Warren Buffett’s formula for investing success

Without a doubt, Warren Buffett is one of the best investors the world has ever seen. His yearly letters to shareholders of Berkshire Hathaway (NYSE: BRK.A, BRK.B) are full of valuable investing wisdom.

On the subject of stock picking, Buffett has often explained what he looks for when investing. In the 1994 letter to shareholders he described the basic process.

“We believe that our formula — the purchase at sensible prices of businesses that have good underlying economics and are run by honest and able people — is certain to produce reasonable success. We expect, therefore, to keep on doing well.”

While this formula will help investors achieve good results, it isn’t necessarily easy to apply. Even the first element, a sensible price, depends on three factors: the prevailing interest rates, the investor’s own required rate of return, and the ability to make a reasonable estimate of the intrinsic value of a company. What, then, does Buffett say about valuing a company?

“The value of any stock, bond or business today is determined by the cash inflows and outflows — discounted at an appropriate interest rate — that can be expected to occur during the remaining life of the asset.” (1992 Letter to Shareholders)

As the market rises it will become more difficult for investors to find appropriate stocks at sensible prices. Equally, the psychology of participants in a rising market is such that people begin to fear missing opportunities more than losing their capital. When investors start chasing up the price of shares for this reason, investors’ optimism inflates a bubble.

Writing in early 2000 (prior to the bursting of the dot com bubble) in his 1999 Letter to Shareholders, Buffett commented on the relationship between the total market capitalization and GDP and what was – in his view – the over optimistic expectations of shareholders. He concluded, “If investor expectations become more realistic — and they almost certainly will — the market adjustment is apt to be severe, particularly in sectors in which speculation has been concentrated.”

As I wrote in this article, investors may have inflated expectations of the future returns of major banks, especially Commonwealth Bank (ASX: CBA), which is up about 35% in the last 12 months. While the dividend yield of over 5% is no doubt pleasing investors, it seems unlikely that the share price will appreciate at the same rate over the coming year.

Foolish takeaway

The market is up about 20% in the last 12 months and it is approaching the highs it reached in May. Since July, superannuation contributions have been higher, so there is an increasing amount of money available for investment. As good prices become harder to find, it becomes all the more important to maintain realistic expectations about future performance and avoid speculation.

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Motley Fool contributor Claude Walker does not own shares in any of the companies mentioned in this article. Find him on Twitter @claudedwalker.

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