Warren Buffett Investing Rules – Part 1
Recently, I presented my 34th annual financial program. This year’s topic was “How Warren Buffett Did It.” As part of my handout, I had a section with rules that Warren Buffett follows (or has, but does not follow) that might be interesting for others to know. Here they are.
Fundamental analysis
This is investing based on the underlying strength of the company and not on the way the stock trades or is expected to trade (which is called technical analysis). Buffett uses fundamental analysis and doesn’t “bet” on the way the stock will trade
Access to information
When Warren Buffett wants to review a Company, he has access to all of the public information everyone else has. What he does differently is that he has a team of people that know where to look, what to look for, how to access it, how to use it and how to integrate the myriad data to form a clear opinion. Most people simply cannot do this
Value investing
Value stock investors try to spot more mature companies paying reasonably good dividends that also appear underpriced. Buffett is a value investor. Growth investors look for underpriced companies whose stock price is expected to grow to provide them with gains while dividends are not as big of a concern. Value investors look at traditional valuation measures such as price/earnings ratios and dividend yields. They also look for stocks they expect to grow once the market either “corrects” or realizes their “mistake” of the lower stock prices. Meanwhile, they enjoy good dividends. They are not expecting dramatic growth, although, that sometimes occurs
Payout ratios
This refers to the percentage of profits that a company pays in dividends. The ratio is derived by dividing the dividend by the profits. A stock that pays an $80.00 per share dividend and earns $100.00 per share has an 80% payout ratio. A stock that pays a $20.00 dividend and earns $100.00 has a 20% payout ratio. The lower the payout ratio is, the greater the possibility for increases in the dividend. Additionally, the greater the availability of funds to be used by the Company to expand operations, introduce innovations, enter new markets, or have excess cash to buy back shares that are trading below their intrinsic value. Buffett likes the lower payout ratio companies
Corporate tax rates
Corporations such as Berkshire Hathaway (“BRK”) only pay tax on 30% of the dividends they receive. At a top corporation tax rate of 35% this means BRK pays a 10.5% tax on its dividends. Some of BRK’s investments are in “convertible” preferred stock issues (rather than bonds) and are not usually available to other investors. What Buffett does is provide funds and then receives the preferred stock paying an above-market rate that he can convert into common shares at the stock price on the day he makes his investment. If the stock goes down, he keeps getting the high dividend. If stock goes up, he keeps getting the dividend until he decides to convert to common shares, or he has to convert because of a predetermined conversion time limit (or due date) when the preferred stock was issued to him. Bonds pay interest that is fully taxed to the recipient
Ability to Act
One of the great advantages Buffett has is his ability to make quick decisions and provide ready cash. BRK is set up that way with a small group of trusted advisors in his Company
Risk
A basic belief of investing is diversification which is a method of spreading and offsetting risk. This means that you do not have a high percentage of your total assets in only a few issues, or in one type of investment. Even though Buffett has a large portfolio, in four of the stocks, BRK own accounts for 60% of his public stock investments. This does not indicate adequate diversification for a typical investor. I am not criticizing him – I am just calling this to your attention
Understanding what the Company does
Buffett only invests in companies where he understands what the Company does to make money. I read a story where Buffett was asked if he wanted to take over, and save, Bear Stearns, he said he started looking at their financial statement and every time he came upon something he didn’t understand, he made a note on the cover. At one point he noticed his very many notes and decided it was too confusing and passed on it
Warran Buffett Risk
I give a basic financial planning speech where I’ve identified over 20 risk factors investors should consider. One of them I call the “Warren Buffett Risk.” This is a situation where Buffett decides to “buy” a company and makes an offer. He is not known to bid once his offer is made. Many people are disinclined to bid against him for fear of offending him. This can mean that the public shareholders could receive less than what they could have received if there was a “bidding war.” Buffett’s argument is that he did the work, identified the value and is making the best offer for the Company
To be continued in my next blog.
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