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Berkshire Hathaway founder Warren Buffett — one of the most successful investors in the world — says he and vice chairman Charlie Munger are not “stock pickers; we are business pickers.”
In the company’s annual shareholder letter published over the weekend, Buffett explained that the “secret sauce” of their investing success is to make “investments in businesses with both long-lasting favorable economic characteristics and trustworthy managers.”
This approach is known as value investing, where the goal is to hang on to a top-performing stock rather than trade stocks based on short-term price fluctuations, otherwise known as active investing.
Of course, picking winners isn’t easy. But Munger has previously outlined four rules that the two Berkshire Hathaway executives follow when choosing whether to invest in a business.
Aside from Buffett’s No. 1 rule, “don’t lose money,” here are four questions that Munger and Buffett ask when deciding whether or not to invest in a business.
1. Do you understand the business?
Aside from knowing how a business operates and what it offers to consumers, you also want an idea of where a company is going to be in 10 years, if not for decades, says Buffett. “If you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes,” he wrote in his 1996 letter to shareholders.
Berkshire Hathaway famously missed out on tech companies Google and Amazon in the early 2000s, because Buffett wasn’t sure he understood the businesses in terms of their long-term profitability. This made it harder to determine the value of their stocks.
While Berkshire may have passed on Google and Amazon, other investments in blue-chip companies like American Express and Coca-Cola have paid off over time.
This cautious approach might mean missing out on more speculative opportunities, but Buffett has said that he and Munger “miss a lot of things, and we’ll keep doing it.”
2. Does the business have a durable competitive advantage?
Buffett has said that the “most important” factor in picking a successful business investment is the company’s competitive advantage, which he likens to a “moat” surrounding an “economic castle.”
The more secure the competitive advantage, the more likely the company will prosper over decades.
A competitive advantage could be a powerful brand that people are always willing to pay for, like Coca-Cola, or it could be a unique business model, like selling insurance directly to the consumer rather than through insurance brokerages, as is the case with Geico.
3. Does the business’ management have integrity and talent?
Buffett has said that he looks for three things in a manager or leader: intelligence, initiative and integrity. But integrity matters most of all, “because if you’re going to get someone without integrity, you want them lazy and dumb,” he said in a 1998 speech.
“We do not wish to join with managers who lack admirable qualities, no matter how attractive the prospects of their business,” Buffett wrote in a 1989 shareholder letter. “We’ve never succeeded in making a good deal with a bad person.”
With integrity comes trust. That means Buffett and Munger don’t have to spend much time micromanaging every decision a leader makes.
“The important thing we do with managers, generally, is to find the .400 hitters and then not tell them how to swing,” said Buffett at the 1994 Berkshire annual meeting.
4. Does the price make sense?
As passive investors, Buffett and Munger seek out companies that seem to be trading for less than their intrinsic value.
While there’s no universal measure of value, companies with long-lasting earning potential tend to have consistent earnings, good cash flow and a low amount of debt. When a stock price seems low compared to the company’s value, that’s an opportunity to buy.
But that doesn’t mean that Buffett and Munger seek out the best bargains based on the stock price alone. Simply getting a fair price on a company’s stock can be an effective strategy, too. You’re investing in the business long-term, not just the stock price at the time of purchase.
“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price,” wrote Buffett in his 1989 annual shareholder letter. “When buying companies or common stocks, we look for first-class businesses accompanied by first-class management.”
Get CNBC’s free Warren Buffett Guide to Investing, which distills the billionaire’s No. 1 best piece of advice for regular investors, do’s and don’ts, and three key investing principles into a clear and simple guidebook.
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