Warren Buffett is widely regarded as the world's most successful investor, and it is no mistake we have repeatedly echoed his wisdom throughout this Investing Classroom series. The book value of his company, Berkshire Hathaway BRK.B, compounded at 21.9% per year between 1965 and 2004. That is more than double the 10.4% pretax return to the S&P 500 over the same period. According to Forbes, Buffett is the world's second-richest man with a net worth of about $44 billion at this writing. But he didn't stumble across a giant oil field, develop software, or inherit wealth. Rather, he built his fortune solely through astute investing. Aspiring investors, then, will certainly benefit by studying his methods. Fortunately, Buffett has been forthcoming.

In Berkshire's 1977 annual report, Buffett described the central principles of his investment strategy:

"We select our marketable equity securities in much the way we would evaluate a business for acquisition in its entirety. We want the business to be one (a) that we can understand; (b) with favorable long-term prospects; (c) operated by honest and competent people; and (d) available at a very attractive price."

Determining Fair Value

Buffett determines the attractiveness of a company's price by comparing it with his estimate of the company's value. To determine value, he estimates the company's future cash flows and discounts them at an appropriate rate. Discounting is necessary because $1,000 today is worth more than $1,000 received after one year. If an investor can earn 6% interest on his or her money, then $1,000 today is worth $1,060 in one year. Conversely, an expected $1,000 cash flow one year from now is worth only $943.40 today, because $943.40 earning 6% grows to $1,000 in one year. (For more on discounted cash flow and the time value of money, see Lesson 403.)

This discounted cash-flow valuation method was described by John Burr Williams in his 1938 book,The Theory of Investment Value. It is used by countless investment professionals, so Buffett's approach to valuation is not a competitive advantage. However, his ability to estimate future cash flows more accurately than other investors is an advantage.

Another part of his edge may be due to his sharp mind, but Buffett insists that successful investing doesn't require a high IQ; it depends more on a successful framework and having the proper temperament. Buffett succeeds largely because he focuses his efforts on companies with durable competitive advantages that fall within his circle of competence. These are key features of his investing framework.

Understanding Your Circle of Competence

If Buffett cannot understand a company's business, then it lies beyond his circle of competence, and he won't attempt to value it. He famously avoided technology stocks in the late 1990s in part because he had no expertise in technology. On the other hand, Buffett continued to buy and hold what he knew. For instance, he was willing to purchase a large stake in Coca-Cola KO because he understood the company's products and its business model.

Although it might seem obvious that investors should stick to what they know, the temptation to step outside one's circle of competence can be strong. During the technology stock mania of 1999, Berkshire's return badly trailed the market's return, and a number of observers commented that Buffett was hopelessly behind the times for eschewing technology stocks. However, Buffett has written that he isn't bothered when he misses out on big returns in areas he doesn't understand, because investors can do very well (as he has) by simply avoiding big mistakes. He believes that what counts most for investors is not so much what they know but how realistically they can define what they don't know.

Sustainable Competitive Advantages

Even if a business is easy to understand, Buffett won't attempt to value it if its future cash flows are unpredictable. He wants to own simple, stable businesses that possess sustainable competitive advantages. Companies with these characteristics are highly likely to generate materially higher cash flows with the passage of time. Without these characteristics, valuation estimates become very uncertain.

His large stake in Coca-Cola provides us with an example of the type of company he favors. Coca-Cola is more than 100 years old, and it has been selling essentially the same product during its entire existence. Coke was the leading soft drink in 1896 just as it is today. It seems unlikely that customers will ever lose their taste for it. Buffett believes that the product and the Coca-Cola brand are durable competitive advantages that will enable the company to earn economic profits for shareholders for many years to come.

On the other hand, technology is a fast-changing industry where the leading company of today can be driven out of business tomorrow by more innovative rivals. Market-leading products are always vulnerable to obsolescence. Thus, even if Buffett had technological expertise, he would be reluctant to invest in the industry because he couldn't be confident that a technology company's cash flows would be materially higher in 10 or 20 years, or even that the company would still exist.

Partnering with Admirable Managers

Buffett seeks businesses with talented, likeable managers already in place. Although he has the ability to change the management at Berkshire's wholly owned subsidiaries, Buffett believes that power is "somewhat illusory" because "management changes, like marital changes, are painful, time-consuming, and chancy." He has written that good managers are unlikely to triumph over a bad business, but given a business with decent economic characteristics--the only type that interests him--good managers make a significant difference. He looks for individuals who are more passionate about their work than their compensation and who exhibit energy, intelligence, and integrity. That last quality is especially important to him. He believes that he has never made a good deal with a bad person.

An Approach to Market Prices

Once Buffett has decided that he is competent to evaluate a company, that the company has sustainable advantages, and that it is run by commendable managers, then he still has to decide whether or not to buy it. This step is the most crucial part of the process so it deserves the most attention.

The decision process seems simple enough: If the market price is below the discounted cash-flow calculation of fair value, then the security is a candidate for purchase. The available securities that offer the greatest discounts to fair value estimates are the ones to buy.

However, what seems simple in theory is difficult in practice. A company's stock price typically drops when investors shun it because of bad news, so a buyer of cheap securities is constantly swimming against the tide of popular sentiment. Even investments that generate excellent long-term returns can perform poorly for years. In fact, Buffett wrote an article in 1979 explaining that stocks were undervalued, yet the undervaluation only worsened for another three years. Most investors find it difficult to buy when it seems that everyone is selling, and difficult to remain steadfast when returns are poor for several consecutive years.

Buffett credits his late friend and mentor, Benjamin Graham, with teaching him the appropriate attitude toward market prices. You may remember Graham's parable in which he said to imagine daily quotations as coming from Mr. Market, your very temperamental partner in a private business. Each day he offers you a price for which he will buy your share of the business, or for which you can buy his share of the business. On some days he is euphoric and offers you a very high price for your share. On other days he is despondent and offers a very low price. Mr. Market doesn't mind if you abuse or ignore him--he'll be back with another price tomorrow.

The most important thing to remember about Mr. Market is that he offers you the potential to make a profit, but he does not offer useful guidance. If an investor can't evaluate his business better than Mr. Market, then the investor doesn't belong in that business. Thus, Buffett invests only in predictable businesses that he understands, and he ignores the judgment of Mr. Market (the daily market price) except to take advantage of Mr. Market's mistakes.

Requiring a Margin of Safety

Although Buffett believes the market is frequently wrong about the fair value of stocks, he doesn't believe himself to be infallible. If he estimates a company's fair value at $80 per share, and the company's stock sells for $77, he will refrain from buying despite the apparent undervaluation. That small discrepancy does not provide an adequate margin of safety, another concept borrowed from Ben Graham. No one can predict cash flows into the distant future with precision, not even for stable businesses with durable competitive advantages. Therefore, any estimate of fair value must include substantial room for error.

For instance, if a stock's estimated value is $80 per share, then a purchase at $60 allows an investor to be wrong by 25% but still achieve a satisfactory result. The $20 difference between estimated fair value and purchase price is what Graham called the margin of safety. Buffett considers this margin-of-safety principle to be the cornerstone of investment success.

Concentrating on Your Best Ideas

Buffett has difficulty finding understandable businesses with sustainable competitive advantages and excellent managers that also sell at discounts to their estimated fair values. Therefore, his investment portfolio has often been concentrated in relatively few companies. This practice is at odds with the Modern Portfolio Theory taught in business schools, but Buffett rejects the idea that diversification is helpful to informed investors. On the contrary, he thinks the addition of an investor's 20th favorite holding is likely to lower returns and increase risk compared with simply adding the same amount of money to the investor's top choices.

The Bottom Line

Buffett's thinking permeates Morningstar's philosophy and valuation framework. We fully believe that you can greatly boost your investment returns if you invest like Buffett. This means staying within your circle of competence, focusing on companies with wide economic moats, paying attention to company valuation and not market prices, and finally requiring a margin of safety before buying.

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