Warren Buffett’s “Secret Sauce” for Successful Investing

Warren Buffett, CEO of Berkshire Hathaway, attends the 2019 annual shareholder meeting in Omaha, Nebraska on May 3, 2019.

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Berkshire Hathaway founder Warren Buffett – one of the world’s most successful investors – says he and Vice Chairman Charlie Munger are “not stock pickers; we are company pickers”.

In the company’s annual letter to shareholders released over the weekend, Buffett explained that the “secret sauce” to their investment success is making “investments in companies with both economic supportive and trustworthy managers”.

This approach is known as value investing, where the objective is to hold on to a best performing stock rather than trading stocks based on short-term price fluctuations, otherwise known as active investing.

Of course, picking winners isn’t easy. But Munger previously outlined four rules the two Berkshire Hathaway executives follow when choosing whether or not to invest in a company.

Besides Buffett’s #1 rule, “don’t lose money,” here are four questions Munger and Buffett ask when deciding whether or not to invest in a company.

In addition to knowing how a business operates and what it offers consumers, you also want to have an idea of ​​where it will be in 10 years or even decades from now, says Buffett. “If you’re not ready to own a stock for 10 years, don’t even think about owning it for 10 minutes,” he wrote in his 1996 letter to shareholders.

Berkshire Hathaway is famous for missing out on tech companies Google and Amazon in the early 2000s because Buffett wasn’t sure he understood the companies in terms of long-term profitability. It was therefore more difficult to determine the value of their shares.

While Berkshire may have passed on Google and Amazon, other investments in blue chip companies like American Express and Coca-Cola have paid off over time.

This cautious approach could mean missing out on more speculative opportunities, but Buffett said he and Munger are “missing a lot, and we will continue to do so.”

Buffett said the “most important” factor in choosing a successful business investment is a company’s competitive advantage, which he likens to a “gap” surrounding an “economic castle.”

The more secure the competitive advantage, the more likely the business is to thrive for decades.

A competitive advantage could be a powerful brand that people are always willing to pay for, like Coca-Cola, or it could be a unique business model, like selling insurance directly to the consumer rather than through the intermediary of insurance brokers, as is the case with Geico. .

Buffett said he looks for three things in a manager or leader: intelligence, initiative and integrity. But integrity matters most, “because if you want to have someone without integrity, you want them to be lazy and stupid,” he said in a 1998 speech.

“We do not wish to associate ourselves with managers who lack admirable qualities, no matter how attractive the prospects for their company,” Buffett wrote in a 1989 letter to shareholders. a bad person.”

With integrity comes trust. This means that Buffett and Munger don’t have to spend a lot of time micromanaging every decision a leader makes.

“The big thing we do with managers, in general, is find the .400 hitters and not tell them how to swing,” Buffett said at the Berkshire annual meeting in 1994.

As passive investors, Buffett and Munger look for companies that appear to be trading at a price below their intrinsic value.

Although there is no universal measure of value, companies with long-term revenue potential tend to have consistent earnings, good cash flow and low levels of debt. When a stock’s price appears low relative to the company’s value, it’s an opportunity to buy.

But that doesn’t mean that Buffett and Munger are looking for the best deals based on stock price alone. Simply getting a fair price for a company’s stock can also be an effective strategy. You are investing in the company for the long term, not just the stock price at the time of purchase.

“It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price,” Buffett wrote in his 1989 annual letter to shareholders. , we are looking for top-notch companies with top-notch management.”

Get CNBC Free Warren Buffett’s Guide to Investingwhich distills the billionaire’s best advice for regular investors, dos and don’ts, and three key investing principles into one clear and simple guide.

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