QUALIPORT
Five Big Buffett Mistakes

By Maynard Paton (TMFMayn)
August 24, 2004

Warren Buffet has always been the subject of much investor discussion. And rightly so. A few months ago, the US investing legend revealed he'd generated a 22.2% annual average return over the past 39 years.

Such is his stock picking talent and down-to-earth approach, Buffett's attracted numerous disciples. However, as this portfolio has found out, emulating the old man's performance is far easier said than done. If, like the Qualiport, you're on the road to Buffett-style glory, here are the five big mistakes to avoid:

1. Believing you too are a genius: Joe Public doesn't make $30b-plus from the stock market. So face it: Buffett's got that special something -- a great head for figures, an unquenchable thirst for money, whatever -- that you almost certainly haven't.

A lot comes also from experience. Buffett's now 73 years old and has been dabbling in stocks since he was in short trousers. He's seen it all, done it all: you haven't. Furthermore, he can spend all day poring over annual reports and musing about his investments. Having a few spare hours at the weekend to ponder your portfolio isn't going to put you in his league. Buffett followers have to accept their personal limitations.

2. Believing most businesses are long-term holds: Buffett is famed for the long-term buy and hold mantra. However, not many businesses have the moat/barriers to entry/operational franchise to outperform over time. Sooner or later, competition comes into play. Going on this study, Buffett has found less than ten common stocks have been worth holding for a decade or more. Intriguingly, most of his share picks appear to have been held for less than five years.

3. Believing you also have billions to invest: Being seriously rich has one downside: to get your portfolio motoring, your watch list must focus on larger companies. Buffett's favourite shares, Coco-Cola (NYSE: KO) and so on, are all popular mega-caps that have an army of analysts covering their every move. Although great buying opportunities can crop up among big blue chips, far more occur in the stock market's lower reaches. Private investors could do better looking for medium-and small-sized quality companies. Buffett (reputedly) said recently that if he had 'just' $1m, he could make 50% a year.

4. Believing what's good for Buffett is good for you: Many Buffett devotees get too wrapped up in what the great man himself is doing. He buys a brick manufacturer, textile firm or retail group and all of a sudden, such businesses take on a whole new dimension with people trying to see where the attraction lies. But the simple fact is that while he owns somewhat 'unBuffett-like' businesses, it does not mean similar companies possess the same all-round qualities. The Qualiport found this out the hard way:

"Before we look closer at Independent Insurance, it should be remembered that the main business of Berkshire Hathaway (NYSE: BRK.A), chaired by Warren Buffett, is insurance. The skill that sets Buffett apart from almost every other investor is his ability to invest the float into great companies, whether they be quoted or not." Read more.

Indeed, the worst mistake to make is to believe insurers, a particular fancy of Buffett, make good long-term investments. As many investors now know, the financial sector is particularly prone to nasty accounting surprises, not least because of the numerous assumptions that go into determining the profitability of the industry's participants. Buffett though, being in charge of his insurance business and having a fair amount of financial expertise, has much more chance of assessing an insurer's (or any other financial company's) progress than you.

5. Believing in the Discounted Cash Flow (DCF): It's the great Buffett valuation debate: does he use DCFs or not? Here's the real truth: who cares? While the theoretical intrinsic value of a business is indeed the net present value of its future cash flows, calculating such a value is fraught with trouble.

For starters, rosy growth projections often prompt investors to overpay (the textbooks require you to estimate growth out to infinity!). And who can actually predict a company's profits say, ten years out, other than to comment: "they'll be a little/quite/a lot higher or lower"? In addition, small adjustments to discount rates and other inputs frequently lead to large variations in the final value, such that virtually any figure can be achieved.

For private investors looking at cash flows, far better to make a rough estimate of a company's free cash generation, expect minimal growth and only buy when you're getting a decent upfront return. In other words, look for obvious and immediate value.

More: Can You Copy Buffett? Two Fools Give Their View.

A version of this article was first published in March 2003.

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