How to invest in shares like Warren Buffet?

Since Indian markets (SENSEX and NIFTY) are making new high every day, suddenly there is enormous interest in investing in direct equity or in equity mutual funds. In this article, I am not going to discuss about the right time to invest or how to invest (through direct route or indirect route using mutual funds), but I will discuss the investment approach followed by famous investor of all the time "Warren Buffett".

I believe that, after reading this article, most of the readers will able to make some judgement about the current market scenario and will able to keep aside the noise generated by various day to day news and will able to focus on the investing approach narrated here.

Warren Buffett is one of the most successful stock market investors of the past several decades. His entire approach is to focus on the value of the business and its market price. Once Buffett finds a business he understands and feels comfortable with, he acts like a business owner rather than a stock market speculator. He studies everything possible about the business, becomes an expert in that field and works with the management rather than against them. In fact, often his first act on buying shares in any company is to grant the managers his proxy vote for his shares to assure them that he has no intention to try and move the company away from its core values.

Buffett champions the value investment strategy, and puts no credence in day to day movements in share prices, the impact of the economic mood overall or any other external factors. He maintains a long-term perspective at all times, and never loses sight of the underlying value of a business.

THE BUFFETT APPROACH TO INVESTMENT

(1) Never follow the day to day fluctuations of the stock market.

The market only exists to make it easier to buy and sell, not to set values. Keep an eye on the market only for someone who is willing to sell a stock at a not-to-be-missed price. Do not build your opinions about the long-term potential of the stock (underlying business) based on daily news, quarterly results or market making new high or low.

Investor should aim to understand the business by reading about it in all possible manner and then look at the price at which Mr. Market is quoting it on a given day. Mr. Market will be very optimistic on few days in a year when it will quote the business at a very rosy price and it will be very pessimistic on the other day when it will quote the same business at very low value. This gives enough opportunity for an intelligent investor to buy the business (stock) when Mr. Market is unnecessarily pessimistic about it, and the sell the business (stock) when Mr. Market is over enthusiastic about it.

(2) Don’t try and analyze or worry about the general economy.

If you can’t predict what the stock market will do from day to day, how can you reliably predict the fate of the economy? How many times, we have seen that experts predicting that in this calendar year NIFTY will give you +20% returns and actually NIFTY has corrected by the same proportion. You should remember that, after every good year there could be a bad year. Here, I am not suggesting any market direction but idea is that rather than looking for such predictions, you should spend time in analyzing the stock (the business).

(3) Buy a business, not its stock.

Treat a stock purchase as if you were buying the entire business, using the following tennets:

Business Tennets

1. Is the business simple and understandable from your perspective as an investor?

It is always a good idea, to buy the stock of the company which you understand well. If you can see that, people around you are buying Maruti Suzuki car, then it could be a good idea to have a look at its financials and evaluate the possibility of buying the stock of Maruti Suzuki. Alternatively, if you work in a Bank, then you are probably the best person to know which bank is performing better, and you can think of buying the stock of that bank. Business should be simple to understand for a layman investor.

2. Does the business have a consistent operating history?

It is prudent to select the stock (the business) based on its past performance for at least 8 to 10 years. Most of the companies evolve and mature over a period of long time, so it is worth while to buy those stocks which are in existence for a decent period of time so that you can make judgement about their past and hence the future performance. Look for business with high operating profit margins as it suggests that the management is able to pass on raw material price hikes to its customers and it has strong moat.

3. Does the business have favourable long-term prospects?

After analyzing the past performance of the business, one need to look into its future prospects. If the business is in niche area then it will always have higher competitive advantage and it may have favourable long-term prospects.

Let us take an example of HDFC, which is a well-respected business house in India. Since Indians will most likely continue buying real estate and with growing population coupled with affordable housing schemes promoted by Indian government, it should be possible to conclude that, Housing Finance business has long term prospects in India and it should grow at a decent pace for many more years to come. It could be a secular growth story for many years to come and though it is in the field of Finance which has its own cycles, the housing finance business could sustain for much longer time than some other businesses.

Management Tennets

1. Is management rational?

Investor should able to judge the management based on various parameters like Management salary as compared to its profits. There are many well managed companies in India where promoters and managers themselves do not take very high salary as compared to the average employee. One should look for such business, and if you come across the one, you should take a deep dive and analyze it further. If the management is ready to take short term pains in order to gain in the long term, then an investor should grab such business at the right price.

2. Is management candid with its shareholders?

Managements which are conservative in forecasting their growth and transparent to its share holders will always command a respect and Mr. Market sometimes gives premium valuations to such business. Investors should look for those managements which promise less and always deliver more. Management should allocate capital in such a way that, it should able to grow the business and at the same time, should able to reward shareholders through reasonable dividend. Having a well-defined dividend policy goes a long way in building confidence among its shareholders.

Financial Tennets

1. Focus on return on equity, not earnings per share.

If you focus only on EPS (earning per share), you may come across some inferior businesses which are growing their EPS at faster rate but have large long-term debt on its balance sheet. It is better to invest in a business having moderate growth and low debt to equity ratio, as this kind of business can grow with minimum debt. Focus on high ROE (Return on Equity) and high ROCE (Return on Capital Employed) business in addition to its EPS growth.

2. Search for companies with high profit margins.

High operating profit margin and high net profit margin often means that the management is able to pass the increase in raw material cost to its customers. Such companies have very high competitive advantage and often operate in some niche area. If you can find the business which can retain their competitive advantage for long period of time, you have probably found your next multi-bagger investment.

3. For every Rupee of retained earnings, has the company created at least one Rupee’s extra market value?

If the management is not generous in distributing its profits to shareholders as dividends, then one should be careful about the capital allocation policy of the management. For every rupee retained by the management, are they investing it in new plants, or new business streams to generate higher growth in future or is the retained capital is just staying back with the company on its balance sheet? Investor should look for answers to such questions.

(4) Buy business with sufficient Margin of Safety

1. What is the value of the business?

There are various approaches in deriving the intrinsic value of the business.

One of the approaches adopted by Warren Buffet is Discounted cash flow valuation method. Finance professionals often use the discounted cash flow (DCF) valuation method to determine the attractiveness of an investment opportunity. DCF analysis uses future free cash flow (FCF) projections and discounts them to estimate the present value, which is then used to evaluate the investment potential.

Benjamin Graham has used another approach as stated by the following formula to derive intrinsic value of the stock.

Intrinsic Value = EPS x (8.5 + 2G)

Here, EPS is the trailing 12-month EPS, 8.5 is the P/E ratio of a stock with 0% growth and G is the growth rate for the next 7-10 years.

Later on, Graham has revised this original formula as below:

Intrinsic Value = [EPS x (8.5 + 2G) x 4.4] / Y

Here, 4.4 is what Graham determined to be his minimum required rate of return. At the time of around 1962 when Graham was publicizing his works, the risk-free interest rate was 4.4% but to adjust to the present, we divide this number by today’s AAA corporate bond rate, represented by Y in the formula above

2. Can the business currently be purchased at a significant discount to its value?

After deriving the Intrinsic Value of the stock, now investor has to decide the appropriate purchase price of the stock. It is advised that, Investor should buy the stock when it is trading at about 20%-25% discount to its intrinsic value. So, if the intrinsic value of the stock is Rs. 1000, then investor should buy it only when it trades at Rs. 750 to Rs. 800.

The reason for buying the business at significant discount acts as a “Margin of safety” in the purchase price. Since intrinsic value is based on either discounted cash flow or derived based on estimated long-term growth of the business, it is advisable to have some margin of safety. Even if the growth predictions go wrong or an investor makes an error in his/her calculations, he/she will not incur major losses since he/she is buying the business with significant discount to its current value. This margin of safety is very important, and it is practiced by many value investors across the world including Warren Buffet.

3. Manage a portfolio of businesses.

Once an investor has bought the business, now ideally, he/she should hold it for a very long time. By holding the stock for very long time, say 5 to 10 years, he/she can benefit by the compounding nature of the earnings and the stock price. The upside of the stock is potentially infinite if you can continue to hold it for a long time.

Investor should focus on the underlying fundamentals of the business and do not keep monitoring its price on a daily basis. There are various portfolio management strategies which can be followed by an investor which is a topic of separate article.

In practice, does these principles work?

Answer to this question is not simple and straightforward. You need to customize this Buffet investment template to your needs. All of us have financial goals, such as, retirement, children education, children marriage, vacation, buying house or car. Hence one need to have an investment horizon as per your goals. 

For long term goals which are 10+ years away, you may remain invested in shares for longer time-frames. For short term goals which are less than 5 years away, you can better stick to FD/Debt fund. 

You also may have to book profits when individual stocks in your portfolio look overvalued as per your calculations, and shift that profit to FD/Debt fund. You may have to define your own asset allocation as per your goals, and invest in some shares from the 3-5 years perspective, and book profits in overvalued shares and either shift those funds (from booked profits) to undervalued stocks or FD/Debt Funds, depending on your own situation.

Also, generally every investor will have her/his checklist for buying and selling the shares over & above the Buffet investment template.

To summarize, Intelligent investing means having the priorities of a business owner focused on long-term value rather than a stock trader focused on short-term gains and losses.