Doc's note: You can easily mimic the investment strategy that made legendary investor Warren Buffett one of the wealthiest people in the world.
Today, Extreme Value editor Dan Ferris shares some simple but brilliant insight into what made Buffett so successful. As Dan explains, this simple rule is the difference between mediocre returns in the market or prospering like Buffett...
According to a former Forbes columnist, that's what it took to make Warren Buffett one of the richest men in the world.
Former Forbes columnist Mark Hulbert did a study a few years back. He looked at all of Warren Buffett's investment decisions over the years. Hulbert concluded that 15 stocks made Buffett rich beyond anyone's wildest dreams, turning him into a modern investment legend. Without those 15, Hulbert said, Buffett's returns would have been mediocre.
I'm not sure exactly which 15 stocks they were, but you and I both know some of them: Coca-Cola, Gillette, GEICO, Washington Post, Wells Fargo, and American Express, to name the most famous examples. When Buffett decided to get into those stocks, he bought as much as he could, knowing he was planning to hold them indefinitely.
Buffett has done that since the beginning of his investment career, no matter how much money he had. He put half his net worth into GEICO at age 20.
How did Buffett find those 15 stocks that were worthy of big chunks of his investment capital? Good question. Simple answer, too. He focused only on companies 1) whose businesses he understood, 2) with good management teams, 3) with a competitive advantage sufficient to produce high returns on capital for many years to come, and 4) priced to make him rich.
That's what Buffett is looking for in an investment. And, as Yogi Berra might say, if you don't know what you're looking for, you're never going to find it. In my monthly Extreme Value service, I'm look for companies trading at a discount to their intrinsic value, as measured by net assets and/or earnings power.
Simple as that.
Whatever your criteria are, you need to know them cold. That's the only way you'll be able to make really big money in stocks. You can't, for example, expect to own 50 different stocks and manage your own portfolio as a part-time endeavor. Like Buffett said, "I can't be involved in 50 or 75 things. That's a Noah's Ark way of investing – you end up with a zoo that way."
In Janet Lowe's book, Warren Buffett Speaks, she quotes a key passage describing Buffett's advice on how to find and focus on those few gems that will make you rich:
Draw a circle around the businesses you understand, and then eliminate those that don't qualify on the basis of value, good management, and limited exposure to hard times.
The circle Buffett mentions is the circle of competence he has spoken of many times. He can only get rich on those few stocks whose businesses he understands. Period. If a stock is outside that zone, it might go up, but it'll go up without Buffett on board.
Here are a few words from Buffett on how to work within your circle of competence to find great investments:
I would take one industry at a time and develop some expertise in half a dozen [companies]. I would not take the conventional wisdom now about any industries as meaning a damn thing. I would try to think it through.
If I were looking at an insurance company or a paper company, I would put myself in the frame of mind that I had just inherited that company, and it was the only asset my family was ever going to own.
What would I do with it? What am I thinking about? What am I worried about? Who are my competitors? Who are my customers? Go out and talk to them. Find out the strengths and weaknesses of this particular company versus other ones.
If you've done that, you may understand the business better than the management.
If you think your circle of competence is small and would never fit your 15 stocks, Buffett has some advice for you about that, too:
If we can't find things within our circle of competence, we won't expand our circle. We'll wait.
I wonder what your own stock portfolio would look like if you looked at each stock and asked, "Is this company within my circle of competence?" If you can't answer with an emphatic "yes," it would be better for the stock to go up without you than to keep your money in something you don't understand. If you don't understand the business, then you'll have to admit that either event (going up or down) will come to you as a surprise.
And when it comes to your money, surprises are something you don't need. Avoid them by knowing your circle of competence and staying inside it.
Editor's note: Each month in Extreme Value, Dan looks for the safest, cheapest stocks... and recommends buying only when the price is right. Click here to learn more.