"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
If you can grasp this simple advice from Warren Buffett, you should do well as an investor. Sure, there are other investment strategies out there, but Buffett's approach is both easy to follow and demonstrably successful over more than 50 years. Why try anything else?
Two words for the efficient market hypothesis: Warren Buffett
An interesting academic study (link opens PDF file) illustrates Buffett's amazing investment genius. From 1980 to 2003, the share portfolio of his holding company, Berkshire Hathaway, beat the S&P 500 index in 20 out of 24 years.
During that same period, Berkshire's average annual return from its share portfolio outperformed the index by 12 percentage points. The efficient market theory predicts that this is impossible, but the theory is clearly wrong in this case. And "you can look it up."
Buffett has delivered these outstanding returns by buying undervalued shares in great companies such as Gillette (now owned by Procter & Gamble) and Washington Post. Over the years, Berkshire has owned household names such as UPS, Exxon Mobil and Wal-Mart.
Although not every share pick worked out, Buffett and Berkshire have, for the most part, made a mint. Indeed, Buffett's investment in Gillette increased threefold during the 1990s. Who'd have guessed you could get such stratospheric returns from razors?
The devil is in the details
So buying great companies at reasonable prices can deliver solid returns for long-term investors. The challenge, of course, is identifying great companies and determining what constitutes a reasonable price.
Buffett recommends that investors look for companies that deliver outstanding return on capital and produce substantial cash profits. He also suggests that you look for companies with a huge economic moat to protect them from competitors.
You can identify companies with moats by looking for strong brands alongside consistent or improving profit margins and returns on capital.
How do you determine the right buy price for shares in such companies? Buffett advises that you wait patiently for opportunities to purchase shares at a significant discount to their intrinsic values — as calculated by taking the present value of all future cash flows.
Ultimately, he believes that "value will in time always be reflected in market price." When the market finally recognises the true worth of your undervalued shares, you begin to earn solid returns.
Beginning investors will need to develop their skills in identifying profitable companies and determining intrinsic values before they'll be able to capture Buffett-like returns.
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If investing in wonderful companies at fair prices is good enough for Warren Buffett — arguably the finest investor on the planet — it should be good enough for the rest of us.