With the recent publication of Warren Buffett's letter to the shareholders of Berkshire Hathaway (NYSE: BRK-A, BRK-B), I thought I'd use the opportunity to take a fresh look at Buffett's approach to investing. What does he do that makes him so successful? What can we learn from him?
Be greedy when others are fearful…
… and fearful when others are greedy. Of all Buffett's many sayings, this is probably the most oft-quoted. And for good reason, as it sums up what is for me the most important principle in investing.
That is, to be contrarian — to go against the crowd. Because what is popular is expensive, and what is unpopular is cheap. So you need to buy what no-one else is buying.
Anyone for retail stocks?
While the shares of David Jones Limited (ASX: DJS), Myer Holdings Limited (ASX: MYR), Harvey Norman Holdings Limited (ASX: HVN) and JB Hi-Fi Limited (ASX: JBH) have been punished, perhaps rightly, several other retailers' stocks have also been pummelled just by association. Super Retail Group Limited (ASX: SUL), Fantastic Holdings Limited (ASX: FAN) both appear unloved, unpopular and cheap.
Investing has been compared to shopping in a supermarket. You would jump at buying half-price goods in a shop, so why not do the same in investing? Logically, these concepts are the same, but psychologically they are complete opposites.
In a supermarket, everyone wants to buy the half-price offers, so these products are by far the most popular. It's easy to buy these goods because you are going with the crowd — you are buying what everyone else is buying. Popularity is a sort of psychological stamp of approval.
But the situation is completely different with shares. The share price is directly related to the popularity — whatever is popular shoots up in price. So to get bargains in the stock market, you have to go against the crowd.
That's why what the Sage of Omaha does makes sense logically, but is so hard to do in practice.
Buy companies that are likely to grow
So, you are buying shares that are unpopular, and thus cheap. Is that the end of the story? Of course not.
You are also looking for companies that will grow. And not just for a while, but for year after year. That's why those who ask whether Buffett is a value investor or a growth investor are missing the point. He is, of course, both.
The classic example of this is Coca-Cola (NYSE: KO), which Buffett bought into in 1988. For years the company had been too expensive for his frugal tastes, but in the late Eighties Coca-Cola was locked in a fierce price war with Pepsi, which sent the share price tumbling.
Buffett could see that these difficulties were short term, and that Coca-Cola remained a great brand. He could also see that the business had an unbeatable product that could be successful all around the world. And the Coca-Cola board were intent on doing just that.
To date, Coca-Cola has been one of the Sage's best investments.
For Australian investors, Cochlear Limited (ASX: COH) probably best fits the bill. The price has fallen thanks to a product recall, and the issue is a short term one. The company still has a great brand and massive growth opportunities. Woolworths Limited (ASX: WOW) is another. Rampant price deflation is a short term issue, the share price has fallen dramatically, but Woolworths continues to grow its supermarkets, petrol, liquor and hotel businesses, expanding into home improvement and divesting non-performing assets (Dick Smith).
Buffett is clear on this — he is an investor, not a trader. Everyone is different, and if you are able to get a substantial return from trading then good luck to you.
But if you want to follow the Buffett approach then you should keep trading to a minimum. After all, every time you trade you eat into your precious profits, and reduce your return. Plus, when you trade you are often a slave to your emotions, and emotional trading is rarely profitable.
Going back to the example of Coca-Cola, Buffett deliberately chose this company because he knew it would grow for a long time to come. He knew he could safely tuck this company away in his portfolio and look forward to many years of unhindered growth, and not incur any of those expensive trading charges.
Finally, let's turn our attention to patience. This is important when you buy or sell. Don't trade as soon as you get an investment idea. Instead, keep the share on your watch list, and keep some money spare in your trading account. Bide your time, and great investing opportunities will appear.
Investing is the one discipline where time really is your friend. The law of compounding means that the profits you make year-on-year will keep on increasing, like a snowball rolling down a hill.
But you need to be patient. You need to sit out the bad years in anticipation of the good. The longer you wait, the better. Buffett has been investing for 60 years, and he just keeps on going, accumulating more and more of those precious snowflakes.
What I really like about Warren Buffett is that he keeps no secrets: he is really open about how he invests, and his shareholder letters are a case in point. Take your time to read and listen, as there is so much you can learn.
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- Woolworths: Steady as she goes
- Super Retail Group: The super retailer?
- Fantastic Holdings: Fabulous results
Motley Fool contributor Mike King owns shares in Cochlear & Woolworths. The Motley Fool's purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson. Click here to be enlightened by The Motley Fool's disclosure policy.
A version of this article, written by Prabhat Sakya, originally appeared on fool.co.uk