Warren Buffett---How He does It


All the passages below are taken from the book, “How Buffett Does It” by James Pardoe. It was published in 2005.




Once you get into the right business, you can let everyone else worry about the stock market.


According to Warren Buffett, one critical factor in successful investing is to remember that you are buying part of an actual business. The stock is nothing in and of itself; instead, it's a representation of a real enterprise. When you think about your portfolio, what should come to mind is not Bloombergs, tickers, or tables of small type in the Wall Street Journal. What should come to mind, says Buffett, is a business or a collection of businesses---real enterprises engaged in the right businesses.

In other words, it's not about "playing the market"; it's about buying businesses---the right businesses. In the long run, the right business almost can't help but prosper. By the same token, the wrong business simply can't deliver the goods---short term or long term.

The most important thing that you can do before buying a stock, then, is to think long and hard about the underlying business and its future and view yourself not simply as an investor but as a business analyst. Pay attention to the price, of course---but pay more attention to value. ("Price" and "value" ought to be closely connected, of course, but in many cases they get disconnected.) Value grows out of what the business is doing, how well it is doing it compared to the competition, the scale on which it is doing it, and how those factors project into the future. The smart investor is the one who picks a "valuable" business based on these kinds of assessments.

When it comes to investing, Buffett emphasizes, it's all about the performance of the business behind the investment. What is the business doing, and how well is it doing it (in both a relative and absolute sense)? Investing is never emotional; it is always what Buffett calls "business-like."


Business performance is the key to picking stocks. Study the long-term track record of any company that is on your buy list.


In 1985, Buffett analyzed the largest U.S. textile company and its business results from 1964 to 1985. Its stock had sold at $60 per share in 1964. Twenty years later, the share price had barely budged. Despite heavy expenditures, the business had struggled more or less consistently. Wrong business, Buffett concluded. "Buy and hold" can't work if you go into the wrong business in the first place.

A look back at all the vanished and vanquished dot-com companies proves the importance of Buffett's business analysis. During those heady days, people were buying all kinds of high-tech stocks whose prices were going up exponentially. But they were ignoring the value of the underlying business and its long-term prospects. Investors were buying stocks based on the action of the stock rather than on the quality of the business that the stock represented.

Companies such as Global Crossing and Etoys.com were selling for more than $80 a share. Today, they are worthless. Buffett did not buy one Internet stock because, as he saw it, these were not predictable, profitable businesses with strong balance sheets and cash flows. His business analysis told him not to go near these types of companies with a 10-foot pole.

How does Buffett determine which businesses to buy? He looks for four main things:


1. Businesses he can understand

2. Companies with favorable long-term prospects

3. Businesses operated by honest and competent people

4. Businesses priced very attractively


A conservative football coach once explained his dislike for the passing game by saying that when a football is passed, three things can happen, and two of them are bad. Buffett has the same aversion when it comes to businesses he does not understand. His business approach is safe, conservative, and unglamorous---but very effective.

Buffett likes easy-to-understand businesses because he knows that their future is more certain and their cash flows are easier to predict. Companies such as See's Candies, the Nebraska Furniture Mart, and Coca Cola are some of his favorites because they are stable companies with predictable cash flows and earnings that likely will be doing the same thing 50 years from now.

If you can't make those kinds of predictions with confidence, says Buffett, you are speculating rather than investing. Sure, investing involves uncertainty. The goal is to eliminate as much uncertainty as possible in part by going into businesses that are reasonably easy to "decode." Candy and Coke lend themselves to a kind of analysis that, say, broadband capacity does not.

Buffett avoids complex companies that are subject to dramatic change because of their uncertain futures. Earnings and cash flow are two of the pillars of a successful company. An enormous capitalization---although impressive---quickly can turn into a will-o-the-wisp. Market caps matter because they are one measure of a company's clout and borrowing power. But cash in the door, quarter after quarter into the foreseeable future, matters far more.

Some might criticize Buffett for not venturing into exciting new businesses. If so, he probably would not be offended. The bird in the hand, he might reply, is worth two in the bush. Better to take the good-and-known return than the potentially-enormous-but-highly-speculative return. Better to hit singles and doubles on a regular basis than to strike out swinging for the fences.


Search for certainty in uncertain markets---businesses that are likely to outperform their peers over the long run.


In many cases, says Buffett, the past is the best indicator of the future. This may sound strange to some people. Haven't we heard about the accelerating pace of change and about how the economy of the future will be enormously different from that of the past? Buffett doesn't necessarily disagree with this assessment; he just doesn't make investments based on that kind of thinking. Look for a business that's doing the same thing today that it was doing a decade ago, he says. Why? Well, for one thing, it's had plenty of time to figure out how to do it right. And second, that business---Buffett often points to See's Candy as an example---has found a niche within which things don't change very fast. Assuming that this stays true in the future, the company is unlikely to make any major blunders.

Is the product durable? Ask yourself the following question, even though it may sound silly at first: Which is more likely to be here in 10 years---a particular software application or a particular type of soft ice cream from Dairy Queen? The answer should be obvious: the ice cream. Software is simply moving too fast to be a good bet 10 years out.

If you don't have a good idea of what the business is going to be like in 10 years, then you do not understand the business. If you don't understand a business into which you're putting money, you are speculating rather than investing. You are hoping rather than thinking.

Here are a few things investors can do to help their long-term prospects:


Remember that a stock is a piece of a business.

Don't buy a stock because of its price action: buy a stock based on analysis of the business and its future prospects.


Evaluate the fundamentals of the business before you buy any stock.

Profits, earnings, cash flow, balance sheets, and income statements---these are a few of the keys that can help you to determine the long-term health of any business.


Use the Internet to do your homework.

Even a few years ago, investigating a company and its prospects would have taken days or weeks---and might even have been impossible for the nonprofessional investor. Not so today; today, there are hundreds of free Web sites that reveal all types of information about a company, such as annual reports, earnings, Security and Exchange Commission (SEC) filings, cash flow, and so on.


Don't think about "stock in the short term." Think about "business in the long term."




Look for a Company That Is a Franchise


Some businesses are what Warren Buffett calls "franchises." They have high walls and deep moats around them. They are more or less unassailable. These are the businesses you want to find.


Warren Buffett wants to buy businesses that have enduring competitive advantages and products. He looks for companies that dominate their markets. To describe his business ideal, he employs the metaphor of a massive, impregnable castle surrounded by a deep protective moat.

Companies built like strong castles are what Buffett calls "franchises." By this he means not a franchise like a Diuikin' Donuts or a Burger King, but an entity that has a privileged position that almost guarantees its success. An "economic franchise" provides a product or service that is


1.   Needed or desired

2.   Not overly capital-intensive

3.   Seen by its customers as having no close substitute

4.    Not subject to price regulation


See's Candies, mentioned earlier, is an example of such a franchise. It's a company with a durable competitive advantage. It has been selling candy successfully for more than 70 years and most likely will be selling candy for the next 70 years.

See's products stand out from all its competitors (can you name a competitor?). and people buy See's candy because of its reputation and quality. Customers are willing to pay a premium for its products, eschewing cheaper alternatives in favor of the real thing. So your goal, as an investor, is to try to buy businesses that are franchises.

Many would-be investors begin their search by asking a question such as the following: "How much is this company, in this industry, going to change the world?"  Buffett feels that this is missing the point in a fundamental way. Yes, a product that is "needed or desired" (criterion I above) is likely to have at least some power to change the world or part of it. But far more important, says Buffett, is figuring out whether this company has a competitive advantage that's sustainable. It is better to own See's Candies---which doesn't set out to change the world---than DeLorcan Motors. which briefly tried to cross swords with Detroit. See's has a moat; DeLorean didn't---and is now long gone.


Search out the fortress-like firms. Find companies that stand out from their com­petitors.


Buffett didn't always understand the importance of the franchise. Earlier in his career, he was far more focused on "great buys"---which turned out to be bad buys in the long run. Buffett bought himself an expensive education in the unappealing economics of farm equipment manufacturers, second-tier department stores, and New England textile mills. Not a strong wall or a deep moat among them!

In 1965, Buffett bought the New England textile company Berkshire Hathaway. Twenty years later, he closed down the textile operation of Berkshire Hathaway because it had no future and was losing money. Global competitors were killing this piece of the company; and---with no long-lasting competitive advantage and no moat to safeguard its prospects---the textile business eventually crumbled.

Compare those early mistakes with what Buffett did in 2003, when he shocked many observers by buying about 2 billion shares of Chinese oil company PetroChina. This huge company, which many people had never heard of, dominates the oil business in China, is the fourth most profitable oil company in the world, and produces as much crude oil as Exxon. This is the type of business stronghold to add to your portfolio when you are fortunate enough to find it.

One other key to buying franchises---or any business---is to wait until the company is reasonably priced. This has been a hallmark of f3uffett s methodology.


Do not dart in and out of the market. Research shows that frequent trading leads to mounting losses.


One Buffett expert and author. Timothy Vick, suggests that you make a list of your favorite companies and also the top prices that you would be willing to pay for them. Keep the list close by and monitor it every so often. This will help you to maintain discipline while allowing you to avoid moves that will hurt your portfolio.

In Vick's best-selling book. How, to Pick Stocks Like Warren Buffett (for the sake of full disclosure, this book also is published by McGraw-Hill), he makes a very compelling argument for "warehousing stocks" as Buffett does: ". . .. it forces you to be vigilant. Before buying, you must determine a reasonable value of the company, which means studying the enterprise. Putting some time into the valuation process will greatly decrease your chances of buying prematurely" (p. 98).

Here are some suggestions for helping you to pick and hold the right companies:


Search out the franchises that will stand the test of time.

Always be on the lookout for companies that meet Buffett's criteria: a company that produces products that are needed or desired, that has no close substitutes, that does not eat up capital, and that is not subject to price regulation.


Study companies' underlying fundamentals before you buy them.

Make sure that you are doing the right due diligence before making stock purchases. "This will help you to make better investment decisions and increase your prospects of success over the long haul.


Don't hesitate to "take strikes" before you swing.

Buffett advocates taking strikes. That's baseball parlance for a batter who lets some balls get by before swinging at them. Over time, the best investors make fewer and fewer buy and sell decisions.


If you see piranhas and crocodiles in a big moat surrounding a big castle, says Buffett, you have the type of long-lasting business that can reward investors.




Choose Simplicity over Complexity


When investing, keep it simple. Do what's easy and obvious, advises Buffett; don't try to develop complicated answers to complicated questions.


Many people believe that investing in the stock market is complex, mysterious, and risky and therefore is best left to the professional. This common mind-set holds that the average person can't be a successful investor because success in the stock market requires an advanced business degree, a mastery of complicated mathematical formulas, access to sophisticated market-timing computer programs, and a great deal of time to constantly monitor the market, charts, volume, economic trends, and so on.

Warren Buffett has shown this to be a myth.

Buffett has figured out a successful way to invest in the stock market that is not complex. Anyone with average intelligence is more than capable of being a successful value investor, without the assistance of a professional, because the fundamentals of sound investing are easy to understand.

Buffett will only invest in easy-to-understand, solid, enduring businesses that have a simple explanation for their success, and he never invests in anything complicated that he does not understand.


Remember that degree of difficulty does not count in investing. Look for long-lasting companies with predictable business models.


The essence and beauty of Buffett's investment philosophy is its simplicity. It doesn't require complicated math. a financial background, or knowledge of how the economy or stock market will fare in the future. It is based on common-sense principles and patience---midwestern values that any investor can understand and implement. In fact, Buffett believes that investors do not help themselves when they rely on such things as mathematical formulas, short-term market forecasts or movements, or charts based on price and volume.

In fact, says Buffett. complexity can work against you. Don't drive yourself crazy trying to decode the latest theories about investing, such as options pricing or betas. In most cases, you're better off not even knowing about these cutting-edge systems. An important lesson that Buffett learned from his mentor, Ben Graham, was that you don't have to do "extraordinary things to get extraordinary results.”

Keep it simple. Here's your goal: Buy stock in a great company, run by honest and capable people. Pay less for your share of that business than that share is actually worth in terms of its future earning potential. Then hold on to that stock and wait for the market to confirm your assessment.

This is the core principle of Buffett's philosophy of investing. It explains all his incredible achievements. It explains how he turned a $10.6 million Washington Post stock investment into a holding presently worth more than $1 billion, how lie made a $1 billion Coca-Cola stock investment that today is worth more than $8 billion, and how he bought S45 million worth of GEICO Insurance shares and saw his investment grow to more than $1 billion.


If you don't understand a business, don't buy it.


Buffett has turned Berkshire Hathaway into a $100 billion-plus company using this simple guiding principle. When investing in the stock market, he puts his money in easy-to-understand, solid businesses with strong, enduring prospects and capable and ethical management in place. He buys lots of shares when the stock market is selling them at a discount. In a nutshell, this explains his success.    

Forget sophisticated stock-picking computer programs that key on price history, volatility or market direction. Furthermore, discard equations full of logarithms and Greek letters. Buffett does use a computer---but mainly to play bridge and not to track stock price movements. Your investment goal should be the same as Buffett's: on the lookout for reasonably priced shares in understandable businesses that have a strong likelihood of higher earnings growth in the years to come. That's it!

Here are three principles that should underlie all your investment decisions:


Always keep it Simple.

Don't make investing unnecessarily hard. Stick with what you know and buy solid businesses that have strong and ethical management. Investment decisions that involve complexity should be avoided.


Make your own investment decisions.

Be your own investment advisor. Beware of brokers and other salespeople who aggressively push an individual stock or mutual fund to fatten their commissions. Obviously, these individuals don't have your best interest at heart.


Study the man who Buffett studied under.

The man who had the greatest influence on Buffett besides his father, Howard, was Benjamin Graham, the father of value investing, who taught Buffett decades ago that success in investments doesn't necessarily grow out of complexity. It's a good idea to read what he has to say.



Don't forget that Buffett's simple strategies have led to his extraordinary results.




Stay within Your Circle of Competence


Develop a zone of expertise, operate within that zone, and don't beat yourself up for missing opportunities that arise outside that zone.


When it comes to picking which businesses to invest in, Warren Buffett is guided by what he calls his "circle of competence." His circle of competence includes only those stocks and industries in which he feels most comfortable to be involved in.

As noted previously, Buffett did not invest in high-tech companies during the high-tech boom. Why? Because they were outside his circle of competence. And lots of industries, stresses Buffett, fall outside that circle. He and his associate, Charlie Munger, don't consider themselves experts in computer-chip technology, in the assessment of commodity futures, or in the potential of mineral prospects. It's not what they do.

They don't think of themselves as being skilled at dealing with fast-moving companies or industries. In his public utterances, Buffets grants that there may well be people out there who have acquired some sort of predictive skill that helps decode the long-term prospects of companies in the fast lane---but he knows that he doesn't possess that skill. And lacking it, he says, he simply has to stick with what he knows.

Buffett is intensely disciplined about his circle of competence. He makes no investments outside that circle---period. And he resists the temptation to make the circle bigger. In fact, he says, the size of your circle of competence is not particularly important. What is important is knowing where the boundaries are and staying within them. Drift outside that circle, and the chances of making investment mistakes grow exponentially. See something outside your circle---something new and exciting---toward which the herd is stampeding? Stay away.

Every year (since 1982) Buffett lists a "businesses wanted" ad in his annual reports, advertising for the types of businesses he would like to buy. He seeks


1.   Large purchases (at least $50 million of before-tax earnings)

2.   Businesses that have demonstrated consistent earnings power (rosy projections of future earnings are of no interest)

3.   Businesses earning good returns on equity while carrying little or no debt

4.   Businesses with strong management in place

5.   Simple businesses (read: "not a lot of complex technology")

6.   An offering price (a company with no visible price tag is likely to waste Buffett's time)


This ad is of particular interest in this discussion because it specifically outlines Buffett's circle of competence---the business arena where he is most comfortable making investment decisions. This is, in effect, his checklist for determining if an investment is inside his circle.

Although Buffett might not understand microchips, nanotechnology; and gigabytes, he does understand cowboy boots, bricks, carpet, and paint. A look back at the year 2000 shows Buffett at work in his circle. He bought both Justin Industries, a leading maker of cowboy boots, and Acme, a Texas brick manufacturer.

Bricks? How interesting can bricks be? Interesting enough, Buffett replies, if it's the right company. When asked to name a brand of brick, Buffett continues, three out of four Texans say, "Acme:" The company cranks out a billion bricks a year, or close to 12 percent of all bricks produced in the United States annually. In the same year that he bought Acme, Buffett also purchased (for $1 billion in cash) the Benjamin Moore Paint Company, which has been making paint for 117 years. And finally, he also bought 87 percent of the world's largest carpet manufacturer, Shaw Industries.

Boots, bricks, carpet, and paint---they may not sound exciting, but their earnings capability is very exciting. Three years after being purchased by Buffett, Acme Brick, Benjamin Moore Paint, and Shaw industries all reported record earnings. The lesson? Stay within your circle of competence. Act on what you know. If you do, you're better able to act fast and more likely to act big. By steadfastly sticking to this principle, Buffett has increased Berkshire Hathaway's book value from $19.46 per share in 1965 to more than $50,000 in 2005. No other investor comes close to such an accomplishment.

As an investor, you need to specifically define for yourself a circle of competence. By extension, you also need to define what is outside your circle of competence. Initial public offerings (IPOs), shorting stocks, mutual funds, futures, penny stocks, and options---do you understand these things? Can you evaluate their future profitability successfully? If you cannot understand or evaluate them, then they are outside your circle of competence, and you should not get involved with them.

Charlie Munger likes to use the mental model of three baskets on your desk: "In," "Out," and "Too tough." Munger says that he and Buffett put a large percentage of all the investment opportunities that come their way into the "Too tough" basket.

The takeaway: Create a checklist just like Buffett does and invest only when those conditions are met.

Don't venture out of your circle. Put most things in the "Too tough" basket, act only when you feel competent in your analysis, and don't hesitate to act forcefully inside your area of competence.

Here are three rules to live by when putting together your investment portfolio:


Write down the industries and businesses with which you feel most comfortable.

This will help you to define your circle of competence. If Buffett does not venture outside his circle, then you should not either.


Do not make exceptions to your circle-of-competence rule.

Before making that one exception to your circle-of-competence rule, sit back and think: Why risk your money on things you don't understand or can't evaluate? Be disciplined enough not to make exceptions to the competency rule.


Play your game, not someone else's.

The example that Buffett cites as an illustration is soybean futures. If someone else cleans up in the soybean market, says Buffett, fine---it's not his game. Stick to your own game.


If you can rule out 90 percent of the businesses in the United States as outside your circle of competence, you're likely to do a far better job investing in the remaining 10 percent.





Concentrate Your Stock Investments


Avoid what Buffett calls the "Noah's Ark" style of investing-that is, a little of this, a little of that. Better to have a smaller number of investments with more of your money in each.


Most "experts" tell investors to diversify---that is, to own many equities at one time---so that if one particular stock plummets, it won't drag down your whole portfolio. Warren Buffett goes more or less in the opposite direction.

Diversification, the practice of owning shares in many different companies, according to Buffett, is not necessarily the right way to invest. Buffett's policy is to concentrate his holdings. He likes to have only a few holdings and to invest a lot of money into them. If you've found the right stock, why buy only a little? He subscribes to Mae West's philosophy that "too much of a good thing is wonderful."

Buffett's endorsement of concentration---and conversely, his rejection of diversification---is another key clue to his investment philosophy. It should come as no surprise by now that it goes against the prevailing wisdom of Wall Street.

Most brokers recommend that you diversify your investment portfolio." Don't put all your eggs in one basket," they advise. "Hedge your bets." They would rather have you be like Noah and hold two shares of every conceivable company. Buffett disagrees. Buy 5 to 10 good companies at a bargain price and buy as large a position in each as you can. Why put money into your twentieth best choice, asks Buffett, rather than your top five or ten?

When Buffett feels strongly about an investment, he does not hold back. In fact, he tends to invest huge sums in it. For example, he invested $1 billion in Coca Cola stock, ultimately purchasing 200 million shares. He purchased 151 million American Express shares. He purchased more than 2 billion shares of PetroChina---the Chinese oil company---at a cost of $488 million. That holding, incidentally, is now worth more than $1.2 billion.

In 2004, Berkshire Hathaway had significant investments in only 10 publicly traded companies. At other times, it has had major holdings in as few as 5. Buffett has demonstrated repeatedly that when you buy a lot of shares in the right business at the right price, this strategy---a strategy of concentration---can work wonders over time.


When you are convinced of a strong business's prospects, be aggressive and add to your position rather than buying the fifteenth or twentieth stock on your list of possible investments.


Charlie Munger, Berkshire Hathaway's vice chairman, also strongly believes in non-diversification. In fact, he goes a step farther, arguing that "in the United States, a person or institution with almost all wealth invested, long-term, in just three fine domestic corporations is securely rich." It's patience and non-diversification, says Munger, that explain the astounding success of Buffett and Berkshire Hathaway.

So when brokers urge you to diversify your holdings and warn you that too much wealth in a few stocks puts you at significant risk and with a very unbalanced portfolio, keep in mind that Warren Buffett is presently worth over $44 billion because he directly owns 474,998 shares in one single company, Berkshire Hathaway. Benjamin Graham's GEICO Insurance holding was similarly responsible for most of his wealth. Munger believes that when the opportunity to get into a "wonderful business run by a wonderful manager" arises, it's a big mistake not to load up.

Why not wait to find a great company at a great price and make a substantial investment in it instead of investing diluted amounts in 27 mutual funds or 27 different stocks?

How can you take advantage of this Buffett strategy? Try these three to-do items:


When putting together your stock portfolio, aim to own no more than 10 stocks.

Buffett believes that despite what the experts say, diversification can increase your chances of subpar returns. Do your homework and find 5 to 10 stocks that you would want to own for the next 5 to 10 years. Then wait until they hit your price point. When they do, buy them with confidence and---perhaps most important---have patience.


Make sure that the stocks you buy fit Buffett's criteria.

They need to be in good, solid (even "boring") businesses that have strong management teams. Study the performance of the firm under present management. And don't get an itchy trigger finger. Wait for these companies to be priced attractively.


Be courageous.

Many of Buffett's biggest investments were bravely done during economic and business downturns when almost everyone else was too scared

to act.


Portfolio concentration---the opposite strategy of diversification---also has the power to focus the mind wonderfully. How? If you're putting your eggs in only a few baskets, you're far less likely to make investments on impulse or emotion.




Understand "Mr. Market" and the "Margin of Safety"


What makes for a good investor? According to Warren Buffett, a good investor is someone who combines good business judgment with an ability to ignore the wild swings of the marketplace. When the emotions start to swirl, says Buffett, remember Ben Graham's "Mr. Market" concept, and look for a "margin of safety."


Warren Buffett studied under Benjamin Graham at Columbia University. Buffett was, incidentally, the only student in Graham's 22 years of teaching to get an A+ from Graham. Graham taught Buffett two very important concepts that he still follows today. One is the Mr. Market" allegory, and the second is to always have a margin of safety with the purchase price.

These two ideas, along with viewing stocks as part ownership of a business, are the Graham "Rocks of Gibraltar." Buffett feels that if an investor has a grasp of these three basic ideas, he will put himself in a position to do well. Buffett alluded to these concepts on the one-hundredth anniversary of Graham's birth, saying that they were valid then and were likely to be important a century into the future.

Who, or what, is the "Mr. Market" invented all those years ago by Buffett's mentor Ben Graham?

Buffett describes Mr. Market as a business partner---one with incurable emotional problems who appears every day, without fail, and names a price at which he will either buy or sell you his interest in the business.

Mr. Market, according to Buffett, is what used to be called "manic-depressive" and today might be called “bipolar." His psychological troubles intrude on the prices he quotes. When he's feeling euphoric, he sees only good things in the business and puts a high price on his holdings. In truth, when he's in this mood, he doesn't really want to sell you his interest because he s afraid you'll accept his price, buy his shares, and get the benefit of all the price appreciation that he thinks is just around the corner.

And then there's the dark side of Mr. Market. When he's down, he sees nothing but trouble, inside and outside the business. In this mood, he's afraid you'll unload your holdings on him, and he'll be left holding the bag during the coming downward spiral. In this mood, he puts a low asking price on his shares and hopes that you'll grab them.

Mr. Market is nothing if not persistent, explains Buffett. He comes around every day, no matter what mood he's in. He doesn't seem to mind if you ignore him: he'll he back tomorrow with a quote. All you have to do is figure out what mood Mr. Market is in and decide what you're going to do about it. Ignore him? Take advantage of him? Again, he doesn't seem to mind which way you go.

But the key, says Buffett---paraphrasing Graham---is never to fall under his influence. That influence can be powerful at times. His gloom can fill the room. His euphoria can be intoxicating. Read the mood, says Buffett, and act in ways that take the mood into account---but don't get swept up in the mood yourself.

Ben Graham's "Mr. Market" is a metaphor that every value investor should use as the basis for understanding the price workings of the stock market. It helps to make sense of market madness. And it helps to signal and underscore the arrival of opportunity. As an investor, you always should be ready to exploit Mr. Market when he is depressed and share prices are falling. This means that good businesses are getting tarred by a bigger brush. This is exactly the time for aggressive opportunism---for seizing of an opportunity - that is presented by stock market silliness and for making a big investment in a stock because you believe its intrinsic value is higher than its price.

When the stock market crash of 1987 pushed down the price of Coca-Cola, Buffett took advantage of "Mr. Market's" gloom, which was then imposing an unnaturally low price on a business that Buffett knew to be solid. He bought $1 billion worth of Coca-Cola stock at an average price of about $11 a share. He felt that Coca-Cola was a great franchise and that at the time the intrinsic value of Coca-Cola was greater than its low stock price. It was, he later explained, the most powerful brand in the world. Its products are relatively cheap and are universally liked. Per capita consumption tends to go up year after year in countries around the world. Mr. Market is down on this stock? Excellent, says Buffett: time to buy. It's like the department store that is going out of business, and everything is marked down 50 percent: This is a great opportunity to buy things of value at a great price.

After adding Mr. Market to your intellectual framework, you also need to grasp the importance of margin of safety---another of Ben Graham's principles. Simply put, "margin of safety" means that the price of the stock is substantially lower than the value of the business. You don't want the price and value of the business to be close. You want a lot of daylight between those two figures----an "enormous margin;" in Buffett's words. Once again, you want to buy the dollar bill that is selling for 40 cents on the stock market. Buffett talks about driving a 10,000 pound truck across a bridge designed to carry 30,000 pounds---in other words, plenty of room for error.

And here's where the irrationality of Mr. Market works in your favor. Eventually, he gets very gloomy, causing share prices to fall precipitously. This gives you an opportunity to achieve a margin of safety in the purchase of shares. Eventually says Buffett, the market will recognize their value, and their price will rise. Sooner or later Buffett says confidently, value counts.

Again. don't let Mr. Market suck you into his mood. Don't let him value businesses for you, emphasizes Buffett. He is your servant rather than your guide.

When assessing the margin of safety, says Buffett, use the concept of "intrinsic value" as your starting point. This is the measurement that really counts. It attempts to determine the discounted value of the cash that can be taken out of the business during its remaining life.

It is, as Buffett is the first to admit, a "highly subjective" estimate. Future cash flows get revised up or down, and intrinsic value floats along with them. The variability of interest rates also affects any calculation of intrinsic value. Nevertheless, says Buffett, it remains the most useful starting point for understanding the relative attractiveness of an investment compared with an alternative investment. This is yet another reason why Buffett prefers easy to-understand businesses: He can look at their earnings, cash flow, and capital needed to run their companies, and he can use that information to analyze their intrinsic value. He then can see if there is a significant discrepancy between price and value.

Your goal? To do what Buffett does and to take advantage of mistakes by Mr. Market when he attaches low prices to businesses that are worth a lot more. When Mr. Market's gloom creates a margin of safety, it's time to act.


Make sure that you understand Buffett's concepts of Mr. Market and the margin of safety.

This will help you to attain the proper mind-set to make better investment decisions.


Heed Buflett's analogies.

Buffett has commented that like the Lord, the market helps those who help themselves. But---he is quick to add---the market doesn't forgive those who "know not what they do."


Bide your time, and wait for Mr. Market to get depressed and lower stock prices enough to provide a margin-of-safety buying opportunity.

Once again, Buffett's advice of patience and discipline come through loud and clear. If you can develop his level of discipline and wait for an opportunity, you will be rewarded.


Some people complain about market volatility. Not Buffett: He believes that volatility---Mr. Market's dramatic mood swings---is what creates opportunity for savvy investors. Wait until other people start acting foolishly, and then act wisely.





View Market Downturns as Buying Opportunities


Market downturns aren't body blows; they are buying opportunities. If the herd starts running away from a good stock, get ready to run toward it.


A typical newspaper article in the summer of 2004 reported that the Dow Jones Industrial Average had "plunged nearly 150 points" to a new 2004 low as investors "bailed out of stocks in the wake of a disappointing jobs report and continuing high oil prices" and "sold off heavily for a second straight day" because of worries about inflation and slow job growth, which threatened to "interrupt the economic recovery for a sustained length of time:"

And so on and so on. Take the numbers out of the preceding paragraph, and it could serve as a template for any number of articles over the past several decades. Bad things happen out there in the world, and markets fall. Then good things happen, and markets rise.

Then they fall again, and Wall Street---and the industry around Wall Street---panics. "Panic" is a word that has been banished from Wall Street's vocabulary, but the reality of the panic mentality is still there. Most people with money in the stock market hate it when stock prices fall. They view market corrections as setbacks at best and as disasters at worst. When they lose their nerve, they "cut their losses" and bail out of the market.

When markets plunge, however, there is at least one investor who is not selling his shares and running for the exits. Warren Buffett, once again, presents a stark contrast to the prevailing wisdom of Wall Street. Most people sell at exactly the wrong time---when prices are falling. Buffett loves it when stock prices plunge because it presents buying opportunities. By extension, he says, savvy investors should learn to get comfortable with market volatility. If we never experienced wild swings---if we didn't have those plunges that give Wall Street fits---we would never get large opportunities opening up.

Most of Buffett's greatest investments were made either during bear markets when share prices of great businesses had plummeted (along with everything else) or when great companies were experiencing temporary but surmountable difficulties and their share prices became depressed.

Washington Post, GEICO, and Wells Fargo are examples of how Buffett pounces on market downturns to invest for the future. In 1973, the stock market was way down, lowering the price of shares in the Washington Post to about $6 each, adjusted for later stock splits. Buffett pounced, pouring $10.6 million into the company.

More than 30 years later, the price of that $6 share is now more than $900, the second most expensive share on the New York Stock Exchange after Berkshire Hathaway itself. Again, Buffett bought into a solid business when its shares were selling at a tremendous discount. This is what Buffett does so well. He constantly searches for underpriced shares whose values are higher than their prices, akin to buying dollars bills for 40 cents.


Search for quality businesses that go "on sale" for reasons other than the underlying fundamentals of the business or the quality of its management.


Owing to the whims of the financial markets, so often controlled by greed or fear, shares of excellent businesses sometimes will sink in price, presenting a great opportunity to buy bargain-priced shares. In other words, the irrationality of the market gets attached to businesses that shouldn't be tarred by the same brush---but are. This is a pouncing opportunity.

In l976, GEICO shares had plummeted from $61 to $2. The company was on very shaky financial ground to say the least. Buffett was convinced that GEICO would recover because it had a great business franchise, a defensible competitive advantage in the insurance business, and strong management.

Consequently, Buffett started to accumulate GEICO shares, ultimately investing $46 million in the company. GEICO had been "misappraised" in Buffett's eyes; all he had to do was make his investment and wait for a more accurate appraisal to be made. As noted earlier, that reappraisal ultimately came. His $46 million stake turned into a billion-dollar stake.

In 1990, Buffett bought 5 million shares of Wells Fargo Bank at a time when banks were getting hammered, thanks to a recent history of shaky loan-making and a poor business climate. Wells Fargo in particular was having problems because of the depressed California real estate market. But Buffett liked Wells Fargo. He liked its management team, he liked the business, and he particularly liked the depressed stock price.

The moral of these stories---and many more like them---is that Buffett bought many shares when great businesses were selling at a discount owing to market and business conditions. Almost every strong business is going to encounter difficulty at some point, and its share price is going to drop. This is often the best time to buy, because eventually the stock market will recognize the value of the company, and the stock price will catch up.

As Buffett's mentor Ben Graham wrote: "The investor who permits himself to be stampeded or unduly worried by the unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. Price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal."

How do you inject some of the Buffett magic into your own investing techniques? Consider the following:


Change your investing mind-set.

Reprogram your thinking. Learn to like a sinking market because it presents opportunity. Do not get caught up with the masses and hit the panic button when markets fall.


Always search for value.

Buffett's greatest investments were made when share prices were depressed owing to market conditions or to a company experiencing temporary difficulty. The key is to recognize the difference between a temporary setback and a real fatal flaw in a company.


Pounce when the three Buffett variables come together.

When a strong business with an enduring competitive advantage, strong management, and a low stock price comes onto your investment screen, pounce---even if you start with only a limited number of shares.


Buffett says that investors don't lose when markets fall---only "disinvestors." So be like Buffett: Be an investor.




Be Fearful When Others Are Greedy and Greedy When Others Are Fearful


You can safely predict that people will be greedy, fearful, or foolish, says Buffett. You just can't predict when or in what order.


The stock market always will be influenced by periodic epidemics of the powerful emotions of greed and fear. "I can calculate the motions of the heavenly bodies but not the madness of people," Isaac Newton once said. Warren Buffett often exploits outbreaks of these highly contagious emotions by behaving in a way opposite to the prevailing sentiment.

If most investors are greedy, then Buffett becomes "fearful" (or at least extremely conservative). If most investors are fearful, Buffett gets "greedv" (or at least unusually acquisitive). By following this strategy, Buffett has made a lot of money while others were not so successful.

In the 1960s, the stock market embarked on a sleigh ride in which prices shot up and volume soared. A lot of people got very excited about the stock market---and in the process contributed heavily to driving up share prices. In other words, as the balloon started to fill up, people eagerly pumped more hot air into it. It is in this phase of the moon---the phase of overheated avarice---that Buffett almost always chooses to sit on the sidelines.

He will not make investments while stock prices are rising irrationally and are decoupled from the actual value of the underlying business---in other words, situations in which prices have escaped the gravitational pull of actual business performance.

Eventually, predictably, this bull market of the 1960s came crashing to its end. And when the stock market collapsed, the great herd of investors became very fearful, as they almost always do after an irrational euphoric period. Instead of buying stocks, people dumped their shares, thereby driving prices down. They simply stopped investing.

The early 1970s were a notorious bear market. People were selling their shares out of fear. In 1973-1974, the economy was in recession, things were gloomy, and the Dow Jones had plunged below 700. Having gotten this far in this book, you probably can predict what else happened in this period: Buffett started buying. In fact, he started buying a lot. It was at this time, for example, that he made his now legendary Washington Post investment.

Unfornulatelv, as Buffett has observed, the irrational mood swings---from euphoria to misery and back again---aren't limited to naive investors. Professionals, including pension fund managers, are equally susceptible. At the market peak in 1971, Buffett points out, pension funds were committing all their available funds to the equity markets. A scant three years later, after the bottom had fallen out, they were investing only one dollar in five in equities. They got it exactly wrong, concludes Buffett---getting intoxicated when others were getting intoxicated and getting scared when others were getting scared. They did not take advantage of low prices but instead bought shares at high prices and then sold them when prices dropped.

Buffett. of course, behaved far differently. He made a large number of investments when the stock market was offering great companies at rock-bottom prices. He took advantage of the discounted shares of good businesses.

We also know how Buffett became very fearful during the Internet stock bull market when everyone else was buying shares greedily. He did not lose any money, while millions of Americans ended up losing their shirts on Internet stocks. Periods of fear and greed will break out intermittently and grip the investment community. You must behave exactly as Buffett does in these situations and use these emotions to your advantage.

Here are rules to live by when formulating your-fearful when people are greedy" investment strategy:


Buy when people are selling and sell when people are buying.

Program yourself to be fearful when most investors are greedy. Stocks are most interesting, says Buffett, when almost nobody is interested in them. This is true of many markets---commercial real estate being another good example---but it's especially striking in the stock markets, where the stampeding of the herd is so easy to detect. (In fact, given the pervasiveness of financial news coverage today, it's impossible to overlook the herd.) When people in the herd are fearful, they are not interested in buying stocks---but that's exactly when you should be interested. Of course, follow the other piece of Buffett's advice and do not invest blindly or mindlessly. Only when the investment in question meets your selection criteria should you make the investment.


Be ready to act quickly when opportunity strikes.

When the Dow Jones Industrial Average hit rock bottom in 1974 at 580, Buffett likened himself to an "oversexed guy in a whorehouse.” Be ready to act quickly and courageously when fear prevails and market prices plummet.


What will happen tomorrow? Will the market go up, down, or sideways? To Warren Buffett, these are uninteresting questions---except insofar as the "contagious diseases" of fear and greed will affect his own investing prospects, either by driving down prices and creating opportunities (fear) or by driving up prices and closing off opportunities (greed). When opportunities arise, Buffett is prepared to move. When greed prevails, Buffett is prepared to wait on the sidelines.




Take a Close Look at Management


The analysis begins---and sometimes endswith one key question: Who's in charge here?


Warren Buffett looks for great businesses that also have great management---and, as summed up earlier, he won't invest until both factors (great competitive position and great management) are in place. Therefore, as an investor, it is very important for you to closely evaluate the management team of any prospective business in which you are thinking of investing.

There are several key factors to scrutinize as you begin your assessment:


1.   Is the management team working for shareholders, or is it working to enrich itself at share holders' expense (e.g., through excessive salaries, bonuses, options. and expensive perks)?

2.   Is management frugal, or is it overweighted with spendthrifts?

3.   Is management dedicated to improving shareholder value and the rational allocation of capital?

4.   Does management repurchase shares for the benefit of shareholders and avoid issuing new shares that dilute shareholder ownership?

5.   Are shareholders treated as partners or patsies?

6.   Is the company's annual report candid and straightforward or fluff?

7.   Does management appear to engage in honest accounting, or does it appear to be hiding information and concealing the true numbers?


At the end of the day, what were the Enron, WorldCom, and HealthSouth stories all about? They were all about the chaos and value destruction that can result when managers put their own interests above those of the business and of the shareholders. They were all about the perils to shareholders of incompetent executives. Or, to put it more positively, they were all about the importance of ethical and competent leadership. When Buffett makes an investment, he is "going into business with" that company's leaders. When you phrase it in this way, you have very little choice but to partner with individuals whom you trust and admire.

You can make a bad deal with a good person, but---says Buffett---you can't make a good deal with a bad person. Why would you even try? Your own reputation may well suffer, and your investment will he put at unnecessary risk. Entrust your money to people you trust.

In 2003, Buffett took home a salary of $100,000 from Berkshire Hathaway. In that same year, the average chief executive officer's compensation (base salary and bonuses) totaled more than $2 million. And that doesn't speak to options or other kinds of special executive perks. Most CEOs enjoyed lots of these perks; Buffett has no options, bonuses, or lavish executive perks. In fact, 99.9 percent of his wealth is in the shares of his company.

The result? Buffett makes money only when his shareholders make money. He treats shareholders as partners, and every decision he makes is made with the aim of improving shareholder value. For example, because issuing new shares dilutes the holdings of existing investors, Buffett goes that route only grudgingly and only rarely. When Buffett took control of Berkshire Hathaway in 1965, there were 1,137,778 outstanding shares. Forty years later, amazingly, the number of outstanding Berkshire Hathaway A shares is less than 1.4 million. At Berkshire Hathaway, frugality and cost consciousness are ingrained parts of the corporate culture.

Charlie Munger sails, "The opulence at the head office is often inversely related to the financial substance of the firm.” Berkshire Hathaway's corporate headquarters in Omaha are unimpressive and unglamorous (to put it kindly). If you re looking for multimillion-dollar office rehabs, don't bother looking in Buffett's corner of Omaha. On the other hand, if you're looking for financial substance---glamorous numbers---you've come to the right place.

Sam Walton, the founder of Wal-Mart, was famous for his frugality and lack of corporate ostentation. This is the kind of manager that Buffett loves and seeks to associate himself with. Look for managers who are more interested in cutting costs than in installing gold-plated faucets in the executive bathroom (or $6,000 shower curtains, as one infamous CEO is reported to have purchased).

So the quality of management is very important to Buffett. But good management must be married to a good business. You can be the best jockey in the world. Buffett warns, but you can't win the race riding a broken-down nag. That's the stuff of fairy tales, and fairy tales aren't the basis of good investments.

Avoid investing in poor businesses, even if they have great management. Ultimately, the quality of the business will win out---will lose out---and sink the investment.

Buffett has a number of warnings for investors to look out for when assessing companies and their management, especially in their annual reports. First of all, analyze their accounting. If it looks weak, stay away. If the company doesn't expense options; presents fanciful pension assumptions: trumpets its earnings before interest, taxes, depreciation, and amortization (EBITDA): and relies on a blizzard of unintelligible footnotes, these are all bad signs. Let's assume that you have at least a modest ability to read financial statements. If you can't understand something in a company's financial statement, savs Buffett, it's because management doesn't want you to understand it. Do you want a business partner who hides things from you? Certainly not!

In addition, Buffett warns investors to be suspicious about companies that look exclusively to the future for their “good news." Is the good news all about earnings projections and growth expectations? Bad sign, says Buffett. He does so based partly on his own experience as a CEO, The senior managers at Berkshire Hathaway have no clear idea what one of their businesses is likely to earn in the coming year---or even the next quarter. When an executive claims to know the future, Buffett warns, that's a bad sign. And when an executive actually hits those numbers, quarter after quarter, that's a really bad sign. It strongly suggests that something is being manipulated somewhere. If you make ironclad commitments to "make your numbers," you may put yourself in a position where you have to make up the numbers---eventually leading to all kinds of mischief and unhappiness. HealthSouth did this exact thing as its CEO boasted of 46 consecutive quarters of exceeding analyst's earnings expectations before the accounting fraud ultimately was uncovered.

Bad signs that are visible are the best indicators of bad signs that are invisible. A dirty kitchen, savs Buffett, rarely has just one cockroach. Seeing one is enough to tell you that there are more lurking in the walls. If you think they're there, they probably are there.

Enron exhibited many of these warning signs---Enron's management fleeced millions of shareholders---so scrutinize the quality of management to avoid the damage incompetent, unethical, and greedy leadership can incur.

To avoid these kinds of disasters and to increase your chances of a successful investment, always do the following:


Assess the management team before you invest.

The quality of management is almost as important as the quality of the underlying business. Buffett only does business with ethical people whom he likes. He never profited from a company with unethical management.


Look for shareholder-friendly companies.

Invest in companies with management that puts the needs of shareholders above its own needs. Look for companies that implement stock-repurchase plans to benefit shareholders and companies with a track record of frugality and rational allocation of capital.


Avoid investing in any company that has a record of financial or accounting shenanigans.

Weak accounting usually means that management is trying to hide weak business performance.


If management stresses the appearance of performance over the substance of performance, says Buffett, keep your wallet in your pocket.




Practice Independent Thinking


When investing, you need to think independently.


Independent thinking is one of Warren Buffett's greatest strengths, and he recommends it to the rest of us. This may sound like a bit of a truism: Of course you should think independently, right? But, in fact, many of us engage in what might be called "dependent thinking," in which our opinions are shaped mainly by what others think. This isn't independent thinking; in fact, it's more like mindless imitation.

Because he has achieved quasi-celebrity status, Buffett gets a lot of scrutiny---and, by extension, a lot of praise and criticism in response to his investment decisions. But Buffett does not depend on the validation of others in making those decisions. He is immune to their applause when they praise him, and he is quite comfortable ignoring them when they condemn him.

Buffett learned a very important lesson from Ben Graham: "You're neither right nor wrong because people agree with you. You're right because your facts and your reasoning are right." Whether many people or important people agree or disagree with you doesn't make you right or wrong; good thinking informed by good facts makes you right. This is the heart of independent thinking---using facts and reasoning to reach a conclusion and then sticking to that conclusion regardless of whether or not people agree with you.

A look back at the recent Internet bubble shows the value of independent thinking and illustrates how thinking based on facts and reasoning is far superior to that based on prevailing public opinion. The great bubble was an amazing period in recent stock market history. During those heady times, the birth of an exciting new industry (and spin-off industries) spawned hundreds of companies and created thousands of new millionaires.

One of the more remarkable things about those new Internet and high-tech companies, of course, was the meteoric rise in their stock prices and capitalization. Some Internet companies only a year or two old were worth more than much more established Fortune 500 companies. For example, EToys.com hit $80 a share and had a $10 billion capitalization. Webvan.com's peak capitalization was $7.5 billion.

Needless to say, millions of investors were enjoying tremendous gains through their high-tech holdings. People were getting rich---and getting rich quick. Ironically, Berkshire Hathaway was not doing well during that same period, and its share price reflected it. Despite the tremendous gains made by high-tech stocks, Buffett refused to buy a single Internet stock or participate in this new "gold rush" in any way.


Stay away from a rampaging herd. If you don't, you and your investments might get stampeded.


Consequently, Buffett bore the brunt of a lot of disparagement. He was ridiculed by pundits and criticized by shareholders. The media had a field day questioning Buffett's abilities. The financial weekly Barron 's wrote on December 27, 1999, in its headline: "Warren, What's Wrong? Warren Buffett, America's Most Renowned Investor, Stumbled Badly This Year. Will His Berkshire Hathaway Recover?"

Other publications had the following headlines: "A Three Decade Legend Loses Some Luster," "Is Buffett Washed Up? and "Tech Phobia May Topple Buffett." Many people felt that Buffett should invest in high-tech stocks, and they could not understand how he could pass up such opportunities. But despite the public censure---even ridicule---he stuck to his guns and didn't budge.

Buffett's facts and reasoning were clear: He did not understand these Internet businesses and therefore stayed away from them. He had no idea which one of these high-tech companies would have a long-term competitive advantage and how they would be performing in 10 years. He also believed that irrational market psychology was responsible for many of the high-tech share prices. In such a circumstance, he believes, stock prices are actually set by the people who are greediest, or most emotional, or most depressed-in other words, by people who are detached from long-term reality. The result can be stock prices that are "nonsensical."

Based on this thinking, Buffett decided not to invest in any of these companies, even as millions of investors fell all over themselves to buy their high-flying stocks. Buffett felt that he was right because his facts and reasoning were right; he did not feel that he was wrong simply because almost everyone disagreed with him. His independent thinking was later vindicated when the great bubble burst and high-tech stocks collapsed.

As a result, most Internet companies went bankrupt, and the tech-heavy Nasdaq experienced more than a 75 percent decrease in value. Hundreds of billions of stock market dollars went up in smoke. What would have happened if Buffett had followed public opinion and joined the Internet herd? Mindless imitation of others would have cost him dearly.

Based on experiences such as this, some investors conclude that a contrarian investing strategy is superior to a "follow-the-crowd strategy" ("Contrarians," as the name implies, simply run in the other direction from the herd.) But again, Buffett disagrees. If the herd is doing the wrong thing, going 180 degrees in the opposite direction may be no better. This is investing based on polling rather than thinking, says Buffett---and any investment strategy based on polling rather than thinking has to be a bad strategy.

It's all about thinking---clearly and independently. And the stakes are high. Buffett is fond of quoting philosopher Bertrand Russell: "Most men would rather die than think. Many do."

The lesson to be learned from Buffett is to rely on facts and reasoning in making your investment decisions. Do not make a decision just because it is the popular or contrarian thing to do.


Never substitute popular wisdom for independent thinking.

Don't follow the herd. Do your homework and make your own investment choices. Do not allow yourself to be taken in by others or make a decision just because it is the "in thing" to do.


Make independent thinking one of your portfolio's greatest assets.

Being smart isn't good enough, says Buffett. Lots of high-IQ people fall victim to the herd mentality. Independent thinking is one of Buffett's greatest strengths. Make it one of your own.


Do not be a mindless contrarian investor.

Buffett believes that doing anything mindlessly is the wrong thing to do. Don't follow the herd mindlessly and don't go against it mindlessly in the spirit of contrarianism. Both paths lead to dangerous places.


Gather your facts, sit down, and think, advises Buffett. There is no substitute!




Become a Sound Investor


Buffett says that Ben Graham was about "sound investing." He wasn't about brilliant investing or fads and fashions, and the good thing about sound investing is that it can make you wealthy if you are in not too much of a hurry, and it never makes you poor, which is even better.


Warren Buffett---through his words and actions---has laid out a proven path for investors to follow. By following Buffett's advice, the average investor can practice sound value investing and can achieve sound results without the services of a professional.

Let us review Buffett's fundamentals. He likes to keep things simple and easy. He avoids the complex and difficult. His ironclad rule is that he will invest only in things he understands, and he avoids everything else. He will do things only within his circle of competence.

He stays very disciplined when standing at the investment plate, and he only swings at pitches in his “sweet spot." He shuns hyperactivity and instead recommends long stretches of inactivity. He is quite comfortable with a grand total of 20 investment decisions in a lifetime. You often have to sit on your hands---that's just part of the game.

Buffett's investment style is not a get-rich-quick scheme. Instead, it's a get-rich-slow plan. It takes time for the acorn to become an oak tree.

Proper temperament is very important. Specifically, an investor must keep his head during the good times and the bad. He must hold on for dear life when he owns shares in a great business with a great management. An investor always must keep his eye on the business, its performance, its management, and its intrinsic value.

A stock is part of a business, and how the business performs ultimately will determine how the stock price performs. You want to buy shares in companies headed by competent and ethical managers who keep shareholders' interests paramount.

You do not want to over-diversify your holdings. Instead, you want to concentrate them in high-quality businesses.

There always will be great distractions for investors---endless significant macro events concerning geopolitics, changes in the economy, and a stream of never-ending stock market forecasts. To become a sound investor, you must ignore these distractions and focus on the underlying businesses. Ignore the ticker. Your concern is value, not price---unless, of course, a dip in price offers a new opportunity to invest where there is a margin of safety.

Mr. Market will help you to understand the stock market, and you will use the greed and fear of people to your advantage: You will be fearful when others are greedy and greedy when others are fearful.

You will realize that a lot of nonsense is practiced on Wall Street. For instance, some investors swear by streams of stock charts and other short-term "tools:" The key is not to concern yourself with charts and other things that don't address the actual value of a business.

You will resist the tempting enticements of these things because you will be the one to proclaim (or at least realize) that the emperor of Wall Street does not wear any clothes. You will avoid high-tech businesses with uncertain futures and seek out low-tech businesses---franchise-like businesses with big moats around them that consistently generate strong earnings and cash flows without big capital investments. These are the businesses that will be around a decade from now.

You will cultivate the habit of doing a lot of the right type of reading, such as the Wall Street Journal, and keeping abreast of business events. You will accumulate facts that will form the basis of independent thinking, secure in the knowledge that facts and reasoning---rather than the opinions of others---will determine if you are right or wrong.

You will not mindlessly imitate others. You will develop good habits to help you use all your horsepower. It is these sound principles that explain Warren Buffett's success---and hopefully will explain yours.


To become a sound investor, develop sound investing habits.

The investment habits of Warren Buffett provide a detailed roadmap for other investors to follow that will increase their chances of success. Pay attention to the principles and habits of Buffett and you will become a better investor.


Always fight the noise to get the real story.

The “real story" of stocks is in the fundamentals. It's not in charts or forecasts or found emanating from the mouths of "talking heads" on the business channels. It's earnings, competitive advantage, enduring brands, and so on.


Always practice continuous improvement.

The key to investing is to get better at it with time. Learn from other people's mistakes as well as your own. Write down the things you do right as well as the things you do wrong. Work toward doing more of the former and less of the latter.


It's less about solving difficult business problems, says Warren Buffett, and more about avoiding them. It's about finding and stepping over "one-foot hurdles" rather than developing the extraordinary skills needed to clear seven-foot hurdles.