Sage Investment Advice from the Oracle of Omaha

Toward the end of each February,  Berkshire Hathaway (BRK.B) CEO Warren Buffett pens his annual letter to shareholders, wherein he reviews the conglomerate's prior-year results and also takes the opportunity to comment on topical issues in the investment world. The latter is usually a mix of homespun wisdom and satirical allegories that I think, if followed, can help most people become significantly better investors.

In Berkshire's 2006 shareholder letter, released last Thursday, Buffett commented for the second year in a row on how the fees charged by many investment managers--primarily private equity funds and hedge funds--continue to dent investor returns. Buffett used the example of a hedge fund generating a 10% gross return, but after giving effect to both the management and performance fee, the fund's investors would only have realized a 6.4% net return. Even though Buffett used 10% only as an example, it's not an entirely unrealistic return, and as Buffett points out, a low-cost investment in an S&P 500 index fund earned about a 15% return, costing investors only a "token fee."

The obvious implication here is that the large fees paid to some investment managers can eat away a big chunk of investors' potential excess return. So, is the answer for most investors to simply invest in a passive index fund? Well, even though last year this strategy would have generated a pleasing return, my colleagues at Morningstar collectively believe the S&P to be modestly overvalued heading into 2007. As such, in my opinion, an index investment doesn't seem like a good option at this point, either.

Find Good Businesses
So what are investors to do? Well, Buffett's shareholder letter points out a few things that I think, when taken together with Morningstar's research, can help investors generate pleasing returns over time. First, when discussing the challenges facing the newspaper industry, Buffett remarked, "If you want to get a reputation as a good businessman, be sure to get into a good business." I think that the natural corollary to this statement is that if you want to be a good investor, be sure to invest in a good business.

At Morningstar, we think a good business is one that can earn a sustainable return above its cost of capital. We define these types of businesses as having an economic moat, which is the result of the business possessing one or more sustainable competitive advantages. We refer to companies with very strong competitive advantages as wide moat firms, and those with still good--but not exceptional--competitive advantages as narrow moat firms. Thus, I think that by simply limiting your investment universe to narrow and wide moat companies, you already have a leg up on becoming a better investor.

Buy at a Discount
However, simply buying all wide or narrow moat firms will not necessarily result in improved investment returns, as the price paid for these types of businesses is equally important. In this year's shareholder letter, Buffett included a quote from the son of his longtime friend and former colleague Walter Schloss that said of Schloss' investment philosophy, "We try to buy stocks cheap." Buffett went on to say, "Walter produced results over his 47 partnership years that dramatically surpassed those of the S&P 500."

At Morningstar, buying stocks cheap isn't a new concept, and we view an inexpensive stock as one that is trading at a substantial discount (margin of safety) to its intrinsic value. Those stocks that have the largest margin of safety relative to our estimate of intrinsic value generate a 5-star rating, which means that our analysts think that these stocks are cheap enough to potentially generate above-average returns for investors over the long haul.

Now you're probably thinking, perfect, if I just buy businesses with moats whose stocks are also rated 5 stars, I'll earn superior investment returns. Well, perhaps, but there is another element to consider as well. While Buffett mentioned explicit management fees in this year's shareholder letter, in last year's letter he wrote, "For investors as a whole, returns decrease as motion increases." I also think it's advantageous to keep one's portfolio turnover low, as this will help minimize the explicit costs, but perhaps more importantly, low turnover will also allow investors to benefit from the effects of compounding, providing an even bigger boost to long-term returns.

To recap, I think that by combining Buffett's advice with Morningstar's research, investors can improve their returns by utilizing this relatively straightforward formula that seeks to purchase good businesses at inexpensive prices while keeping portfolio turnover low. What's more, by following this strategy, investors can hopefully avoid the fate of Buffett's allegorical "Gotrocks family," who actually get poorer each year, while at the same time enriching their bevy of investment managers.

Stocks for Your Radar
To get started boosting your own returns, register for a free two-week Premium Membership trial with Morningstar and sign up for my e-mail alerts. I'll help get you going with the following five wide-moat stocks that are currently rated 5 stars by Morningstar.

 Automatic Data Processing (ADP)
ADP is the leader in payroll processing solutions, and it benefits from its position in several ways. It boasts a 30% share of this market, by Morningstar analyst Kristan Rowland's estimates, and its large size enables it to benefit from scale economies. Additionally, its fixed-cost investment in payroll processing solutions means that each new customer added is hugely profitable and that returns on invested capital are likely to remain topnotch. Further, it would be prohibitively expensive for a new entrant in this business to match the investment ADP has made in its platform and brand. The unrivaled scale, high entry barriers, and brand recognition all contribute to ADP's wide economic moat.

 CheckFree 
CheckFree's transaction-processing business has great growth prospects and is surrounded by a wide economic moat, says Morningstar analyst Mark Weber. The firm's economic moat is a product of scale and network economics. CheckFree's costs are largely fixed, and the firm handles almost 5 times as many transactions as its nearest competitor, generating unmatched economies of scale. As a result, CheckFree can offer lower prices than the competition.

 Getty Images  
Getty Images' stock imagery business generates loads of excess cash for its shareholders. Increasing competition at the lower end of the market has presented new challenges, however. Morningstar analyst Jonathan Schrader thinks Getty's moat is wide enough to withstand these new pressures, allowing the company to continue to generate excess returns for many more years, albeit at a slower growth rate than the company has enjoyed in the past. And the stock looks like a veritable bargain following last Tuesday's decline, which shaved more than 3% off its price.

 Marsh & McLennan  (MMC)
Marsh & McLennan's wide moat--owing to brand leverage and the firm's broad perspective on solving customer risk-management problems--has been reinforced by new, motivated leadership, says Morningstar analyst Bill Bergman. New initiatives have borne fruit in recent renewed sales momentum and margin expansion, and returns should improve in the years ahead, in Bergman's opinion.

 United Technologies (UTX)
Aerospace and industrial conglomerate United Technologies looks downright cheap, as last Tuesday's market correction lopped nearly 3% from the company's stock price. Nevertheless, there's much to like here. United Tech generates 60% of sales from markets in which it holds the number-one or -two market share position. In Morningstar analyst Tom D'Amore's opinion, the company also appears poised to benefit from foreign demand: International markets recently accounted for 60% of revenue, attesting to the firm's well-established presence abroad.