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Five Gifts From Warren Buffett

Thu, 29 Aug 2013

On the occasion of his 83rd birthday, we examine how the Berkshire chairman's principles help investors succeed, too.

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Video Transcript

Christine Benz: Hi. I'm Christine Benz for Morningstar.com, and welcome to The Friday Five. Warren Buffett is turning 83 on Aug. 30, so we decided to honor the occasion by discussing some of the key gifts that he has given investors over the years.

Joining me to do that is Jason Stipp. He is site editor for Morningstar.com.

Jason, thank you so much for being here.

Jason Stipp: Great to be here, Christine.

Benz: Jason, you say that the key gifts that Buffett has given investors is that he has given them some of these frameworks to think about their own investing plans, and you've listed five key concepts that you think really have helped lead to better investment decision-making.

Let's start with the first one, Jason. It's the concept of moat, and that's something we've definitely incorporated into our own stock rating philosophy. Let's talk about that concept and why it can be so impactful when investors attempt to pick companies.

Stipp: A lot of these concepts won't be groundbreaking to regular Morningstar.com readers. As you said, we have a moat rating, but I hope to add a few new angles and dimensions on some of them anyway.

The economic moat rating is the idea that strong companies with wide moats have sustainable, competitive advantages. That means they can keep more of their profits longer than companies that don't have those competitive advantages. There are few sources of moat. It makes sense to look for companies like this, because they're going to be stable, buy-and-hold companies that will do better than their peers, even over a very long time periods.

The interesting thing to note about the moat rating, however, is that when a company has wide moat, Morningstar data has found that our fair value estimates are also much more certain about that company. It makes sense, because this company is more stable, it's easier to forecast its returns. But especially for 5-star wide-moat companies, we found the relationship between that 5-star rating and its returns is very strong. So if you're seeing wide moats at a low cost, it's a lot easier to forecast it's going to do well, and in an age of a lot of uncertainty, that's something that we found increasingly you can bank on with more confidence.

Benz: So generally speaking, if you're going through our data and you see that our analyst has a company assigned as having a wide moat rating, you can generally have more confidence in the other things that they're saying about it. So their price to fair value is more likely to be correct and so forth.

Stipp: Right. It's mainly because these companies are just easier to forecast. We know their businesses. We know that their strengths will endure. We've done that fundamental research about the company and its strengths. So because of that we're able to put a much more confident fair value on that firm.

Benz: That leads to the next concept that you think Buffett has really shown investors the way on, and that's sticking with your circle of competence. So if you really understand a company and can look into it and understand how its business works, you're more likely to make an accurate assessment of what it should be worth.

Stipp: I've heard Buffett … talk about this pile that he has, it's a "too hard" pile and I think he sometimes puts tech companies in there. I think he has put financial companies that were overly opaque. The idea is, again, I think working against uncertainty. So Buffett believes in buying businesses, not buying a stock chart in hopes that it will just go up. So you need to know the underlying fundamentals of that business in order to be able to forecast that business's prospects and profits, in order to value it. So if you can't do any of those things, you're essentially just gambling. Of course, what Buffett wants to do is buy businesses, not go to Las Vegas.

Benz: One other concept that Buffett has definitely talked about, and our equity analysts have certainly incorporated into their process, is making sure you give yourself that margin of safety. So in case your thesis doesn't play out as maybe you thought it would, you still have a little bit of downside protection. Let's talk about why that one is so important.

Stipp: That's right. Just understanding a company and liking the fundamentals, and even if it has a wide moat, is not enough for Buffett. He also wants to buy at a good price. Again, I think uncertainty is an issue here, because if you're too optimistic with your fair value estimate, having bought at a discount gives you some buffer. If something unexpected happens to the company, something unforeseen, again, you have a valuation buffer. If you're right and your thesis plays out the way that it should, there is usually some extra return in it for you, because the market will come around and see, this company had been undervalued. It is actually performing better than maybe the market thought. So that means better than a fair return for you if you bought, again, at that discount.

Benz: Another concept that's related to that margin of safety is that sometimes when you're looking for the companies that are truly underpriced, you've got to be willing to swim against the tide. So you say Warren has taught us all to be a little bit contrarian when we look for opportunities.

Stipp: Warren has a lot of different ways he talks about being contrarian. I think one of the most timely [examples] is, during the financial crisis, it was really at the height of pessimism in October 2008, he wrote an Op-Ed for the New York Times called "Buy American, I Am." He said, one of my favorite quotes from that Op-Ed, "If you wait for the robins, spring will be over." What he is saying is, by the time everything looks like it's going to be OK, it's too late to get back into stocks. Now, of course, in October 2008 he was a little bit early being a contrarian. Also he didn't claim that he knew when the market was going to turn around. What he said was, I know it will turn around, and of course he was right. We saw that in March 2009.

The other issue I think in being contrarian that's maybe more attributable to Warren Buffett's partner, Charlie Munger, is the idea of being contrarian to yourself. So that means trying to avoid what we call this "confirmation bias." So, as humans, it's natural for us to want to go out and seek evidence that supports what we already believe. It's very not human to go out and try to prove yourself wrong, because you want to feel smart. So, Munger has often talked about this. I'm sure Buffett has also preached this, but it's good to go out and be contrarian to yourself, find disconfirming evidence that might cause you to think about a stock or a risk that you hadn't considered before because it didn't fit your original thesis.

Benz: Another of the great gifts that Buffett has given investors is this concept of tuning out the noise. Let's talk about why that's so important, Jason.

Stipp: I think part of being successful contrarian is being able to get away from all the chatter, whether it's overly fearful chatter, or it's overly optimistic chatter. It's quite easy to get convinced that things are different this time, or that a stock market that's been going down will continue to go down, or one that's going up will be able to continue to go up forever.

Buffett lives in Omaha, and he likes living in Omaha, and says Berkshire will stay in Omaha, because it gets him away from all of that noise--noise that really doesn't have any effect on the fundamentals. He wrote, "If you can't think clearly in Omaha, you're not going to think clearly any place."

I think it makes a lot of sense to be able to step away from the constant cable news chatter and just make sure that you're focused on the fundamentals of the companies you're invested in and the things that might change those fundamentals instead of the day-to-day squiggles of the stock charts that you're likely to see.

Benz: Jason, thank you so much for being here to summarize some of the greatest gifts that Warren Buffett has given all of us investors over the years.

Stipp: Great to be here, Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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