Smarter plays for individual investors

Warren Buffett ranks as one of the greatest investors of all time. Over more than three decades, his Berkshire Hathaway Inc. has purchased dozens of stocks and businesses. During that time, the company has outperformed the Standard & Poor’s 500 Index by a wide margin. Buffett achieved his record by following a disciplined investment strategy. He waits years for stocks to sell at discounts. Buffett does not hesitate to hold cash if nothing meets his exacting standards.

Seeing his record, many investors seek to mimic Buffett’s style. When the master buys a stock, the imitators also make the purchase. While there is much to learn from Buffett, those who seek to copy him should beware. Buffett’s approach is difficult to implement, and even the master himself has made mistakes while using the strategy. Some trademark Buffett tactics that most investors should avoid…

Mistake: Holding a concentrated portfolio. Academics have long argued that investors should own a wide variety of stocks and other assets. That way, if some holdings fall, others may rise. Buffett understands the scholarly research, but prefers to hold “concentrated” positions, keeping big stakes in just a few industries. Altogether, Berkshire derived one-fourth of its revenue and half its profit from one industry — insurance.

Buffett’s success can be traced to his concentrated approach. But most investors should tread more carefully. In fact, Buffett says most investors should diversify extensively. Many part-time investors should stick with mutual funds. A sound approach is to buy an index fund, such as one that tracks the S&P 500. While funds may never outpace the best stock pickers, the index trackers never finish at the bottom of the standings.

Mistake: Buying nothing but cheap stocks. Stocks are often thought of as being from one of two categories — growth stocks, which have growing earnings and price multiples that are higher than average… and value stocks, which have little or no earnings growth and relatively low prices. Buffett does not fit neatly into any one camp. His portfolio includes some stocks that may be considered “growth” and others that fit into the value category.

Some investors may want to follow his example of holding growth and value. By owning both, you can diversify a portfolio because growth and value sometimes move in different directions. But for long-term investments, I prefer putting more than 50% of assets in value stocks. According to research by Eugene Fama, PhD, professor of finance at the University of Chicago, and Kenneth French, PhD, professor of finance at Dartmouth, value stocks tend to outperform growth over long periods. The best performance comes from stocks that are in the cheapest 10% of the market as indicated by their price-to-book ratios (p/b). This is the share price divided by the book value, a measure of a company’s assets minus its liabilities. Fama and French found that during the 27 years ending in 1990, the cheapest 10% of stocks returned 21% annually, compared with the most expensive 10%, which returned 8% annually.

Mistake: Investing only in big companies. Because his company is huge, Buffett finds it more convenient to buy big companies. Otherwise, to put Berkshire’s assets to use, he would need to own a great many small companies and it would be difficult to watch so many as closely as he would like. The result would be an unwieldy portfolio that would be too hard to manage. But ordinary investors should hold at least some small-company stocks. According to Fama and French, the smallest stocks in the market produce the biggest returns. During the 27-year study, the smallest 10% of stocks grew more than six times, while the largest 10% returned less than half as much.

Mistake: Favoring losers. As a value investor, Buffett often buys unloved stocks, picking up shares that have fallen. He shuns growth stocks that have been embraced by the markets. But investors seeking to build diverse portfolios should include at least some growth stars as short-term holdings.

When stocks have climbed for six months, they have tended on average to continue climbing for the next 12 months, according to a study by Narasimhan Jegadeesh, PhD, professor of finance at Emory University, and Sheridan Titman, PhD, professor of finance at the University of Texas.

Investors who take advantage of the short-term moves of growth stocks must be prepared to trade quickly. Studies indicate that after 12 months, the growth stars begin to lag.

Mistake: Holding for life. After buying a stock, Buffett holds it indefinitely. If the shares climb sharply, he still won’t sell. And if the company doesn’t show earnings growth, he still hesitates to sell. Buffett often refrains from selling because he believes that it is difficult to tell the right time for unloading a stock. Rather than making mistimed moves, he holds.

Because most investors, especially those near retirement age, can’t wait the decades that Buffett is prepared to wait, they can’t be so patient. Expensive shares with shaky earnings can deliver disastrous short-term results.

Before buying a stock, Buffett estimates its intrinsic or fair value. This requires projecting the company’s cash flow into the future and then “discounting” it to the present using an appropriate interest rate that takes the risk of the investment into consideration.

Measuring fair value precisely isn’t easy, but there are ways to estimate when a stock’s price has become too rich. Start by comparing the stock’s p/b to those of the company’s competitors. If the stock commands a relatively high multiple, then it could be priced above fair value. Additional check: Compare the stock’s current p/b to those from the past. When a stock’s p/b exceeds its typical historical level, it is another sign that the price may be too high.

Mistake: Sticking with what you know. Buffett prefers buying companies that are easy to understand. Until recently, he bought only US companies. He still has very little international diversification.

Unlike Buffett, most investors should use more international diversification. Their portfolios should include shares from the emerging markets of Asia and Latin America. Overseas markets don’t always move in lockstep with Wall Street.

For convenience, consider owning foreign shares by buying mutual funds or American Depositary Receipts (ADRs), foreign issues that trade on US exchanges.

Do Buy Utilities Like Buffett

Until recently, Buffett rarely bought utilities. Now he’s beginning to invest in power companies. You should, too. Utility companies should be a core holding in most investors’ portfolios.

Reasons: The best utility companies can generate steady cash flow. Companies with strong cash flows are able to pay their bills and invest in expanding their businesses. Many utility companies also provide solid dividends. These can provide investors with steady income, an important consideration during times when share prices are falling and portfolios are not producing capital gains.