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Know How: How to Put Buffett’s Philosophy into Practice

Lessons from this year’s Berkshire Hathaway meeting.

Matthew Coffina, CFA, 06/17/2013

This article originally appeared in the June/July 2013 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.

Year after year, shareholders return to Omaha to hear Warren Buffett and Charlie Munger expound on topics large and small. Here are some of the enduring lessons that came up in this year’s Berkshire Hathaway meeting.

1 It’s OK to pay a fair price for a company with very strong, growing competitive advantages.

Buffett credits Munger with teaching him that “it is far better to buy a wonderful business at a fair price than to buy a fair business at a wonderful price.” In my opinion, investors are far more likely to lose money by compromising on quality to buy an apparently “cheap” stock than by purchasing a fairly valued company with a very strong competitive position (what Morningstar calls a wide moat).

2 Stay sane while others go crazy.

Buffett said the average investor can expect to see four or five serious market dislocations in a lifetime. The challenge is to have the “mental fortitude” to take advantage of them.

3 Investing is about much more than just numbers.

Investing involves a large degree of subjective judgment. Buffett and Munger don’t buy stocks solely based on financial ratios; they need to understand how the business actually works.

4 Think like an owner.

Thinking like an owner changes your whole perspective on stock investing. If a company has a bad quarter or two because it is making investments for the future, that’s a good thing. If there’s no change in a company’s fundamental outlook, a decline in the stock price can be a good thing, too; it allows you to increase your ownership stake at a better price.

5 Stay within your circle of competence.

For investors who have neither the time nor inclination to research individual securities, Buffett and Munger recommend low-cost index funds. Berkshire’s managers concentrate on companies in the United States and have no problem passing on stocks whose future outlook they deem too hard to understand.

6 Management quality and culture are essential.

You want to find companies where outstanding stewardship is part of a deeply ingrained culture that will live on through future management transitions.

7 Management should set a straightforward performance yardstick, and then stick to it.

Buffett measures performance for Berkshire Hathaway by using growth in book value per share. He compares this growth with the returns of the S&P 500; if Berkshire’s book value appreciates faster than the S&P 500, Buffett and Munger are earning their keep. If book value doesn’t keep up with the S&P 500, in Buffett’s words, “our management will bring no value to our investors.”

8 In general, however, book value is a terrible proxy for intrinsic value.

Book value is based on historical cost and occasionally arbitrary accounting rules. Companies that make wise investments over time will end up with assets worth more than their historical cost, but the opposite could just as easily be true of companies that make poor investments.

9 Macroeconomic forecasts are of little use to investors.

“To ignore what you know because of predictions about something nobody knows is silly.”

10 The United States’ past and future is a story of ever increasing prosperity.

Buffett said that he envies a baby being born today in the United States because, “on a probability basis, that is the luckiest person ever born.” Buffett is a perpetual optimist.

Matthew Coffina is a stock analyst at Morningstar.

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