Mistakes are part and parcel of the investing business. But you can put the odds in your favour by following Warren Buffett’s simple investing advice. We name six UK companies he should be interested in buying.
For such a brilliant investor, Warren Buffett sure lives by a stupid set of rules.
I'm referring, of course, to Buffett's famous first (and second) rule of investing: Never Lose Money. That's certainly an admirable goal, and it's one that we here at The Motley Fool strive for -- to be right about every share, every time. However, there's a small problem with Buffett's rule. It's impossible.
Mission Impossible
It once seemed like everything the man touches turns to gold, but even Buffett has been wrong on occasion. His investment in two Irish banks during 2008 didn't pan out, nor did his purchases of H.H. Brown Shoe Co. or Dexter Shoes (perhaps Rule No. 3 should be "Never Invest in Shoe Companies").
His recent purchases haven't all been moneymakers, either. In his latest letter to shareholders, Buffett lamented that purchasing ConocoPhillips (NYSE: COP) too soon had cost his company "several billion dollars."
Given his stated modus operandi., how could Buffett be so cavalier about these losses? It's simple. For starters, the man has more money than just about any person on this planet. And secondly, his famous advice may not mean what you think it does.
Do As Buffett Does, Not As He Says
When Buffett says "never lose money," he doesn't actually mean that investors should never lose money. Instead, he means that investors should strive to limit their downside risk by purchasing shares in businesses with significant competitive advantages when those businesses trade at a large discount to their intrinsic value.
If you concentrate on buying such companies, it's less likely you will lose money on each of your investments and highly unlikely that you will lose money over the long run. That's the real meaning of Buffett's famous rule -- and it's the secret to his sustained success.
Rule No. 3: Buy Great Businesses At Good Prices
A great business is often easy to spot. In fact, Buffett has even given us a handy framework. In his recently released 2008 annual report, Buffett outlined six key traits that he looks for in any acquisition candidate:
- At least US$75 million in pre-tax earnings.
- Demonstrated consistent earnings power.
- Good return on equity with little or no debt.
- Strong, committed management.
- A simple business model.
- A fair price.
Scores of companies meet these criteria. As you'll see in the table below, I've identified six popular companies that appear to fit Buffett's bill. The trick, however, is buying these businesses at a significant margin of safety.
To calculate a company's intrinsic value, Buffett is said to usually forecast future cash flows, and discounts those amounts to a present value as one would when pricing a bond. For the purposes of this article, I'll substitute the price-to-earnings ratio (P/E), which is admittedly a crude approximation of a company's value:
Would Buffett buy these stocks? He already owns some Tesco shares, so it's a yes for them. And he owned Guinness for a short time in the 1990s before it merged with Grand Metropolitan to form Diageo. As for the rest, my personal opinion is most of them would get close to passing Buffett's 6 key traits of a company he'd be keen to acquire. It just goes to emphasise, yet again, how good quality companies have become quite cheap during this vicious bear market.
And that brings us to rule No. 4:
Rule No. 4: Pick Your Shares Wisely
Buffett doesn't purchase shares because he saw them mentioned on BBC's Working Lunch, or he received a hot tip from a friend in the know. He takes his time, studies the company and its industry, and buys only when he is confident that he understands the company and it meets his aforementioned criteria. His famous thought experiment below nicely sums up his feelings about stock selection:
If you thought of yourself as having a card with only twenty punches in a lifetime, and every financial decision used up one punch, you'd resist the temptation to dabble. You'd make more good decisions and you'd make more big decisions. ... You'd get very rich.
Buffett's point is not that investors should limit themselves to a predetermined number of trades. Rather, you should carefully study a company and make sure you fully understand it before you buy shares. With greater understanding comes greater confidence -- and greater returns as well.
At Motley Fool’s Champion Shares premium stock picking service, Chief Analyst Maynard Paton doesn't recommend shares based on short-term trends or stock market movements. Like Buffett, he studies superior businesses -- and then waist patiently for these businesses to fall to attractive price levels. To see which superior businesses Maynard believes are trading at significant discount to their intrinsic value right now, including one company mentioned in the above table, simply click here to begin your free 30-day trial of Champion Shares. As always, there is no obligation to subscribe.
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> Bruce Jackson does not have a beneficial interest in any of the companies mentioned in this article.
