Why the investment strategy of Warren Buffett will work for new investors: Value Investing

By Investment Blogger, on December 28th, 2010

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There is no denying of fact that Warren Buffett is perhaps the greatest value investor of the recent decade. It is estimated that from a meager $100 he has build up a value investing empire worth couple of billions of dollars. He has still not opened a business of his own, all money he had made is by investing in other companies or by acquisitions. It also worth noting that he has never purchased a stock of Microsoft though he is one of the good pals of Bill gates. Warren Buffett is not only blessed with great luck when it comes to value investing in stock market but he carries a great investment philosophy of value investing taught to him by his mentor Benjamin Graham.

Value investing strategy of Warren Buffett is perhaps the simplest investment strategy that all new investors can copy. By using value investing Warren Buffett buys shares of ‘big companies’ when they are ‘undervalued’. Just by using this simple principle Warren Buffett has managed to make billions in the industry of stock market.

The beauty of Warren Buffetts value investing principle is to acknowledge great companies before other investors notices. I know it is not easy and this is the reason why the volume of profits that Warren Buffett made during his early years is far more than what he is making now. There are two reasons for this, one the principle of value investing has become so known that almost every body is using it like a piece of cake. Secondly, it is more of a guess, that all value companies has almost reached its saturation point. So does it means that the value investing principle of Warren buffett will cease to work? The answer is a big no, the problem is that after the global economic crisis of 2007/2008, the markets have revived and all stocks which were then trading at hugely undervalued rates has now gained back its position. According to me in today’s market you will find no stocks (which are preferred by Warren Buffett) which are undervalued. The reason is that in recent times we have seen huge buying from institutions, funds, traders and retail investors. Such cumulative buying has certainly resulted in market price of stocks to become overvalued. This is one reason why, since last two years Warren Buffett is hardly buying any shares. The reason being there are no value stocks left for him to pump his money in. Warren Buffett’s value investing strategy works like a patient eagle, it can wait for suitable prey for hours together. And when the time comes, he does no delay in catching the prey. Warren Buffett can wait for one value stock for year and years. His strategy is simple, he will buy only large cap stocks when their market price is below their intrinsic value.

Companies with a very large market cap are very scarce in the market. This is the reason why all type of market analysts and investors always keep a keen eye on every price fluctuations of such stocks. As soon as the price falls below a set level you can be certain to see a huge buying in such companies. Warren Buffett has his own set of calculation for intrinsic value of company. He will not buy till the market price of stocks fall below (maintaining the margin of safety) this intrinsic value. Till prices are close to its intrinsic value, Warren Buffett does not become excited with small price fluctuations.

It is not easy to whether the market price of a particular stock is undervalued or not. Actually if I would ask a lay man that do you know if the stock price of company A which is currently trading at $10 is undervalued or not, his answer will be “I do not know”. But if I would ask the same question to Warren Buffett he will do his internal calculation on ‘intrinsic value’ of the company and will will easily say that the stock is overvalued or undervalued. But the problem is how a lay investor will calculate the intrinsic value? I am sure that 90% of investors will not have even a faintest idea of how to calculate intrinsic value of a business. Frankly speaking even the so called financial literates of this world also perhaps will not know how to calculate intrinsic value. And this is a reason why not everybody is Warren Buffett.

But please do not loose hope, there are easier ways to know whether a company is trading at underpriced levels or over priced levels. Let me explain you how; suppose you have $1000 in your pocked and you have option of investing is savings account of bank, or companies fixed deposit. If you have to select between this two it will be easier because we know what level of returns these financial instruments offer. Like savings account will give returns between 3.5% to 4% and companies deposit will give between 9% to 10%. So logically we would select companies deposit over savings account.

But if the option is between companies fixed deposit and stocks then it becomes a difficult guess. The reason being, for stocks we do not know what level of returns are possible. But I give you an idea how to estimate the expected returns on stocks then I think I will be able to solve a major portion of your problem. So here it is, open a companies balance sheet and and look at its net profit (net earning) figures for last three years. I am sure if company has made a profit this value will be published in bold letters. Divide this earning with the number of shares outstanding in the market. This will give your earning per share values (say $2). If present market price of stock is say $10 then earning yield will be 20%. Compare this earning with the expected return of companies fixed deposit (10%). Any logical man will know that 20% is better than 10%. So by using earning yield philosophy stock of this company will be a better choice than companies deposit.

How to use Earning Yield to buy stocks

It is not sufficient to buy a stock only on basis of earning yield. It is also important to know that whether the company has capability to generate the same level of returns next year and years to come. This can be judged by calculating the return on invested capital of the company. Suppose the invested capital per share is $5 (working capital + fixed asset) and its earning is $2 then return on capital will be $2 / $5 equal to 40%. Certainly a 40% return on capital is great. Note that the risk free return available in the market is no more than 7%. So 40% return is great.

How to evaluate profitability of a company: Return on Capital (ROC)

I am sure Warren Buffett also must be using the same principles to so his set of complicated calculations pf intrinsic value. Warren Buffett is a great value investor and I hope we can learn form his value investing principles to draw some conclusions of our own.