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The Buffett-ology!

This blog would be different from our regular blogs on mutual fund investing. This blog will speak about investing concepts that are more applicable for equity investment. In our blog ‘Equity Mutual Funds or Direct Equity - What is better’ we discussed a few advantages and disadvantages of direct equity exposure compared to mutual funds investing. While we had suggested the newbie’s to start with mutual funds schemes, the direct equity culture is also witnessing growth. There has been a consistent rise in new (especially active) trading accounts. Those who have entered the equity markets in the past one year or after the Covid-19 pandemic.

Perhaps it was easy money in the equity markets till date. Whichever stock one selects has provided sizable returns. But as we say, such short term periods do not define the equity markets. One needs to be a consistent player amid all peaks and troughs of the markets. And consistency comes from principled ways of investing. This blog would be helpful for those who want to be a consistent and long term player in the equity market. With some modifications, similar principles can be applied to mutual fund investing also.

There is hardly any investor who doesn’t know about the legendary investor - Warren Buffet, who is ranked amongst the wealthiest people in the world. Buffet, known for his style of ‘value investing’ and buying companies at dirt cheap prices, has created immense wealth for himself and for the investors in his company, Berkshire Hathaway. Thus, Buffett’s investment strategy is arguably considered the most successful ever. Through this blog we are presenting some of the most important tenets of Buffett's investment philosophy.

When Buffett talks of investing, he has 2 basic rules. Rule No.1: Never lose money. Rule No.2: Never forget rule No.1. Many find this is funny, but Buffet says that these rules have helped him.

How to select a company for investment

As for the selection of the companies, Buffet says that he likes to invest in companies that he fully understands. Further, he expects to hold on to his investments for a long duration. And long means really long – in some cases more than a decade. He says, “I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for ten years”. Further, Buffet is not concerned with whether the market will eventually recognise its worth. He invests in a company, and is concerned with how well that company can make money as a business. To sum it up, invest in a business and not the scrip. As the business grows the investor fraternity is usually quick to reckon the same.

Cigarettes or Cola? Buffett clears this one for the investor!

Buffett has some different ideas for understanding a business. He once famously stated, “I will tell you why I like the cigarette business. It costs a penny to make. Sell it for a dollar. It is addictive and there is fantastic brand loyalty.” While he later stated that the tobacco industry was burdened with issues that made him change his opinion of it, this statement sums up Buffett's description of the perfect investment. He has simplified the understanding of business and its products considering the sustainability and even the scalability.

In a similar style, Buffett made investments in Coca-Cola. This is because the business is incredibly simple and easy to understand. The Coca-Cola Company only produces the syrup concentrate – which costs a pittance to make. To distribute the drink worldwide, it sells franchise rights to bottlers in different geographical locations all over the world, who then mix in the carbonated water and sweeteners.

These are the key ingredients to a Warren Buffett investment: simple to understand, huge profit margins and global distribution dominance. Let’s also not forget the brand power of more than 100 years. So, it is the simple approach of understanding the business that is the key to success. Of course, bear in mind that these are not the only things that Buffett analyses, but a brief summary of what he looks for. This would help the investor narrow down their search and select from that smaller pool.

Let us now take a look at how Buffett finds good value stocks by asking himself some questions when evaluating the relationship between a stock’s level of excellence and its price.

The first question to be asked is, whether the company has consistently performed well? Buffett always looks at the return on equity (ROE) to see whether or not a company has consistently performed well in comparison with other companies in the same industry. Note that, looking at the ROE for only the past year isn't enough. Investors should consider the ROE for the past 5-10 years to get a good idea of the company’s historical performance.

The second question is, has the company avoided excess debt? Buffett prefers to see a small amount of debt, so that the earnings growth is being generated from shareholders’ equity as opposed to borrowed money. In India, we have seen sectors like infrastructure, realty and even power sectors reeling under debt pressure and this led to severe underperformance for a longer period.

The third question is, whether the profit margins are too high and whether they are increasing? The profitability of a company depends not only on having a good profit margin, but also on consistently increasing this margin. To get a good indication of the company’s historical profit margins, investors should look back into its records for at least a 5-year period. It is important to look for consistency here.

The fourth question is, how long has the company been public? Buffett typically considers only companies that have been around for at least 10 years. As a result, most of the companies that have had their initial public offerings (IPOs) in the past decade wouldn't get onto Buffett's investment radar. Further, he states that one should never underestimate the value of historical performance as it demonstrates the company’s ability (or inability) to increase shareholder value. This experience comes handy in overcoming the challenges during economic peaks and troughs.

The fifth question is, whether the company’s products rely on a commodity? It is likely that the investor thinks of this question as a radical approach to narrowing down on a company. However, Buffett sees this question as an important one. He tends to shy away (though not always) from companies whose products are indistinguishable from those of their competitors. If the company does not offer anything different from what is offered by another firm within the same industry, there is little that sets the company apart.

And the last question is, whether the stock is selling at a 25 per cent discount to its real value? This is the clincher! Finding companies that meet the other five criteria is one thing, but determining whether or not they are undervalued is the most difficult part of value investing and Buffett’s most important skill.

Conclusion: While this sounds easy, it’s not! Buffett's success depends on his unmatched skill in accurately determining this intrinsic value (net present value derived from future cash flows of the company). While one can outline some of his criteria, one has got no way of knowing exactly how he gained such precise mastery in calculating value. However, if one tries to focus on the above six questions, a person may be able to avoid bad investments.

Pro Tip: With few modifications if a similar strategy is applied for analysing the portfolio of equity mutual funds schemes, one can avoid getting stuck in wrong mutual fund schemes.

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