on it by historic standards; so you’re not paying 20 times earnings, you’re really paying 10 or 12 times earnings. And if you know what the return on invested capital is and the return on assets, and that’s a reasonable PE in light of those numbers, then you’re not going to make a mistake.
I think people just spend way too much time trying to develop complex formulas for these things, when in fact they should be worrying more about the value of the business, what are the metrics of the business, what kind of return on investment is the business getting, you know, what kind of earnings is the business generating, how long can those earnings be sustained, how certain are you about that.
What rate you discount them at is not that important; you can just stick a PE on it that’s a reasonable PE. Investors may enjoy doing it more precisely, but it really isn’t necessary because of the third factor, which is the margin of safety.
Margin of Safety
The margin of safety, as we know, is your hedge factor for being wrong about all of the above. The margin of safety has saved Warren Buffett time after time after time, because although his batting average in investing is very high, he is not batting at 100%, and he would be the first to say that you shouldn’t bat at 100%, because if you are you’re not taking enough risks.
The margin of safety is designed to protect you against that, and it comes in a couple of forms. One is you don’t put up more capital than you can afford to lose, including taking on leverage—that’s part of your margin of safety. And the other part of the margin of safety is that you assume that you’re wrong about the valuation and you just whack something off the price. And you can use a rule of thumb. A good rule of thumb is if you’re paying a third less than you think the intrinsic value should be then chances are you’ve got a good enough margin of safety that over time, you will be very well-protected and you’ll make money. That’s not a hard and fast rule, but one thing that that metric will give you is it will prevent you from overpaying for projected earnings.
I mentioned that Warren prefers to pay for trailing earnings. He doesn’t like to pay for the future; he likes to pay for what you get, and then the future comes, and that’s what you earn. The margin of safety is part of your way of accomplishing that. It’s not a scientific thing. As Warren has often said, if you need a computer to figure it out, you shouldn’t do it.