Warren Buffett is perhaps the world’s most successful general investor. And his compounded gain between 1964 and 2020 works out at 20% a year. He achieved that via his conglomerate of businesses and stocks, the US company Berkshire Hathaway.
At first glance, that figure might seem unimpressive. But it means the total gain over the period was about 2,810,526%. And if I’d invested £1,000 in Berkshire Hathaway in 1964, I’d now be sitting on a shareholding worth about £28m — and that is impressive!
But how did he do it? His business partner, Charlie Munger, distilled the essentials of their investment strategy into four easy rules.
Rule 1. Understand the business
Whether buying complete companies to bolt on to Berkshire Hathaway or stocks for the company to own, Buffett never strays beyond his “circle of competence”.
In other words, if he doesn’t fully understand how a business makes its money he avoids it and its shares. And he felt that way for a long time about technology businesses, for example. It’s only in recent years that he’s ventured into shares of Apple.
But by the time Buffett bought Apple stock, the business model had strong consumer-driven credentials and a rock-solid competitive advantage in its markets.
Rule 2. Durable competitive advantage
And Apple is a great example of a company with a strong brand followed by legions of loyal customers. Many Apple customers come back repeatedly for more of the firm’s products.
Such businesses are desirable because their pricing power helps them to preserve margins in the face of rising costs, such as when inflation bites. Indeed, Apple puts its selling prices up and nobody seems to care, they just keep on buying the products.
Most of Berkshire Hathaway’s businesses and stocks have similar advantages. Buffett describes such companies as having economic moats that are hard for competitors to cross.
Examples he’s holding include American Express and Coca-Cola. But in the UK stock market, I’d look at companies such as Diageo, Unilever, and National Grid among others.
Rule 3. Management integrity and talent
This one’s harder to pin down. But I’d monitor the news flowing from a company while it’s on my watch list to gain insight.
On top of that, well known UK investor John Lee (Lord Lee of Trafford) recommended, in his book, ensuring the directors have meaningful shareholdings in the company themselves. And also that they have clean reputations. He also advises that we look for a history of a stable board of directors with infrequent changes.
Rule 4. Ensure a margin of safety
Buffett’s use of a margin of safety is something he learnt from his early mentor Benjamin Graham — the father of value investing. It means aiming to buy stocks when they price a business below what we think it’s actually worth.
And that’s why Buffett often looks for stocks and businesses when others are selling because they are worried about something. So bear markets, setbacks, and corrections can produce rich pickings for investors following Buffett’s four golden rules.
Positive outcomes are never guaranteed even if I use Buffett’s and Munger’s four rules to pick stocks. But I think they are golden nuggets of wisdom. And I’m using them to pick UK stocks right now.
