There's plenty to learn from super-investor Warren E Buffett, and he's generally quoted ad nauseum. However, I think that investors often misunderstand how Buffett's wisdom might apply to their own investment decisions. In part, that's because Buffett's company, Berkshire Hathaway Inc (NYSE: BRK-B) is enormous, and therefore plays by slightly different rules. So let's have a look at how Buffett's wisdom applies to small investors.
On debt: "We never have any significant short-term debt," says Buffett, "We always have cash coming in every month."
What it means: Don't take out loans to fund stock investments. Make sure you have some dividend stocks to keep cash coming in for new investments.
On business economics: "Some of these businesses, measured by earnings on unleveraged net tangible assets, enjoy terrific economics, producing profits that run from 25% after tax to more than 100%. Others generate good returns in the area of 12% – 25%. A few, however, have very poor returns, a result of some serious mistakes I made in my job of capital allocation."
What it means: The way to measure return on assets (ROA) is earnings divided by unleveraged tangible assets. This is relevant because you'll have to calculate this for yourself when analysing a company. Buffett evidently looks for businesses that have ROA of at least 12%. Anything lower is an investing mistake.
A capital light business, like realestate.com.au owner REA Group Limited (ASX: REA) or a business with a strong brand, such as travel agent Flight Centre (ASX: FLT) will generally achieve high a ROA. In comparison, capital intensive businesses with unreliable demand, like driller Boart Longyear Ltd. (ASX: BLY) risk an average ROA well below 12%. Avoid businesses with poor economics.
On the advantage of being a small investor: "If I was running $1 million today, or $10 million for that matter, I'd be fully invested… The highest rates of return I've ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It's a huge structural advantage not to have a lot of money…"
What it means: If, like me, you have only a modest amount to invest, use it to your advantage! As Buffett says, you don't need to have heaps of spare cash because there are almost always opportunities you can take. You can enter and exit positions relatively easily, allowing you to take advantage of market inefficiencies that are more common amongst smaller companies. That's why my entire portfolio is made up of small cap stocks (although some of them close to losing that status, having grown so much).
