Have you ever made a loss on a share?
By a loss, I don’t mean volatility, or set-backs that cause a share price to go down, temporarily; I mean a permanent, irrecoverable loss of invested capital due to the underlying performance of the business represented by the share — have you ever made a loss like that?
Warren Buffett is different
Warren Buffett doesn’t make losses like that, though. He said in his 2002 letter to Berkshire Hathaway shareholders that he expects every commitment he makes in shares to work out well.
That’s a heck of a statement, but he backs it up with a record that proves that just about all of his share investments do work out well.
In that 2002 shareholder letter, he tells us how he makes every share investment a winner. So, if we want to strive to never again permanently lose money on shares, and increase the chances of making money on shares, we may follow what shapes up as a five-point selection procedure.
Do the work
Buffett’s selection procedure might be, to an extent, fail-safe, but be warned that it also involves a lot of work and some subjective judgement. So, it’s not a get-rich-quick plan or a how-to-make-money-from-shares-without-really-trying plan.
However, if we are serious about our stock market investing and committed to continuous ‘professional’ development as investors, Buffett’s five-point share selection procedure provides a stout framework and distils success in investing to its essence.
This is what we must do:
Scan hundreds of shares to look for those with:
1) Conservatively financed businesses.
Here we must examine the ratio of debt to equity and make a judgement about whether the balance is right to enable the business to thrive without carrying excessive downside risk due to over-gearing.
2) Strong competitive strength.
Some lines of business, or sectors, enjoy better characteristics than others. Some businesses within the same sector as another business carve out a profitable niche or position themselves with economic advantage over their rivals — we must find them.
3) Run by able and honest people.
We must do whatever we can to verify the integrity and past performance of the key executives and managers running the firm.
4) Make a price-to-value calculation.
Good businesses can make poor investments if we over-pay. Buffett never lost sight of his deep-value grounding in the hands of Benjamin Graham. A large part of Buffett’s investing success boils down to searching for miss-priced value.
However, Buffett adapted Graham’s teaching over the years. He no longer appears to look for cheap firms whatever the quality. These days, he looks for quality outfits selling at a fair price — a price that makes sense of an investment — because great businesses rarely, if ever, sell cheap. So should we.
5) Select the very few remaining that have attractive risk to reward ratios.
We need more upside potential than there is downside risk — a lot more. If things can go wrong, they probably will, so find businesses with very few things that seem likely to go wrong and with a clear path to growth.
Number 5 strikes me as the crux of the five-point selection procedure and the point perhaps requiring the most thought and subjective judgement.