Warren Buffett's 6 smart tips on investing

Not all businesses are created equal

Buffett is often heard saying that of the thousands of businesses around, there are only a handful of businesses that pass through his screen test. He calls these businesses 'franchises' and believes they should have the following attributes

Buffett says, "An economic franchise arises from a product or service that:
(1) Is needed or desired,
(2) Is thought by its customers to have no close substitute, and
(3) Is not subject to price regulation."

If the company under evaluation has enjoyed a long track record of greater than average returns on capital as well as profit margins then there is a good chance that the company qualifies for the definition of a 'franchise.'

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Price is what you pay, value is what you get

Identifying a strong Indian 'franchise' is one thing and valuing and investing in it is another. Even the best 'franchises' bought at expensive valuations will not do the trick. So how does one value a 'franchise'? Mr. Buffett has this to say on valuations.

He says: "The value of any stock, bond or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset. Note that the formula is the same for stocks as for bonds."

The technique Buffett has mentioned about is also popularly known as the discounted cash flow, or the DCF.

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Ignorance is bliss

While DCF can be performed on all companies, the result the technique spews out may not be reliable in a lot of cases. So, what is the solution? Simple, ignore such companies! Don't trust us? Let us see what Buffett has to say on the problem.

He says, "What counts for most people in investing is not how much they know, but rather how realistically they define what they don't know. An investor needs to do very few things right as long as he or she avoids big mistakes."

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Tackling the 'forecaster' in you

You've identified a strong Indian 'franchise' and you've performed DCF on it. Your DCF based valuation gives you a valuation that is 10 per cent higher than the current market price. Sensing opportunity, you are ready to take the plunge aren't you?

Yes, if you believe you are the perfect 'forecaster' of a firm's cash flows. However, Buffett thinks that he is not and, hence, he relies on a concept called as 'Margin of Safety' (MOS). What is this MOS? Let us hear in his own words.

He says: "We insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success."

When you buy, please ensure that your DCF-based value per share is at least 50 per cent higher than the current share price so that even if your assumptions turn out to be little aggressive or something unexpected happens to the company, the loss of your initial invested amount is minimized.

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The all-important 'SELL' decision

That solid 'franchise' that you bought two years ago and the one that had a strong margin of safety has given you attractive returns and now you wish to dump it. Dump you should if you've found another equally attractive opportunity in another equally strong 'franchise.'

But that is seldom the case. Furthermore, selling involves transaction costs. For these very reasons, Buffett is against the concept of selling strong 'franchises' unless their performance looks weaker from a long-term perspective. This is what he has to say on the issue.

"If the work is done right while investing in a stock, the time to sell it is never." Furthermore, he adds, "Our holding period is forever."

In Buffett, we have someone who has walked the talk and has remained invested in business for years together. Indeed, the urge to sell is very high, but you would do your investment returns a world of good, if you continue to stick with good, solid 'franchises' for years together.

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The golden rules

Having taken you through the entire process of investing, which probably comes closest to the way Buffett does it, we would like to sign off with two of his rules that we believe can transform you into a much better investor.

They are:

Rule #1: Do not lose money; and

Rule #2: Always remember the rule #1.

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