Why Buffett’s Investing Formula Remains the Key to Success on the ASX

Warren Buffett would be the first to admit that he hasn’t had a great year, at least by his standards. Not since 2008 has his company, Berkshire Hathaway [NYSE:BRKA], seen its share price drop as much as it has. According to CNN Money:

Shares of Berkshire’s A and B shares are each down about 13% so far in 2015. The A shares (BRKA) are for the 1% – they cost just under 195,000 apiece. The B shares (BRKB) trade for about $130.

The last time the Oracle of Omaha’s company did so poorly was in 2008, when both classes of Berkshire’s stock fell 32%.

Of course, 2008 was a lousy year for just about everyone. Remember that whole financial crisis/Great Recession thingy?

But as bad as 2008 was for Berkshire, Buffett still wound up outperforming the broader market that year. The S&P 500 plunged 38.5%.

This year, Buffett is lagging the market. The S&P 500 is down…but only by 2%.

In fairness, no one’s had a great year trading on stockmarkets in 2015. So he’s far from alone on that one.

Either way, Buffett isn’t a day trader. His mind is set firmly on the big picture. As a long term investor, Buffett’s success comes from capitalising on long term growth. Berkshire Hathaway, while down on the year, remains a major success story.

In the past decade, Berkshire’s B shares are up 123%. That’s double the S&P500’s gains of 58% during the same period.

Keep in mind, Berkshire offers two different options for investors: A and B class shares. Only the richest of the rich buy into A shares, worth almost US$200,000 apiece. The B shares, by comparison, trade for US$130 a share, and are aimed at retail investors.

Since they started trading in 1996, B shares have outperformed the S&P500 by 340%. And they’ve never undergone two consecutive years of declines.

You’d also have to go back to the early 1970s before the A shares fell two years in a row. So there’s a good chance that 2015 proves to be a temporary blip for Berkshire and Buffett.

After all, you don’t build a track record, or a following, like Buffett has without knowing a thing or two about stocks. He has an incredible level of consistency with his investments. He’s averaged compounds return of 20% for over 45 years now. And he’s done it by sticking to a no frills philosophy.

Buffett’s secrets for success aren’t really secrets at all. His entire philosophy is based on a few basic principles. And they’re effective for the very reason that they’re both simple and easy to understand.

It’s safe to say that Buffett still has a thing or two to teach us all about investing. The rules Buffett has used successfully for half a century should form the foundation of any investment strategy. When something works, it works for a reason.

Yet as risky as stocks are, applying common sense to investing is something most traders don’t do.

An example of this is the effort investors put into finding high quality stocks. Many investors have a lot of trouble with this. But what defines a high quality stock anyway? And who’s to say there’s a one size fits all rule for determining quality?

Many people remain in the trap that stockmarkets are all about quick returns. If you’re not making risky bets, you won’t make any money, right? Isn’t that what all the high flyers are doing?

Not Buffett. He’s as safe as houses. And it’s why his unique philosophy has been so successful for him. It’s also why he’s built up such a large following.

The cult of Buffett runs high here at Markets and Money. Our chief editor, Greg Canavan, an authority on stockmarkets himself, is a big fan of Buffett. He’s spent his entire career helping Aussie investors find undervalued stocks.

Greg says there are three core rules that underpin Buffet’s approach to investing. So let’s look at each of them more closely.

Buffett’s first rule; buy stocks as you would your groceries — not your perfume

The simplicity of Buffett’s approach is perfectly illustrated in the first rule. ‘Select the winning stocks the way you would buy groceries’.

What he means by this is that you should always seek to find value in your stock picks. Much in the same way that you would when doing your grocery shopping. Many investors do the opposite, assuming it’s only worth investing in more expensive stocks. But price often doesn’t indicate quality or value.

That’s why Buffett suggests to forget about the so called ‘perfume’ stocks. After all, there’s no way of knowing whether you’re getting value out of a $300 bottle of perfume, is there? Not when the $150 bottle smells exactly like it. So how can you decide which is better quality?

If you purchased that $300 perfume, all you’re really doing is engaging in speculative behaviour. Buffet warns investors against this. Speculative investing is nothing but a form of gambling.

People buy into the idea that price indicates quality because we use our experiences in other areas of our life. While that may be true with some (not all) consumer products, it rarely applies to stocks.

Instead, you should look to the underlying value of a company to assess its true worth.

So what kind of companies fit this bill? These are companies that Buffett says have an ‘intrinsic value’. What he means by this is that they offer something of value to customers even when shares appear to be trading lower.

The oil industry is a topical example.

Low oil prices in the past 12 months have affected Big Oil share prices across the board. But the core product oil companies offer to consumers remains highly valuable. Even if prices have slumped, demand for oil hasn’t. That’s important to remember, because oil hasn’t lost its intrinsic value.

In the case of oil markets, it’s about understanding that politics — rather than supply and demand economics — is the major factor affecting the price. It’s not hard to see oil prices rebounding in the future when OPEC resets its breakeven targets. When prices recover, shares will appreciate to reflect that.

So the key takeaway is to buy stocks as you would your groceries. If you’re like most shoppers, you look for value when you’re doing your family shopping. Through your everyday experience in carrying out this task, you develop an internal knowhow. You know what constitutes value. You know when something off the shelf is overpriced. You know which shop has the best value for money fruit and veg. You just know…

In the same way that you know your go-to brands and items, you should also know and trust the companies that you’re investing in. This is kind of advice that makes sense, but is often overlooked by investors.

It’s human nature to believe that the most expensive stocks are also the most valuable. Remember, though, you’re looking for real, not perceived, value.

Buffet’s second rule; never trust analysts

One of the problems with stockmarkets is the extent to which analysts influence investor behaviour.

If ‘experts’ predict a company will post strong earnings, investors line up to buy shares in that company. The same is true when analysts slap a sell rating on a stock. Yet all of these analysts’ predictions are just that — predictions.

They can’t tell you whether or not that company will actually post profits or losses. At best, they’re making an informed guess.

There have been some notorious expert opinions that have backfired spectacularly.

The 1999 Glassman-Hassett is one example of this. It was a market prediction that came during the height of the dotcom bubble. This was the period during the late 1990s when tech company stocks were booming.

Two analysts claimed the market was entering an age of ever expanding stock valuations.

A few months later, the dotcom bubble popped. And many investors were left badly burnt. Experts buy credibility when they get things right. But they lose all of it when make a hash of it, as they did back in 1999.

Unfortunately, investors fall back into their old patterns. They seek guidance from people that really don’t have any more of a clue than they do.

In truth, there are thousands of little things which affect share price movements in unique ways. That’s what makes stocks so risky and unpredictable.

That’s why Buffet urges investors to remain sceptical of the noise in the market. Always question analyst forecasts. Don’t take the word of company CEOs. Trust your own instinct when seeking for undervalued stocks.

Buffet’s third rule; don’t worry about what anyone else thinks.

As Buffett himself admits, it’s not enough to just be sceptical because you still have to pick stocks to invest in. In other words, you have to think independently about how you invest your savings.

Nobody ever made money investing in the same stocks as everyone else. It’s hard spotting real value in a crowded market. So you need to become comfortable thinking for yourself. You need real conviction in choosing the companies you invest in. Your decisions should be based on evidence that supports the value of any given company.

Buffett urges investors not to react to market sentiment. If a company has low debt, looks profitable but, according to you, is trading below its value…buy it. Ignore what other ‘experts’ and the market is saying. Instead, think for yourself and follow the simple rules that are proven to work.

These are just three of the rules Buffett applies himself for all his investments. There’s a further five rules that Buffett swears by. They’re all detailed in a free report, ‘Eight Simple Steps to Invest Like Warren Buffett’.

In the report, Markets and Money‘s Greg Canavan details how you can use Buffett’s eight rules to pick successful, high quality stocks. Using Greg’s knowledge of equity markets, this easy-to-implement investment strategy can help you identify the best value stocks on the ASX — under any market conditions.

Is now a good time to buy stocks?

Investors are rightly fearful of what the future holds for markets. It’s been a topsy-turvy year, with the ASX down almost 5%.

But as with any stock market correction (or crash), it’s never the entire system that blows up. The trick is to make sure that you’re investing in the companies that will survive — and thrive — during a crash.

Stocks don’t need to be a risky investment. Warren Buffett knows this. In fact, he says they can be as safe as any other asset, even cash:

Today people who hold cash equivalents feel comfortable. They shouldn’t. They’ve opted for a terrible long term asset, one that pays virtually nothing and is certain to depreciate in value’.

However you feel about assets like cash, Buffett makes an indirect point about stocks. Even in the midst of a crisis, stocks remain a viable wealth building tool. But it pays to know what you’re doing if you want to succeed. And it’s why Buffett’s rules of investing have proved so successful.

Mat Spasic,

Junior Analyst, Markets and Money

Markets and Money offers an independent and critical perspective on the Australian and global investment markets. Slightly offbeat and far from institutional, Markets and Money delivers you straight-forward, humorous, and useful investment insights from a world wide network of analysts, contrarians, and successful investors.

Leave a Reply

Your email address will not be published. Required fields are marked *

Markets & Money