One of the functions of a CPA financial planner is to help individuals formulate an investment plan based on their long-term goals. One of the most successful long-term investors of all time is Warren Buffett, so the authors have compiled a list of some of the rules that he has followed for the edification of financial planners and their clients.
Investors should select their investments based on the underlying strength of the company and not on the way the stock is expected to trade (i.e., technical analysis). Buffett uses fundamental analysis and does not bet on the way the stock will trade. This is the cornerstone of his long-term investing strategy.
Doing Your Homework
When Buffett wants to review a company, he uses the same public information everyone else does. He and his team, however, know what information to look for, how to assess it, how to use it, and how to integrate it into a clear opinion. While not everyone has the same acumen as Buffett, some skill and knowledge in how to assess the available information can still be helpful.
Value stock investors try to spot more mature companies paying reasonably good dividends that also appear underpriced. They use traditional valuation measures such as price/earnings (P/E) ratios and dividend yields. They also look for stocks they expect to grow once the market realizes its mistake. They do not expect dramatic growth, although that sometimes occurs. Buffett is just such an investor. One of his strengths is rein-vesting dividends back into the market and taking advantage of long-term continuous compounding.
Where Are the Profits?
Regardless of hype, the herd mentality, or the latest fad, Buffett does not buy any stock whose price is not justified by profits, a reasonable P/E ratio, and the ability to pay sustainable dividends. He also likes companies with secure and dominant brands, which provide the ability to maintain selling price levels (e.g., Coca-Cola, Kraft, Heinz, American Express).
The payout ratio is the percentage of profits that a company pays in dividends. It is derived by dividing the dividend by the profits. A stock that pays an annual $80 per share dividend and earns $100 per share has an 80% payout ratio, whereas a stock that pays $20 and earns $100 has a 20% payout ratio. The lower the payout ratio, the greater the potential for dividend increases. In addition, the availability of retained funds provides the company with the ability to expand operations, introduce innovations, enter new markets, or buy back shares trading below their intrinsic value.
Corporate Tax Rates
Corporations such as Berkshire Hathaway (BRK), of which Buffett is CEO, only pay tax on 30% of the dividends they receive. With a top corporate tax rate of 35%, this means BRK pays only 10.5% tax on its total dividends. Furthermore, some of BRK’s investments are in convertible preferred stock issues (rather than bonds), which are not usually available to other investors. Buffett provides funds to companies and then receives preferred stock, paying an above-market dividend. The preferred shares can be also converted into common shares at the stock price on the day he made his investment. If the stock goes down, he keeps receiving the high dividend. If the stock goes up, he keeps receiving the dividend until he decides to convert to common shares or must convert because of a predetermined expiration date. Note that stock dividends are not deductible by the payer, while bonds pay interest that is fully taxed to the recipient but also deductible to the payer.
Ability to Act
One of the great advantages Buffett has is his ability to make quick decisions and provide ready cash. For example, BRK’s corporate office has only 25 employees, and its small group of trusted advisors takes little time to act, even in a crisis.
A basic belief of investing is diversification, which spreads and offsets risk by investing in a wide variety of issues, sectors, and instruments. Even though Buffett has a large portfolio, five of BRK’s held stocks account for 66% of his public stock investments. This does not represent adequate diversification for a typical investor. He acknowledges this, and has stated that the average investor should instead consider a basic S&P 500 Index fund.
Understanding What a Company Does
Buffett only invests in companies where he understands what the company does to make money. In 2008, Buffett was asked if he wanted to take over and save Bear Stearns in 2008. While reading its financial statement, every time he came upon something he didn’t understand, he made a note on the cover. After covering it with such notes, he decided to pass on the opportunity.
Humans are emotional beings, and many investment decisions are made based on feelings rather than facts. Buffett strives to make fewer emotional investment decisions than most.
Aversion to Loss
Buffett does not like to lose, and he would rather pass on a deal than enter into one lacking underlying value. If the value is there, the stock might not increase as quickly, but the potential downside is also limited. Buffett buys stocks that he feels will have low volatility, low risk, and low leverage, and are therefore safe, cheap, profitable, and high quality. Strong brand recognition, a secret process or patent, or a unique product are also a plus. He also looks for management with strong ethical values and a desire to maximize shareholder value.
Leverage is another way of defining debt. Many investors trade on margin, borrowing against the stocks they own to buy more stocks. Doing this accelerates gains, but can also accelerate losses. Furthermore, interest payments are a drag on profits, and momentary drops in the stock’s price can require the stock to be sold, ending the ability to recover from those drops. Buffett does not use significant leverage to acquire his shares.
A Strong Investment Plan
Buffett has a well-disciplined plan, consisting of investing values, goals, and criteria that he rarely deviates from. He also has the discipline to wait and not chase overpriced companies, often looking to acquire stock at large discounts from his assessment of the company’s fair value.
With a lone exception, BRK has never paid a dividend, accumulating and compounding its earnings to invest in more and more opportunities. Buffett also uses his cash hoard to rebuy BRK stock when he believes the market value is too low. He has indicated that if he did not control BRK, he would not invest in it because of the lack of dividends.
Buying When Others Sell
The maxim is that when the market tanks, more people are selling than buying. The resulting drop in stock prices has nothing to do with the intrinsic value of the companies, and Buffett looks at this as a buying opportunity. After all, people look to buy other products, such as cars or homes, when prices are at their lowest. Why should stocks be any different?
Keep a Rainy Day Fund
Buffett advises to never be in a cash-short position. Worst-case scenarios should be anticipated and saved for. It is impossible to take advantage of timely opportunities without ready cash. Buffett has left instructions for his executors to keep his estate in 10% cash (in the form of T-bills) and 90% in an S&P 500 index fund.
Many people think they can time the market by frequent trading. Buffett does not believe in market timing as a strategy; instead, he believes in buying and holding. He makes his buying decisions for the long term, which precludes frequent selling soon after buying. He only sells quickly if he realizes he has made a mistake or if management or the fundamentals of the company drastically change.
Investors’ Trading Costs
Individual investors have many trading costs that reduce their returns. These include brokerage commissions, the spread between bid and ask prices, taxes, operating and management costs of mutual funds or managed accounts, and subscriptions to investor publications and news services. In addition, there is the time and opportunity cost spent analyzing and trading a portfolio. For Buffett, investing is a full-time job, and individual nonprofessional investors cannot come close to matching the time he spends. In addition, his trades, as for most institutional investors, are at a reduced wholesale cost.
Outsmarting Everyone Else
Most investors, and all traders, are trying to outsmart the others, thinking with each transaction that they have found a diamond in the rough. For every buyer that thinks he has found a sure thing, there is a seller that thinks the opposite. They cannot both be right. Instead of playing a chess game with other investors, Buffett plays solitaire. And he usually wins.
Warren Buffett Is Warren Buffett
Buffett often can make a better deal than others because of his own brand value. When the market was crashing at the start of the Great Recession, knowing that Buffett was investing in certain companies created a reassurance in the markets, propping up the market and restoring confidence.
While not every investor can follow every one of the above practices, they are still each a strategy for success in themselves. CPA financial advisors should use this information wherever possible to advise individuals in their own long-term planning.