Image source: The Motley Fool
When looking at the incredible stock market career of billionaire Warren Buffett, it is easy to imagine him as operating in a different league from the rest of us.
In fact, though, much of Buffett’s success has been built on a few fairly simple investment principles that can be applied even by a small private investor with limited funds.
Here are three of them that I am using.
Know what you’re buying into
Some people spend ages doing research for even fairly minor purchases. Yet they will put hundreds or even thousands of pounds into a company they barely understand.
That is not investing – it is speculating. To invest, someone ought to have a point of view on the value of what they are buying and how that compares to the price they pay.
As Warren Buffett puts it, it does not matter how wide (or narrow) your “circle of competence” is. The important thing is that you recognise it and stay within it.
Think about cash generation, not just profits
Profits are an accounting concept. They can be useful when assessing a business, but they are not the same as the cold hard money pouring in (or out) of the door. Those are known as free cash flows.
Warren Buffett carefully considers the long-term cash generation potential of a business when investing.
To illustrate, consider a share he has held for decades: Coca-Cola (NYSE: KO).
After spending so much on advertising for so long, Coca-Cola could cut back its marketing budget if it needed to and probably still make sizeable sales for years or even decades to come.
It also has pricing power, thanks to strong brands, unique product formulations, and a large distribution network. So it can increase the price of products without necessarily hurting customer demand too much. That can help boost free cash flows.
Coca-Cola also benefits from operating in a market with large, resilient demand. That is no coincidence: Warren Buffett likes companies with large target markets that look likely to stay that way.
Times change and so do tastes. Greater health consciousness poses a risk to sales at Coca-Cola (and indeed some other Buffett investments, from See’s Candies to Kraft Heinz). It recently announced plans to change the formulation for its flagship product in the US, potentially eating into profits.
In the round, though, I see Coca-Cola as an instructive example of the way Warren Buffett looks at the underlying cash generation potential of a business model when considering whether to invest.
Try never to overpay!
Even a good business model on its own may not be enough for him to invest, though.
As Warren Buffett puts it, he aims to invest in “great businesses at attractive prices”.
Note that he does not say “cheap”. No doubt he would lap that up, but Buffett’s approach is not to balk at what he sees as a fair price for a great business.
Sometimes it can even seem expensive at the time based on some valuation metrics. But, as Buffett says, price is what you pay and value is what you get. So while he may underpay, he seeks to never overpay.
