1. Own Businesses That Drown You In Cash
Charlie Munger told the story of a friend of his that was engaged in the farm equipment business. Each year, after working hard and running his operation, he’d look out in the yard at the equipment that had been traded in or was awaiting sale and lament, “there’s my profit sitting out there.” What you want, Charlie explained, is the type of business that you can take money out in the form of cash dividends without it hurting the competitive position of the enterprise. Warren Buffett then chimed in that you want the type of company that’s going to send you a check every month.This would seem elementary, but it’s remarkable how few business owners and investors actually look for this type of asset. For instance, think about someone striking out on his or her own. Often, they’ll say, “I’m going into auto parts,” or “I’m going to start a car wash.” Very, very few people do the analysis necessary to calculate how they can generate the highest profits on the lowest capital investment, which is ordinarily a recipe for excess funds that can be taken out to spend or redeployed to additional investments. Instead, they do what they know, convinced that hard work alone is sufficient to make a better life for their family.
This rule is just as true in stocks – look for companies that earn high returns on equity, assets, and capital, have durable competitive advantages, management that thinks and acts like owners, a strong balance sheet, and that you understand. (If you can’t explain to a third grader in one or two sentences how a company in which you own stock actually makes its profit, you are gambling, not investing.)
2. Pay Attention to Benjamin Graham
Asked to boil down successful investing, Berkshire Hathaway shareholders are told it comes down to three words – margin of safety. Buffett says that is the key to generating satisfactory returns over time because it insulates you from mistakes in judgment, the business cycle, or unforeseen challenges. Put simply, the margin of safety is the difference between the price you pay and the conservatively estimated intrinsic value of an asset, be it a stock, bond, mutual fund, apartment building, or corner grocery store.He also said that Graham’s concept of Mr. Market is a very useful one. He said to think of the stock market as a manic depressive business partner that offers to buy or sell stakes in businesses to you based upon whatever his mood happens to be at the moment. That way, you understand in a fundamental way that, “the market is there to serve, not guide, you.”
3. The Quality of a Business Trumps Managerial Talent
During the question and answer session, Buffett said he’d rather have an excellent business run by mediocre managers than a terrible business run by brilliant managers. That’s counter to the prevailing Wall Street wisdom where analysts and commentators often look for CEO superstars.Businesses that have consumer products or brand names that allow them to raise prices in excess of the rate of inflation are going to do better for the owners than those who have little or no control over product pricing (for more information, see The Perils of the Commodity - Type Business). This includes food companies such as Wrigley, Coca-Cola, Kraft, etc. In an economic recession or depression, you may have your car repossessed but you are unlikely to change your snacking or eating habits. If anything, you may find those comfort foods get purchased more!
4. If You Want to Beat the Market, Think Small
For those who have the huge time and are willing to spend it researching, studying, and analyzing businesses, small stocks are almost always going to present more opportunities than large stocks because there are thousands upon thousands of potential situations to discover and exploit. In fact, Buffett told shareholders that the targeted expected return on many of the big investments Berkshire has been making is between 7% and 11%, roughly, and that if they expect the long-term results of the company to even remotely compare to the past record, they should sell their stock because they’re going to be disappointed.For those investors not willing or able to put the time and effort into selecting smaller company stocks, Buffett recommends an index fund of the S&P 500, possibly Vanguard, and to dollar-cost-average into the position over a length of time. For more information, read If You Can’t Beat ‘Em, Join ‘Em.
5. Sometimes, Sectors Can Be Appropriate
One of the standout comments during the Berkshire Hathaway shareholder meeting was, “We do not pick drug companies one by one.” In other words, if you thought the drug sector was undervalued, you might do better to purchase a basket of stocks, or possibly a HOLDR or ETF, instead of trying to figure out which research and development pipeline had the most promise.
