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Warren Buffett’s 10 Lessons for Investors (Part 1 of 11)

Buffett is a once-in-a-lifetime investor

We all know what a great investor Warren Buffett is. His investing prowess is unmatched. His investments in companies such as IBM (IBM),Coca­Cola (KO), and Wells Fargo & Co. (WFC) are part of investment folklore. He has consistently beat benchmarks such as the S&P 500and outperformed ETFs that track the S&P 500 such as the iShares Core S&P 500 ETF (IVV).

He’s also one of the rare few who regularly share their wisdom with investors. Much of this wisdom may be found in his famous annual letters.These letters are addressed to shareholders of his holding company, Berkshire Hathaway (BRK­B). But, these letters are also available toinvestors online, and can be downloaded for free.

Buffet’s 2014 annual letter has many firsts

Some of us will have read his annual shareholder letter for 2014. Others may have read a news article about it. This letter includes many firsts.

Berkshire completed fifty years under Buffett’s stewardship this year. So, this was his fiftieth annual letter. In it, he summarized theperformance record of Berkshire under his leadership. The letter also includes a write­up by Charlie Munger, his co­partner at Berkshire, onthe future expectations for Berkshire.

Buffet’s cornerstones of investing

Each one of Buffet’s letters is packed with words of wisdom for investors. Yet, there are some things he keeps on repeating regularly. Whatare they? Fret not. You don’t have to read all fifty letters to find out. We’ve done the hard work for you. After carefully going throughBuffett’s letters, we’ve picked out the ten most important characteristics of his investing style to share with you. To learn more, keep reading.

Warren Buffett’s 10 Lessons for Investors

The Buffett Letters: 10 Commandments to InvestorsBy Saul Perez • Apr 1, 2015 9:39 am EST

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Warren Buffett’s 10 Lessons for Investors (Part 2 of 11)

Buffett’s investing style

There are three broad aspects of Warren Buffett’s investing style:

1. investment philosophy2. security selection3. psychology of investing

He has important things to say about all three. In this series, we’ll cover Buffett’s ten most important commandments.

Buffett’s 50-year record is all the proof you need

The biggest investing lesson to be learned from Buffett’s fifty years at Berkshire Hathaway (BRK­B) is this—long­term investing is good.

Buffett has averaged an annual compound gain of 21.6% over these fifty years. In absolute terms this is, hold your breath, a return of1,826,163%! How did he do it? By investing in good companies, holding them for a long time, and letting compound gains do the rest.

The power of compound gains is exponential

Assume you’re as good an investor as Buffett. You want your portfolio to grow 50 times. At Buffett’s 21.6% rate of return it would take youapproximately 20 years to achieve this. Now, you decide to reduce your investment time horizon to 15 years. What will be the impact on yourreturns? In 15 years, at Buffett’s rate of returns, your portfolio will grow only 19 times. Can you see the impact just five years has on yourinvestments? This is the power of compound gains.

Most of the money Buffett made in stocks including Wells Fargo & Co. (WFC), Coca­Cola (KO), and IBM (IBM) is the result of multi­decadeinvesting.

Long-term investing helps keep costs low

Another benefit of long­term investing is that you spend less money on brokerage fees and other costs associated with frequent trading. Themoney saved adds to the portfolio and earns higher returns. Investing in ETFs such as the iShares Core S&P 500 ETF (IVV) can also help youkeep costs to a minimum.

Long-Term Investing Pays the BestBy Saul Perez • Apr 1, 2015 9:40 am EST

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Warren Buffett’s 10 Lessons for Investors (Part 3 of 11)

Bonds are considered safe

The majority of investors believe bonds are safer than stocks. The main reason is that bonds pay regular interest. Bonds issued by thegovernment have the added allure of being guaranteed by the government. But, is stable also safe?

Buffett emphatically declares stocks to be safer

Buffett had this to say in his 2014 Berkshire Hathaway (BRK­B) letter to shareholders—“The unconventional, but inescapable, conclusion to bedrawn from the past fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest insecurities – Treasuries, for example – whose values have been tied to American currency. That was also true in the preceding half­century, aperiod including the Great Depression and two world wars. Investors should heed this history. To one degree or another it is almost certain tobe repeated during the next century.”

Now, you can’t be more emphatic than that.

Stocks add to purchasing power over the long run

One of the main reasons that stocks are safer is that their returns beat inflation over the long term. High­grade bonds, on the other hand, atbest match inflation. So, bonds aren’t able to keep your purchasing power intact in the long run. Stocks, on the other hand, add to yourpurchasing power.

The performance of stocks against bonds or the debt of the same companies is also a good indicator. Here as well, stocks beat the bonds ofcompanies such as Wells Fargo & Co. (WFC), IBM (IBM), and Coca­Cola (KO). These three stocks account for 3.08% of the iShares CoreS&P 500 ETF (IVV).

Stocks Beat Bonds over the Long Run By a Big MarginBy Saul Perez • Apr 1, 2015 9:40 am EST

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Warren Buffett’s 10 Lessons for Investors (Part 4 of 11)

Price and value are two distinct concepts

To buy any investment you need to pay. But how much should you pay? There are many companies belonging to many different industries onthe stock market. Some of them, such as Wells Fargo & Co. (WFC), belong to a cyclical industry. Some companies, such as IBM (IBM),belong to the technology sector that’s driven by very different factors. Then there are consumer companies, such as Coca­Cola (KO), that arecompletely different.

Two problems for investors

An investor faces two main questions as a result of this variety. First, which sectors or industries to choose to invest in. And second, what priceto pay for shares. Buffett is crystal clear on how to approach these questions.

Invest in what you understand

Buffett is emphatic on the question about what sectors or industries to choose. He believes it doesn’t matter. It’s better to invest in a goodcompany in a not­so­good sector than to invest in a not­so­good company in a good sector. Investors need to invest in sectors and companieswith business models they understand.

Focus on value and don’t look at price

Intrinsic value is a concept that was introduced by Benjamin Graham that refers to the true worth of a business. It can be estimated with thehelp of a company’s historical financial statements. You don’t need to estimate intrinsic value accurately. A rough estimate is good enough.You then need to relate it to growth. Will the future growth justify the current price? If the price is much higher, then it’s best to avoid investing.

This focus is why Berkshire Hathaway (BRK­B) has been able to beat the returns of ETFs like the iShares Core S&P 500 ETF (IVV).

Warren Buffett’s 10 Lessons for Investors (Part 5 of 11)

Price Is What You Pay—Value Is What You GetBy Saul Perez • Apr 1, 2015 9:40 am EST

Management Is of Paramount Importance

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Evaluating management is the next step

Once an investor has found a good business to invest in at a reasonable price, he needs to look at the management of that business. InvestorWarren Buffet believes that management, especially the CEO, plays a very important role in a company’s success.

Would you trust a thoroughbred to win if it had an average or worse, a poor jockey? No, you wouldn’t. It’s the same thing with the managementof a company. Buffett always looks for certain qualities in management.

Qualities of an excellent manager

The CEO should have a demonstrated history of exceptional performance in his career. The CEO should have a long­term vision for thecompany and be able to execute it with the help of trusted subordinates.

You may think well, Buffett can always talk to a CEO. But how do you judge a CEO? For one, you can look at CEO rankings to see how wellregarded a CEO is. Remember to look at a few years’ worth of rankings to get a better idea about consistency. You can also readmanagement discussions in annual reports to determine if the CEO has vision.

Buffett believed in some excellent CEOs

Buffett has put stock in some excellent CEOs at Berkshire Hathaway (BRK­B). Richard Kovacevich of Wells Fargo & Co. (WFC), RobertoGoizueta of Coca­Cola (KO), and Louis Gerstner of IBM (IBM) were some of the CEOs Buffett trusted. They were a big reason why Buffett’sportfolio returns beat indices and ETFs like the iShares Core S&P 500 ETF (IVV).

Nevertheless, you should always focus first on the quality of the business and then the CEO. Remember Buffett’s famous lines—“When amanagement with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business thatremains intact.”

Warren Buffett’s 10 Lessons for Investors (Part 6 of 11)

Management Is of Paramount ImportanceBy Saul Perez • Apr 1, 2015 9:40 am EST

Free Cash Generating Businesses Are Best

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Free cash generation makes the best business

Investor Warren Buffett believes that the primary objective of any good business should be to generate lots of free cash. This free cash, alongwith a reasonable amount of debt, if required, can then be used to fund the expansion of the business. Expansion leads to more free cashbeing generated. This should be the virtuous cycle a business aims for.

Berkshire was once a cash guzzler

Buffett abhors any business that constantly needs fresh capital to grow. Such businesses are just cash guzzlers in his opinion. BerkshireHathaway (BRK­B) was a cash guzzler before Buffett took over its management. Berkshire was a textile company that constantly requiredcapital infusion. Buffett sold the textile business and turned it into an investment and insurance company.

Once a business gets into this virtuous cycle, it’s able to maintain strong earnings performance for a long time. But getting there is difficult.Few companies are able to do it. Most of the companies in Buffett’s portfolio maintain this virtuous cycle.

Most of Buffett’s holdings are virtuous

Coca­Cola (KO) generates enough cash to fund its expansion. It has always maintained a manageable debt­to­equity ratio. Another exampleof a company with this virtuous cycle is IBM (IBM). It has a comfortable debt position and a high debt servicing capacity. This high debtservicing capacity is indicated by a stellar interest coverage ratio. This focus on cash is one of the major reasons that Berkshire’s returns havebeaten indices and ETFs such as the iShares Core S&P 500 ETF (IVV) and the iShares Russell 2000 ETF (IWM).

Warren Buffett’s 10 Lessons for Investors (Part 7 of 11)

Size of investment is irrelevant

Often, small investors think that big investors are better equipped to invest. Investor Warren Buffet says this isn’t so. This way of thinking is justa psychological bias.

By Saul Perez • Apr 1, 2015 9:40 am EST

Big Investors Have No Real Advantage over Small InvestorsBy Saul Perez • Apr 1, 2015 9:40 am EST

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When you see someone introduced as an expert on national television you are more likely to believe him. The keyword here is “believe.” Youbelieve because he’s on television and has been introduced as an expert. It may well turn out that he doesn’t know much about investing at all.Buffett believes that’s often the case.

Benefits of being a smaller investor

In fact, smaller investors have one big advantage. Their buying size is small. This means they can buy and sell shares on the stock exchangewithout impacting the price of the stock. Bigger investors, whose buy or sell volumes often account for a substantial part of a day’s volume,can’t do so without impacting the market for that particular stock.

A smaller investor can build a position on any day in Coca­Cola (KO), Wells Fargo & Co. (WFC), or IBM (IBM). A bigger investor needs to planhis purchases due to large portfolio allocations. As a result, the smaller investor can be more nimble.

Big investors are also likely to have more biases. The most important of these biases is the bigger investors’ self­perceived authority to invest.As Buffet always says, very few people are humble enough to acknowledge their limitations.

Buffett always reminds himself of this bias as a big investor. He tries to remain grounded. This has helped Berkshire Hathaway (BRK­B)achieve a stellar performance record. Berkshire has beaten the returns of the iShares Core S&P 500 ETF (IVV) and the iShares Russell 2000ETF (IWM) over the long run. Remaining grounded should help smaller investors too.

Warren Buffett’s 10 Lessons for Investors (Part 8 of 11)

No one is superhuman—we all make investment mistakes

Investor Warren Buffett thinks making mistakes are part and parcel of investing. It should come as some solace to normal investors that evenhe makes mistakes. Nevertheless, what Buffett says is that how you deal with the mistakes is the more important part of investing.

Investment Mistakes Are Common—Admit It and Cut Your LossesBy Saul Perez • Apr 1, 2015 9:39 am EST

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Buffett’s investment in Tesco

Buffet mentions one of his big investment mistakes in one of his Berkshire Hathaway (BRK­B) letters to investors: “At the end of 2012 weowned 415 million shares of Tesco, then and now the leading food retailer in the U.K. and an important grocer in other countries as well. Ourcost for this investment was $2.3 billion, and the market value was a similar amount. In 2013, I soured somewhat on the company’s then­management and sold 114 million shares, realizing a profit of $43 million. My leisurely pace in making sales would prove expensive. Charliecalls this sort of behavior “thumb­sucking.” (Considering what my delay cost us, he is being kind). During 2014, Tesco’s problems worsened bythe month. The company’s market share fell, its margins contracted and accounting problems surfaced. In the world of business, bad newsoften surfaces serially: You see a cockroach in your kitchen; as the days go by, you meet his relatives.”

Cut your losses as soon as you realize your investment mistake

The most important lesson for investors is this. Analyze your selections carefully before investing in them. Keep a watch on them, and if youmade a mistake, get out rather than wait.

Having said that, if you think that the company remains good for the long term but has a temporary problem, stay invested. Coca­Cola (KO),IBM (IBM), and Wells Fargo & Co. (WFC) all had temporary problems over the years, but Buffet stayed invested. That’s because there was nolong­term problem with these companies. These three stocks account for 3.08% of the iShares Core S&P 500 ETF (IVV).

Warren Buffett’s 10 Lessons for Investors (Part 9 of 11)

Overconfidence leads to borrowing

When the markets are on a tear, many investors get carried away. They begin to think that the only way markets will move is up. This is whenemotions get the better of logic. Many investors begin to borrow to invest, thinking the returns will beat the cost of borrowing.

Borrowing to Invest Does More Harm Than GoodBy Saul Perez • Apr 1, 2015 9:39 am EST

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Investor Warren Buffett, an astute observer of human behavior, has often seen other investors make this mistake. He says as much in one ofhis Berkshire Hathaway (BRK­B) letters to investors. “Investors, of course, can, by their own behavior, make stock ownership highly risky. Andmany do. Active trading, attempts to ‘time’ market movements, inadequate diversification, the payment of high and unnecessary fees tomanagers and advisors, and the use of borrowed money can destroy the decent returns that a life­long owner of equities would otherwiseenjoy. It is good while it lasts.” But sooner, rather than later, reality bites and brings you crashing to the ground.

Borrowing to invest reduces long-term returns

Buffett offers another strong piece of cautionary advice to investors about borrowing. “Indeed, borrowed money has no place in the investor’stool kit: Anything can happen anytime in markets. And no advisor, economist, or TV commentator – and definitely not Charlie nor I – can tellyou when chaos will occur. Market forecasters will fill your ear but will never fill your wallet.”

Buffett doesn’t borrow to invest

Buffett uses float to invest. Float, in simple terms, is money you get before you use a service. One example of float is a traveler’s cheque. Themoney is already paid before you use any cheques. The insurance business is another example of float.

Buffett used Berkshire’s float to invest in his large holdings such as Coca­Cola (KO), IBM (IBM), and Wells Fargo & Co. (WFC). These threestocks account for 3.08% of the iShares Core S&P 500 ETF (IVV).

Warren Buffett’s 10 Lessons for Investors (Part 10 of 11)

Buffett has unique views on risk

Measuring risk is difficult. In academic finance, what can’t be measured is often meaningless. So, finance academics use volatility in pricing asa proxy for risk. Investor Warren Buffett doesn’t believe in this definition of risk. Buffett doesn’t think price drops matter. If your companyselection is right and you can hold investments for a long enough time, eventually, you’ll profit from them.

Risk Is a Permanent Loss of CapitalBy Saul Perez • Apr 1, 2015 9:40 am EST

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Fear of risk due to volatility leads to bad investment decisions

Buffett summed it up perfectly in a Berkshire Hathaway (BRK­B) letter to investors. He said if investors fear price volatility, erroneously viewingit as a measure of risk, they may end up doing some very risky things.

He gave the example of pundits who, six years ago, saw stock prices falling and advised investing in so­called safe Treasury bills or bankcertificates of deposit. Investors who heeded this advice are now earning more meagre returns than they had previously expected.

If investors hadn’t feared this price volatility, they could have earned good returns simply by investing in index funds or ETFs such as theiShares Core S&P 500 ETF (IVV) and the iShares Russell 2000 ETF (IWM).

Buffett has held stocks through down cycles

Buffett holds on to stocks he’s confident in during down cycles and comes out the better for it over the long run. Wells Fargo & Co. (WFC) fellduring the subprime crisis. IBM (IBM) fell throughout the dot­com bubble. Coca­Cola (KO) traded below its 1998 highs for the next 15 years.But Buffett held on. The KO stock finally rose above its 1998 highs in 2014. This long­term view of investment negates volatility in the short runand earns investors good returns.

Warren Buffett’s 10 Lessons for Investors (Part 11 of 11)

Acquisitions don’t normally create value

Investor Warren Buffett has always treated companies that make acquisitions with suspicion. The main reason why is that acquisitions areoften carried out for unsound business reasons. Many acquisitions are also quick fixes that end up destroying long­term investor wealth. Infact, financial studies bear this out. Most acquisitions destroy value rather than create it.

Acquisitions Should Be Treated with CircumspectionBy Saul Perez • Apr 1, 2015 9:40 am EST

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Manager’s envy leads to most acquisitions

If a business isn’t growing its sales, the easiest solution is to acquire a competitor. More often than not, acquisitions are made to show goodfigures to the board of a company. Sometimes, management salary is linked to the short­term performance of a company. This too providesperverse incentive for management to acquire.

Today, leveraged buyout options are also available. In a leveraged buyout, a high amount of debt is taken on to acquire companies.Leveraged buyout performance is even poorer. CEOs often forget the price versus value fundamental when acquiring. The price paid is so farremoved from reality that most acquisitions don’t even have a chance to succeed at the outset. By “succeed,” we mean add incremental valueto the acquirer.

Wells Fargo & Co.: A smart acquirer creating value from acquisitions

Berkshire Hathaway (BRK­B) always keeps the price versus value equation in mind when making acquisitions or when investing in a companywith a history of acquisitions.

Wells Fargo & Co. (WFC) is the largest holding in Berkshire’s portfolio. It also accounts for 1.39% of the iShares Core S&P 500 ETF (IVV).Wells Fargo has a history of acquiring smaller banks. But, Wells Fargo has always been smart about acquisitions and has consistently createdvalue with them. The same can be said of some of Berkshire’s other holdings such as IBM (IBM) and Coca­Cola (KO).

If investors follow Buffett’s ten commandments of investing, they’re likely to become better investors.

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