Great investors: the Warren Buffet approach

Warren BuffettMillions of words have been written about Warren Buffett's approach to investing, including books by his former daughter-in-law Mary, old colleague David Clark and fund manager Robert Hagstrom.

Buffett himself has never written a book, but his annual shareholder letters to investors in his Berkshire Hathaway group are essential reading, providing many insights into his approach, even if they don't amount to a step-by-step guide to identifying a Buffett stock.
In addition, Buffett has commended The Essays of Warren Buffett by Larry Cunningham as "a coherent rearrangement of ideas from my annual report letters".

Buffett's roots
Many years ago, Buffett said: "I'm 15% Fisher and 85% Benjamin Graham." What did he mean by that?

In common with Graham, Buffett is a big believer in having a "margin of safety" -- buying shares when they're trading below their true value, typically when they're out of favour with Graham's fickle and impatient "Mr Market". Buffett believes the margin-of-safety principle, so strongly emphasised by Graham, to be "the cornerstone of investment success".

From Fisher, Buffett learned an appreciation of the importance of strong management in a company, and of what Fisher referred to as "management of unquestionable integrity".

Also like Fisher, Buffett advocates investing with a long-term horizon: "If you aren't willing to own a stock for 10 years, don't even think about owning it for 10 minutes."

Finally, Buffett is in accord with Fisher on portfolio concentration, going as far as to say:

"If you are a know-something investor, able to understand business economics and to find five to 10 sensibly priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk."

Moats and cash
The idea of investing in companies with "important long-term competitive advantages" is quintessential Buffett. Companies with a big "economic moat", such as those with strong consumer brands -- Coca-Cola is a Buffett stock par excellence -- have good pricing power and give shareholders a high return on equity.

Buffett avoids industries he doesn't understand -- that are outside his "circle of competence" -- sticking to businesses that are "relatively simple and stable in character", not least because: "If a business is complex or subject to constant change we're not smart enough to predict future cash flows."

Buffett is dismissive of common valuation yardsticks, such as price-to-earnings and price-to-book ratios, and dividend yield, "except to the extent they provide clues to the amount and timing of cash flows into and from the business". Cash is king for Buffett, especially a cash-flow measure he calls "owner earnings".

A Buffett screen
Buffett aficionados and apostles have come up with innumerable stock screens, using sophisticated combinations of financial statement numbers and valuation metrics, to try to capture the universe of stocks Buffett might consider investing in.

The futility of this is amply illustrated by the fact that Tesco (LSE: TSCO), which Buffett recently purchased didn't get flagged up by any of the screens I looked at!
For a manageable list of companies for this article, I took the industries represented among Buffett's top holdings (excluding financials) as a starting point. I then screened the FTSE 350 for companies in these industries using just two criteria: an average annual return on equity of 15% plus over five years and average annual earnings growth of 10% plus over ten years – the latter in the absence of an owner-earnings facility on the screener.

Company Market cap (£bn) Share price Return on equity (%) Earnings growth (%)
AG Barr 0.4 1,122p 21 14
BG Group 43.3 1,275p 20 18
BP 76.2 400p 17 17
Cranswick 0.4 826p 16 15
Reckitt Benckiser 25.0 3,443p 37 18
Smith & Nephew 5.4 595p 21 12
Tesco 25.4 316p 18 12
Unilever 58.4 2,069p 34 17

The FTSE 100 companies or their brands will certainly be very familiar to many of you -- which is how it should be with a classic Buffett stock -- and at least my simple screen has flagged up Tesco!

Of the two smaller companies, I don't know too much about free-range/organic sausage-maker Cranswick, having only once looked at the firm, briefly, a year ago; but I do have AG Barr, the maker of IRN Bru, penned as a Buffett business.

Foolish bottom line
Buffett's approach to investing has perhaps been most succinctly summed up by the Oracle himself:

"Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily understandable business whose earnings are virtually certain to be materially higher five, 10 and 20 years from now."

The master investor we'll be looking at tomorrow shares that view, having said "a share in a stock is not a lottery ticket, it's part ownership of a business", but he has his own distinctive approach to investing.

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