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The Warren Buffett Investment Principles

Written By Brian Hicks

Posted February 14, 2008

Forget Coke. Forget McDonalds. And you can even forget the queen of talk Oprah Winfrey. That’s because when it comes right down to it the best brand in the business belongs to Warren Buffett, that grandfatherly billionaire from Omaha, Nebraska.

That’s true now more than ever up on Wall Street, where the investing classes hang on his every word these days as they continue to come to grips with the dangers of a sub prime contagion that was never contained.

Of course, to the set of value investors that have been following Warren Buffet’s investment principles for years, all of this renewed attention probably comes as no surprise at all. There is a reason after all that he’s called the Oracle of Omaha.

But with the mortgage related mess now threatening to take the markets even lower, and investors of every stripe looking for a savior, Warren Buffett’s billions, and his stellar reputation, may be just the answer that the markets are looking for.

And while Saint Warren certainly isn’t going to save the market from all of its excesses, (not even he has that much money) he may just be able to bailout the only portion of the bond insurance market that is worth saving. That alone would be likely be enough to bring the markets back from the current abyss.

Warren Buffett to the Rescue

In fact, just two days ago the mighty weight of the Buffett Brand was on full display, when he called Becky Quick and the gang on Squawk Box for a little chat. The Dow futures, by the way were solidly in the red at the time.

It was during this chat that Buffett revealed that the his company had approached the three largest bond insurers last week – Ambac Financial Group Inc. (NYSE:ABK), MBIA Inc.(NYSE:MBI) and FGIC Corp.–offering to reinsure about $800 billion in municipal bonds in order to allow them to maintain their triple "AAA" ratings.

Of course, at the very moment he uttered those words the futures staged a big comeback going green to the tune of 72 points in an instant.

That green tide, not surprisingly, carried on into the day’s trade as the markets rallied on mere hope of a Buffett solution, even though it was nothing more than a proposal. And in fact, one of the three troubled insurers had already turned him down, which wasn’t surprising considering that he was basically asking them to fall on their swords.

Nonetheless, investors were warm to the idea of a Buffett solution, hopeful that it could alleviate one of the major market fears that have weighed heavily on the financial markets. "This would just eliminate one major cloud from the market," said Buffett on the call, and the Street agreed.

It was, in short, just part of what might be the master stroke in a legendary career spent buying things on the cheap.

In fact, when it is all said and done, it wouldn’t surprise me one bit if Buffett’s newly found bond insurer is practically the only one left standing-that’s how downtrodden the bond insurer have become and how decisively Buffet has acted.

Warren Buffet’s Six Investment Principles

So how does he do it, buying companies and investing on the cheap?

Well in short, he keeps it as simple as possible and he’s incredibly patient, moving only when the markets are so far in his favor that he can hardly lose. And of numerous books have been written about him, a few of his many tenets for successful investing stand out.

These are a few of them; investment questions that when answered properly have helped Buffet cement his reputation as the best in the business.

They are:

  • Has the company’s performance been consistently good?-Buffett’s tool in this regard is return on equity or ROE. Return on equity is a company’s net income divided by shareholders equity (book value). Buffett uses ROE as a measure of company has consistently performed over time vs. its peers. A good ROE in this regard would be a 5 yr. average between 15-17 percent.
  • Does the company carry too much debt compared to its peers? —The measure of debt Buffett uses in evaluation is the debt/equity ratio. Buffett, in general, frowns upon companies with high levels of debt. Instead he prefers that earnings growth is generated by shareholder equity as opposed to borrowed funds. In this case, the higher the ratio, the more debt that a company carries. And while this figure varies from industry to industry, a good way to measure it would be by looking for a ratio that is less than 80% of the industry average.


  • Are profit margins high compared to its peers? Are they increasing?-Buffett looks for companies with above average profit margins. It’s calculated by dividing the net income by the net sales. Companies with a strong history in this regard over an extended period of 5-10 years typically outperform. An above average performer will typically carry profit margins that are 20% above the industry average. Moreover, those same profit margins will tend to rise as the company becomes more efficient over time.
  • How long has the company been public? -In general, Buffett typically only considers companies that have been around for at least 10 years. That gives them the historical track record to make a proper evaluation of the company’s future prospects.
  • Are the company’s products vulnerable to "commodity pricing"?-Buffett is a strong believer in the economic moat. Therefore, if the company doesn’t offer anything that is unique or substantially different from its competitors he’s generally not interested.
  • And finally, is the company cheap on a valuation level? This is the part of the Buffett magic that is hard to quantify because it deals with a company’s intrinsic value. That’s the value that goes beyond its liquidation value and includes all the many intangibles that are hard to put a figure on, such as the worth of a brand name. In general, Buffet will want to purchase a company that is available at a 25% discount to its intrinsic value.

These, of course, are just a few of the many ways that Warren Buffet has built up his massive portfolio over the years. That’s because to a large extent, Buffet never buys stocks, he buys companies.

The difference between these two styles has not only made him wealthy, but has also made him the best brand on the market today.

When he speaks, the markets follow.

By the way, Warren is not only patient, but also prophetic. Here’s a link to an interview that he and his partner Charlie Munger gave CNN/Money almost three years ago entitled: The Oracle Speaks. It’s an interesting read to say the least from two pretty smart guys. In fact, you could say that they saw today’s market troubles from a mile away.

Wishing you happiness, health and wealth,

Steve Christ, Editor

Wealth Daily