Most investors would love to match Warren Buffett’s returns — gains of more than 20% a year, on average, since 1965 for shares of the billionaire’s company Berkshire Hathaway. Including reinvested dividends, that means each $1,000 invested in the stock in 1965 is worth nearly $4 million today.
I have spent the past two decades studying every investment move that Buffett has made. In the MBA classes that I teach at Georgetown University, my students dissect his trades and deconstruct why they work. I find that Buffett’s simple, homespun investment advice actually is much more appropriate for small investors than for professionals because it requires the ability to take a long-term perspective and the courage to go against the herd — attributes that most money managers lack.
Buffett’s favorite investment strategies — and how to apply them to your own portfolio today…
Buffett rule: Stay within your circle of competence. Buffett invests in companies only when he can confidently project how their businesses will fare for at least the next decade or two. He made his fortune with high-quality companies that provide easy-to-understand products and/or services, such as insurance, transportation, paint and carpeting.
How to use this advice: Invest 10% to 20% of the stock portion in a few stocks in a particular industry or subsector that you enjoy following and that you can get to know inside out. Put the other 80% to 90% in a diversified index fund, such as one that tracks the Standard & Poor’s 500 stock index. Over time, you can add more stocks and reduce your holdings in the index fund.
Buffett rule: Keep at least 20% of your money in cash. Buffett has a war chest of money ready to snap up stock opportunities, and he waits for an opportune moment to deploy it.
How to use this advice: It’s challenging for small investors to hold that much cash when interest rates on bank accounts and money-market funds are low. However, buying stocks at bargain prices can be so lucrative that it makes sense to always hold some cash so that you can take advantage of these opportunities.
Note that Buffett lets his cash percentage grow anytime he cannot find investments that will earn returns sufficiently above the risk-free interest rates offered by US Treasury bills. Risk-free rates are so low now — 3.7% for 10-year Treasuries — that you should be putting much, but not all, of your cash to work.
Example: Long-term investors can buy a conservative exchange-traded fund (ETF), such as SPDR S&P Dividend (SDY), which tracks companies that have increased their dividends annually for at least the past 25 years. You’ll earn a yield of around 3.4% even if the price of the ETF’s shares remains flat for some time.
Buffett rule: Be fearful when others are greedy… and greedy when others are fearful. Some of Buffett’s most brilliant results come from his ability to remain rational in the face of market excesses. He famously avoided tech stocks in 1999, just before the Nasdaq Composite Index lost 78% of its value. He started scooping up blue-chip stocks at the end of 2008, when the US was just coming out of the worst recession since 1929.
How to use this advice: I expect the coming decade to be as volatile as the last one, but you can rely on simple mechanical measurements, such as price-to-earnings ratios (P/Es), to help you make rational, unemotional decisions in the face of mass optimism or pessimism. The P/E is the price of the stock divided by its earnings per share, a number that provides a snapshot of how the market expects the company to perform in the future.
Watching P/Es won’t ensure that you will spot the bottom of a bear market or the top of a bull market, but they can save you from making big mistakes that take years for your portfolio to recover from.
When picking a specific stock, first check whether you are getting it at a bargain price by making sure that its current P/E is below its 10-year average. Second, decide whether the company is a good candidate to grow for many years by confirming that its earnings have grown faster than those of its industry and the broad market over the past 10 years.
Example: During the 10 years prior to Buffett’s purchase of Coca-Cola shares, the company’s earnings per share grew at an average rate of 11.1% a year, compared with an average of 7.1% for the S&P 500 over the same period.
Helpful: You can find historical P/Es and growth-rate information on company Web sites.
Buffett rule: Look for outstanding, shareholder-friendly management. Buffett puts an enormous emphasis on meeting and evaluating CEOs before he buys stocks in their companies.
How to use this advice: Most of us can’t sit down for lunch with CEOs, but we still can vet them carefully…
A CEO should have a history of earnings predictability, increasing earnings for at least seven of the last 10 years.
Be suspicious if a CEO offers excuses or avoids responsibility for the company’s weak performance or pretends that there are only positives. Read the CEO’s annual letters, and listen in on teleconferences held by executives to discuss quarterly earnings. (Check the company’s Web site for dates and phone numbers.) You can read transcripts of many of these teleconferences at www.Morningstar.com/earnings.
Examine a CEO’s compensation package. The CEO should own stock in the company worth several times his/her base salary… and his compensation should be based on company results so that he receives less in years in which the company underperforms.
