How to Invest like Warren Buffett

I often write about Benjamin Graham, because he is considered the father of value investing. His clear teachings of how to analyze stocks and bonds using formulas and restrictive conditions make sense to me and are easy to follow. His book, The Intelligent Investor, first published in 1949, provides all of the information needed to become a successful value investor.

Benjamin Graham taught investment courses at Columbia University in addition to running his Graham-Newman Partnership, investment advisors, for many years. Many of his students at Columbia became successful investors, including Warren Buffett.

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Warren Edward Buffett, born in 1930 in Omaha, Nebraska, is the “Oracle of Omaha.” Warren Buffett grew up in Omaha and Washington, D.C. before attaining his bachelors and masters degrees from the University of Nebraska and Columbia University. Mr. Buffett became interested in investing at an early age and attended Columbia because Benjamin Graham and David Dodd, another well-known securities analyst, taught there.

Buffett then went to work for Buffett-Falk, his father’s brokerage company, before joining Graham-Newman for three years. Mr. Buffett then ventured out on his own and formed several investment partnerships, which purchased a company called Berkshire Hathaway, a textile manufacturing firm. In 1962, Buffett liquidated his partnerships to focus on Berkshire, and the rest is history.

Warren Buffett made one successful investment after another using Berkshire Hathaway as his conduit. He had learned well from Benjamin Graham. Buffett became adamant that his stocks provide a wide margin of safety. The intrinsic value of a company must out-weigh the company’s stock price.

Want to invest like Warren Buffett? Here are seven guidelines to get you started in the right direction. You can find additional information on Warren Buffett here.

  1. Buy Companies at Bargain Prices. Warren Buffett is a true value investor. Buying companies cheap is what being a value investor is all about. Purchase stocks below their intrinsic value and fill your portfolio with these companies. Pay less attention to earnings per share. Look for solid return on equity, high operating margins and low debt. In addition, look for companies that generate lots of cash and have a consistent operating history during the past 10 years.
  2. Be Patient. Wait for the right time to buy. Patient investors are the best prepared when opportunities emerge. Because of market turbulence, stocks of great companies become available to trade at very cheap valuations. This doesn’t mean buy stocks and forget about them! Tracking performance is key and so is getting out when necessary (when your stock is overvalued or trouble is on the horizon). Invest only in companies that will outperform for decades. Follow this approach and you will gradually develop an outstanding stock portfolio like Warren Buffett.
  3. Go Against Conventional Wisdom. Attempt to be fearful when others are greedy and to be greedy only when others are fearful. Going against the crowd can be an effective way to make money.
  4. Stick with What You Know. Stay within your circle of confidence. If you don’t understand what a company does or how it makes money, avoid it.
  5. Be Self-Confident. You must be able to act without affirmation from others (or the market) on your investment decisions.
  6. Buy Companies with Competitive Advantages. Warren Buffett calls this an “economic moat,” which gives a company barriers or protection from its competition. Examples of competitive advantages include high capital costs for rival companies to enter a business, a strong brand identity or patent protection.
  7. Believe in America. Warren Buffett has faith in the long-term prosperity of U.S. companies. This allows him to make investment decisions that are not based on where we are in economic cycles.

Berkshire Hathaway’s largest holdings include a who’s who of American business. Listed below are its major holdings from largest to smallest:

  • Kraft Heinz (KHC)
  • Wells Fargo (WFC)
  • Coca-Cola (KO)
  • International Business Machines (IBM)
  • American Express Co. (AXP)
  • Phillips 66(PSX)
  • US Bancorp (USB)
  • Charter Communications (CHTR)
  • Goldman Sachs Group (GS)
  • Moody’s Corp. (MCO)

Berkshire has many more holdings, of course. The ten companies listed above each have market values of over $2 billion. In addition to the many public companies contained in the portfolio, Berkshire owns 100% of many other companies including: Benjamin Moore, Burlington Northern Santa Fe, Clayton Homes, Fruit of the Loom, Geico Auto Insurance, International Dairy Queen, Johns Manville, Jordan’s Furniture, Pampered Chef, See’s Candies and XTRA Corp.

Twice a year, I combine Warren Buffett’s and Benjamin Graham’s criteria for choosing stocks for a special feature in Cabot Benjamin Graham Value Investor, the publication I edit. To find investment opportunities for you, I looked for stocks with:

1)    Free cash flow of more than $20 million – cash needs include dividends, operating expenses, capital improvements and research.
2)    Net profit margin more than 15% – a good indicator of growth sustainability.
3)    Return on equity more than 15% – a barometer of future appreciation.
4)    Discounted cash flow value higher than current price – Standard & Poor’s is a good source to find discounted cash flow estimates.
5)    Market capitalization more than $1 billion – small companies not allowed.
6)    Standard & Poor’s rating of B+ or better – indicates financial stability and steady growth of earnings and dividends.
7)    Positive earnings growth during the past five years with no deficits – very important to adhere to.
8)    Dividends currently paid – always important and helps your return, too.

I screened our Benjamin Graham Common Stock Database and found two high-quality companies that fit our criteria. Both companies are giants in the Information Technology sector, and both are producing impressive growth numbers.

Microsoft (MSFT) is the leading maker of software, primarily because of its dominance in desktop computer operating systems and office productivity products. The company’s Windows operating systems run more than 90% of all personal computers throughout the world. Microsoft’s server software products are used in 70% of all computer server systems.

Microsoft has two relatively new product lines. Cloud computing, which provides computing and storage on the Internet, is gaining in popularity, and the company has become one of the leaders. Video games have also become big business, and Microsoft has become a leader with its Xbox video game system and accessories. The company recently introduced Kinect to compete with the popular Wii and PlayStation Move games. Kinect is based on a webcam for the Xbox console and enables users to control and interact with the Xbox 360 without the need to touch a game controller. The player uses gestures and spoken commands to control a variety of games.

The software giant continues to spend heavily on research and development to maintain its front-running positions in the technology sector. Sales increased 25% and EPS soared 55% during the quarter ended 9/30/10—quite remarkable for a company with $65 billion in annual sales. Analysts are forecasting a sales gain of 9% for the next 12-month period and an increase of 11% for earnings per share. I believe Microsoft will produce substantially better growth during the next 12 months, which will drive its stock price considerably higher. MSFT shares are clearly undervalued at 10.2 times analysts’ forward 12-month earnings per share estimates. MSFT pays a decent dividend yielding 2.4% (which is about 10 times the amount paid by my bank on my savings account).

Oracle (ORCL) is another leading software manufacturer with a worldwide reach. The company provides totally different products and services than Microsoft, though. Oracle is the largest developer, manufacturer and seller of information management software and services. The company’s database software and product support services provide a large revenue stream enabling Oracle opportunities to expand. Also, during the past several years, Oracle has purchased an impressive number of large software providers, which will help achieve management’s goal to offer a complete line of business software solutions to customers.

Management’s acquisition strategy with the objective of positioning the company for strong growth is generating extraordinary results despite the weak U.S. economy. Oracle’s January 2010 purchase of Sun Microsystems is producing cost savings and new sales opportunities. Sales increased 48% (partly due to the Sun acquisition), and earnings jumped 40% during the three months ended 8/31/10. I expect sales and earnings to rise 20% or more during the next 12 months driven by new acquisitions and by expansion into faster growing foreign markets.

ORCL has begun paying a small dividend, which currently yields 0.7%. The company’s shares sell at 13.8 times forward 12-month earnings per share, which is very reasonable for a company growing at a 20% pace.

I will continue to follow Microsoft and Oracle and other blue-chip, high-quality companies in my Cabot Benjamin Graham Value Letter. My next issue, coming soon, will focus on undervalued stocks with low price to earnings growth (PEG) ratios. I hope you won’t miss it!

Timothy Lutts

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