Abide by Buffett's Investing Principles

Physician's Money Digest, April15 2005, Volume 12, Issue 7

Both the S&P 500 and the original WarrenBuffett Partnership were started in 1957. Ifyou had invested $1000 in the S&P 500 fromday one and reinvested all dividends and capitalgains distributions, at the end of 2003 your portfoliowould have grown to $130,768, with an annualizedreturn of 11.2%. Over the same period, a $1000 investmentin Buffett's original partnership, with the moneyrolled over into Berkshire Hathaway stocks in the late1960s (when Buffett closed the partnership and did thesame), would have grown to $51,356,784, with anannualized return of 26.6%.

Most of the academic world wants to explainBuffett's spectacular performance as luck, an anomaly,or something else. The rest of us can call it talent orgenius and benefit from adhering to his basic principlesof investing, which include the following:

•A stock is a piece of a company. Although in theorywe all know that a stock represents fractional ownershipin a company, most of us look at it as a piece ofpaper with a name, to be traded back and forth. InBuffett's view, you should buy a stock as carefully asyou would enter into a partnership. If you have notstudied the annual reports and financials of the companyfor at least the past 5 years, do not understand itsstrategy, and do not know enough about it to be able toforecast its earnings for the long term, you should notbuy the company's stock.

•Construct a focused portfolio. Buffett says thatover a lifetime you will come across only a few exceptionalinvestment ideas and opportunities. You shouldinvest only in those and invest a meaningful portion ofyour portfolio in each. Others will tell you to diversifywidely and avoid putting all your eggs in one basket.Buffett's advice is to construct a concentratedportfolio of carefully chosen stocks and sell only ifyou realize you made a big mistake or somethingchanges drastically. As Buffett says, his favorite holdingperiod is forever.

•Invest only in what you understand. Buffett statesthat if you do not understand a company and its industrywell enough to be able to forecast with a high degreeof confidence what the company's earnings will be 5,10, or 20 years from now, you have no way of tellinghow much you should pay for it. He points out that thefuture of many companies in rapidly changing industriessuch as technology is inherently unpredictable, andinvestors will be better off staying away from them nomatter how glamorous they appear. Academic studieshave also shown that these companies and industriesmostly turn out to be poor investments, in part becausepeople overpay for these stocks.

•Demand a margin of safety. No matter how carefullywe analyze any investment, things will never turnout exactly the way we expect. Buffett says that wemust invest with a margin of safety and try to buystocks at a discount. According to Buffett, "margin ofsafety"are the three most important words in investing.He claims that this is one of the most importantthings he learned from his teacher, Benjamin Graham.

Unfortunately, for most of us, it is essentiallyimpossible to judge how much of a margin of safetywe have in an investment, because it requires estimatingfirst the intrinsic value of an investment. Onlywhen you are reasonably confident that something isworth $10 can you tell that $5 is a great price for itand you have a 50% margin of safety.

In the end, Buffett's greatest talent is probably hisability to estimate the intrinsic value of an investment.Many value investors follow the same basic principlesas Buffett does, but clearly no one does it as well.

author of The Only Proven

Road to Investment Success (John Wiley; 2001)

and Financial Modeling Using Excel and VBA

(John Wiley; 2004), currently teaches finance at

the Fordham University Graduate School of

Business and consults with individuals on financial

planning and investment management. He welcomes

questions or comments at chandansen@aol.com.

Chandan Sengupta,