Buffett manages to make money while minimising risk. It's a lesson to us all.
If you read one book about Warren Buffett's investing style I'd recommend that it be the first edition of Robert G Hagstrom's "The Warren Buffett Way", as it explains in some detail how Warren Buffett likes to have a 'margin of safety' with his investments.
Margin of safety
This concept was first developed by Benjamin Graham, who was keen to purchase shares that were trading well below their intrinsic value.
Achieve this and you can ignore the unstable gyrations of the market, secure in the knowledge that a good business will be recognised in the long term. As a practitioner of much of Graham's wisdom, Warrant Buffett once said: "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
Of course, if I could apply this knowledge as well as I can quote Buffett, I probably wouldn't be writing this from a terrace in North London, but be sunning myself in the Caribbean. Still, we can all improve our investing techniques by attempting to learn from the best.
Nothing in real life is totally precise and certainly company valuations are subject to error. However, if you also build in a margin of safety, and therefore buy good businesses at bargain prices, you should eventually make a lot of money.
Valuation
When we think of buying companies cheaply, most of us tend to think of AIM stocks that are priced in pennies, salivating at the prospects of a ten bagger. Frequently, these companies are making big losses. Yet, we kid ourselves that they're going to make huge profits in the future without properly researching the prospects for them actually doing so.
That is fine, sometimes it does come off -- but it is an extremely risky approach.
Alternatively, Buffett buys excellent businesses that are well managed, with sustainable competitive positions. Looking at the price in pence of a share is not the starting point but the end point, after having determined what the company's intrinsic value is.
For example, in the late 1980s Buffett bought $1 billion worth of Coca Cola shares at an average cost of around $11, when many "value" investors considered it overvalued because its price was 15 times earnings and 12 times cash flow. Yet, by consistently growing revenues and profits, the share price reached $45 in 1992.
Determinants of intrinsic value
So how can we determine the intrinsic value of a business? Well, the first thing to realize is that price has nothing to do with value.
Value is the discounted present value of an investment's future cash flows (Buffett has traditionally used the 30-year US Treasury Bond rate to discount expected cash flows).
To determine the cash flows of a business Buffett uses the concept of 'owner earnings', as this takes account of whether a company needs large, regular amounts of capital expenditure to maintain its position.
Owner Earnings is defined as 'Net Income' plus 'Depreciation' plus 'Amortisation' less 'Capital Expenditure'. (It is essentially the same as free cash flow although Buffett averages out capital expenditure over several years).
It is important not to be overly optimistic when calculating any future earnings as you'll needlessly inflate the value of the business.
What Buffett did by investing in Coca Cola was invest in a business that was well managed, had a competitive edge, and delivered above average returns on the capital invested. To paraphrase Jim Slater, 'elephants might not gallop but they can move pretty fast if managed properly'.
Diversification
Another aspect of Buffett's safety first approach is that because he takes extraordinary care in selecting his shares, it is less necessary for him to diversify.
Quite often we choose a wide selection of shares because we have too little faith in our own ability to select winning shares. This then leads to a state of nervous tension as we watch the hourly, daily or even weekly gyrations of the stock market.
However, Buffett, in contrast, tends to ignore the gyrations of the manic depressive that is the stock market, secure in the knowledge that he's bought shares at a good price.
In the past, I've bought shares almost on a whim, without even analysing the figures and running a few ratios. And I'm sure I'm not alone in that. After all, with limited time at your disposal, diversification often leads to inaccurate assessment of the risks of buying a share.
Let caution be your watchword when investing for the future of yourself and family: adopt Buffett's safety-first approach.
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