CAN WARREN BUFFETT BE DUPLICATED?

CAN WARREN BUFFETT BE DUPLICATED?

With each passing year, the noise level in the stock market rises. Television commentators, financial writers, analysts, and market strategists are all overtalking each other to get investors’ attention. At the same time, individual investors, immersed in chat rooms and message boards, are exchanging questionable and often misleading tips. Yet, despite all this available information, investors find it increasingly difficult to profit. Stock prices skyrocket with little reason, then plummet just as quickly. There appears to be no rhyme or reason to the market, only folly.

Far above this market madness stand the wisdom and counsel of Warren Buffett. In an environment that seems to favor the speculator over the investor, Warren Buffett’s investment advice has proven, time and again, to be a safe harbor for millions of lost investors. Critics have argued that Warren Buffett’s idiosyncratic approach to investing is impossible to duplicate. It is certainly unique--in a market that emphasizes the frenetic buying and selling of securities, Buffett’s buy-and-hold philosophy is an anomaly. Buffett’s investing philosophy can be captured by four basic points:

1. Analyze a stock as a business.
2. Demand a margin of safety for each purchase.
3. Manage a focus portfolio.
4. Protect yourself from the speculative and emotional forces of the market.

These basic tenets do not seem difficult for any investor to duplicate. This is not to say they will be easy to duplicate, especially the last one, but it can certainly not be called impossible. Buffett’s investing advice to us all was succinctly penned in his 1996 report to Berkshire Hathaway shareholders: Your goal as an investor should be simply to purchase, at a rational price, a part interest in an easily understood business whose earnings are virtually certain to be materially higher, five, ten, and twenty years from now. Over time, you will find only a few companies that meet those standards--so when you see one that qualifies, you should buy a meaningful amount of stock.

Through the decades, money managers have flirted with many different investment approaches: small capitalization, large capitalization, growth, value, momentum, thematic, and sector rotation. At some point each has proved financially rewarding, and each has stranded its followers in periods of mediocrity. Buffett is the exception. He has rarely suffered periods of underperformance. His investment perofrmance, documented over nearly 50 years, has been consistently superior. Remarkably, in a rapidly changing business landscape, Buffett’s investment methods have changed very little. He differs from other money managers in three key areas:

1. The way he analyzes stocks.
2. The way he manages a protfolio.
3. The way he thinks about the stock market.

When Buffett looks at a company he quickly moves past the share price quote and begins to analyze the attributes of the business. He meticulously weighs a business against his business tenets, management tenets, and financial tenets that represent the core of his investment analysis. Next, he calculates from scratch what the business is worth. Only then does he take a look at the stock price.

This approach to stock analysis is far from normal. Most investors look only at the stock price. They spend far too much time and effort watching, predicting, and anticipating price changes, and far too little time understanding the business. Analysts find it too challenging to determine business value from scratch, and almost always start with the current price as their guide, and then use metrics like price-to-earnings ratios, book values, and dividend yields, which tell nothing about the value of a company.

Buffett believes there are only two reasonable approaches to investing in businesses--the know nothing approach and the business focus approach. The know nothing investor will benefit by owning a lot of securities and buying them at different times--that is, buying an index fund using a dollar cost averaging approach. For the business focus investor, 85% of available diversification is achieved with a fifteen stock portfolio, and even 15 stocks may be too many to perform adequate and regular analysis to the level necessary to make consistently intelligent decisions.

To avoid the trap of allowing market prices to dictate your success or failure as an investor, Buffett wisely developed a different success measure. Buffett ignored market prices and focused on economic progress of his portfolio businesses using a concept he called look-through earnings. This simple change in measurement creates a change in the entire investment process. By using look-through earnings you are far less likely to sell your best businesses just because you have a paper profit--and you are likely to develop a buy-and-hold philosophy with your star performers.

Warren Buffett is a huge baseball fan. He often compares stock selection processes to the batters selection of which pitch to swing at. Ted Williams was one of the greatest baseball players in American history, and the only batter to hig .400 (4 hits in every 10 attempts) in the past seven decades. In his book, The Science of Hitting, Williams explained his technique. He divided the strike zone mentally into seventy-seven cells, each representing the size of a baseball. Now, said Buffett, Swinging only at the ball in his best cell, Williams knew, would allow him to hit .400; reaching for the balls in the worst spot, the low outside corner of the strike zone, would reduce him to .230.

The investment analogy of William’s hitting advice is obvious. For Buffett, investing is a series of business pitches, and, to achieve above-average performance, he must wait until a business comes across the strike zone in the best cell. Buffett believes investors too often swing at bad pitches, and their performance suffers. Perhaps it is not that investors are unable to recognize a good pitch--a good business--when they see one; maybe the difficulty lies in the fact that investors can’t resist swinging the bat more often.

Sage@wallstraits.com