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New Year’s resolution for investors – Follow in the footsteps of Warren Buffett

Investors who are yet to read Roger Hagstrom’s The Warren Buffett Way would be well advised to put the book not just at the top of their reading list but also at the top of their resolutions for the New Year.

In the book, Hagstrom distils Buffett’s investment process down to 12 tenets. In part one of this four part review we consider the three Business Tenets that Hagstrom believes Buffett considers before investing in a company.

1) Is the business simple and understandable?

Consider the relative simplicity of Australia’s largest natural gas infrastructure business, the $5 billion APA Group (ASX: APA). It owns a suite of pipeline and infrastructure assets across Australia. With some careful research and analysis many investors could reasonably expect to gain a sound understanding of a firm such as this.

In comparison, energy company Woodside Petroleum (ASX: WPL) boasts a market capitalisation of $31 billion, has operations globally and is exposed to oil and gas commodity pricing. It is many times more difficult for most investors to understand and ultimately value.

A review of businesses Buffett has purchased over the years show that often his investments were made in simple to understand companies such as furniture retailing and chocolate retailing.

2) Does the business have a consistent operating history?

While speculating on a small company which is yet to make a profit can make money, Buffett is only interested in investing in companies that already have sound and consistent operating businesses that can provide him, as an owner, with a steady stream of cash flow. This tenet means Buffett would likely avoid companies yet to make a profit such as software firm Xero (ASX: XRO), in favour of a company such as Ramsay Health Care (ASX: RHC), which has consistently grown its revenue and earnings year-after-year.

3) Does the business have favourable long-term prospects?

Buffett likes to remain focused on the ‘knowable’ while avoiding industries and businesses where the outlook is too uncertain. A current example of this is the newspaper and free-to-air television sectors. Companies such as Fairfax Media (ASX: FXJ) and Ten Network (ASX: TEN) have experienced significant falls in profitability due to structural changes within their industries. Arguably Buffett would be concerned about the long-term prospects of these businesses which would lead him to avoid them in favour of other businesses with more appealing long-term prospects and tailwinds.

Foolish takeaway

Mimicking Buffett’s wealth might be a tall order, however mimicking Buffett’s process and style is not impossible. A conservative, long-term approach utilising the 12 tenets identified by Hagstrom could help many investors select better companies and would make a good New Year’s resolution for investors who currently don’t follow Buffett’s approach.

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Motley Fool contributor Tim McArthur does not own shares in any of the companies mentioned in this article.

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