Warren Buffett’s ‘secret sauce’ for investment success

Warren Buffett, CEO of Berkshire Hathaway, attends the 2019 Annual Shareholder Meeting in Omaha, Nebraska, May 3, 2019.

Johannes EISELE | Getty

Berkshire Hathaway founder Warren Buffett – one of the most successful investors in the world – says he and Vice Chairman Charlie Munger are not “stock pickers; we’re corporate pickers.”

In the company’s annual shareholder letter released this weekend, Buffett explained that the “secret sauce” of their investment success is to “invest in companies with both long-standing favorable economic characteristics and reliable managers.”

This approach is known as value investing, where the goal is to stick with a best performing stock rather than trading stocks based on short-term price movements, also known as active investing.

Of course, choosing winners is not easy. But Munger previously outlined four rules that the two Berkshire Hathaway executives follow when choosing whether or not to invest in a company.

Aside from Buffett’s No. 1 rule, “don’t lose money,” here are four questions Munger and Buffett ask when deciding whether or not to invest in a company.

In addition to knowing how a company works and what it has to offer consumers, you also want to have an idea of ​​where a company will be in 10 years, if not decades, Buffett says. “If you’re not willing to own a stock for 10 years, don’t even think about owning it for 10 minutes,” he wrote in his 1996 letter to shareholders.

Berkshire Hathaway had missed the famed tech companies Google and Amazon in the early 2000s because Buffett wasn’t sure he understood the companies in terms of their long-term profitability. This made it more difficult to determine the value of their stocks.

While Berkshire may have passed Google and Amazon, other investments in blue-chip companies like American Express and Coca-Cola have paid off over time.

This prudent approach could mean we miss out on more speculative opportunities, but Buffett has said he and Munger are “missing a lot of things, and we’ll continue to do so.”

Buffett has said that the “most important” factor in choosing a successful business investment is the company’s competitive advantage, which he compares to a “moat” surrounding an “economic castle”.

The more certain the competitive advantage, the more likely the company will prosper for decades to come.

A competitive advantage can be a powerful brand that people are always willing to pay for, such as Coca-Cola, or it can be a unique business model, such as selling insurance directly to consumers rather than through insurance brokers, as is the case with Geico. .

Buffett has said he looks for three things in a manager or leader: intelligence, initiative, and integrity. But integrity is most important, “because when you get someone without integrity, you want them to be lazy and stupid,” he said in a 1998 speech.

“We don’t want to align ourselves with managers who don’t have admirable qualities, no matter how attractive their company’s prospects are,” Buffett wrote in a 1989 shareholder letter. bad person.”

With integrity comes trust. That means Buffett and Munger don’t have to spend a lot of time micromanaging every decision a leader makes.

“The most important thing we do with managers is generally find the .400 hitters and then not tell them how to swing,” Buffett said at Berkshire’s 1994 annual meeting.

As passive investors, Buffett and Munger seek out companies that appear to trade for less than their intrinsic value.

While there is no universal measure of value, companies with long-term earnings potential generally have consistent earnings, good cash flow, and low debt. When a stock price seems low compared to the company’s value, that’s a buying opportunity.

But that doesn’t mean that Buffett and Munger look for the best bargains based on stock price alone. Simply getting a fair price for a company’s stock can also be an effective strategy. You are investing in the company for the long term, not just the share price at the time of purchase.

“It is much better to buy a great company for a fair price than a fair company for a great price,” Buffett wrote in his 1989 annual shareholder letter. of first class management.”

Get CNBCs for free Warren Buffett guide to investingwhich summarizes the billionaire’s best advice for regular investors, the do’s and don’ts and three key investing principles in a clear and simple guide.

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