How To Become Successful Investor Like Warren Buffet

April 9, 2008

Warren Buffet is a classic value investor and goes to great lengths to ensure that he buys low and sells high. He researches companies thoroughly to find good companies that are trading well below their intrinsic (fair market) value then holds those companies for however long it takes their stock prices to rise to their intrinsic value. If the companies become more valuable while he owns them, their intrinsic values will increase and he may hold them even longer.

Berkshire Hathaway’s portfolio is fairly well diversified, but I doubt that it’s fully diversified, which means they are deliberately exposed to company-specific risk, which would be diversified away in a fully diversified portfolio. with this additional risk, the expectation is higher returns in the long run to compensate for the additional risk.

The returns from dividends are minimal, especially these days, although they provide some cushion in a down market, but that shouldn’t be a big issue for a long-term investor. There are three other sources of return…growth, a risk premium and the potential excess return from buying below intrinsic value. Profit can still be earned from growth and the risk premium if companies are bought at a fair price and later sold at a fair price, but the potential profit from value investing is greater and usually more certain.

A growing company will have increasing earnings. The earnings that aren’t paid to stockholders as dividends are reinvested to grow the company. This reinvested equity capital plus the original equity capital, is matched with an appropriate amount of debt to provide leverage. Because all that capital is exposed to risk, the company’s management will strive to earn a high return on invested capital and leverage is one of the reasons the return is high. This rate of return must be greater than the risk-free rate of return (T-Bills) to justify the risks involved and the greater the risk, the higher the rate of return demanded by investors.

The excess return that comes from buying below intrinsic value is the icing on the cake. If it weren’t for the work required to identify these under-priced companies, it would be unearned return. This reward comes to those who buy low, hold for how ever long it takes for the stocks to become fully valued then sells high. Here high is a relative term. Selling at intrinsic value isn’t in itself selling high; buying below intrinsic value is what makes the price relatively high.

Being an investor, value or otherwise, requires some talent, a lot of work, and patience. If you don’t have the time, knowledge or desire to do due diligence on potential investments and the patience to wait for your investments to mature, you’re better off with a well-diversified portfolio of mutual funds. The pros that manage the mutual funds know how to profit by investing in the right companies.

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