Image source: The Motley Fool
Billionaire investor Warren Buffett has a stock market record that is nothing short of remarkable. He has often spoken publicly about his approach to investing. That means small private investors like me can learn from his approach. I also use parts of it, although what works for one investor is not necessarily right for another one.
Here are three pieces of Buffett’s wisdom I apply in my own investing.
1. Stick to what you know
Some people get into the stock market because someone tells them about a share that looks set to explode in price. As it moves up, they decide to put some money in (and at risk) – despite knowing nothing about the business. That is not investment, it is speculation.
By contrast, Buffett is a firm believer in sticking to what he calls a “circle of competence”.
How wide or narrow that is does not matter. The key point is only to invest in a business you can understand. That helps explain why Buffett’s portfolio is concentrated in a few areas, such as insurance and consumer goods.
2. Invest with a timeframe of decades
Buffett is the ultimate long-term investor. He invests with a timeframe of years or even decades. Some of his holdings have already been in the portfolio for many decades.
That does not mean he is afraid to sell a dud. When a company turns out to behave in a way that was not part of his original investment idea, Buffett has been willing to sell even at a sizeable loss.
But he thinks for the long term. Rather than buying a share today hoping its price will be higher after it releases its results next week, he buys stakes in what he thinks are great businesses, then lets time do its work.
3. Valuation is critical to successful investing
But Buffett’s approach is not just about buying into great businesses. He also aims to do so at an attractive price. After all, even a brilliant business can ultimately be loss-making if an investor pays too much for it.
Consider his stake in Apple (NASDAQ: AAPL) as an example.
It has a large market of actual and potential users. That market typically also involves users spending big sums of money. Thanks to a strong brand, proprietary technology and large customer base, Apple has a significant competitive edge in that market. That gives it pricing power, in turn fuelling huge profits.
But while profits are big, the company’s current market capitalisation of $3.5trn means it sells on a price-to-earnings ratio of 37. That is too expensive for me to buy Apple shares, as I feel it offers me too little of what Buffett calls a “margin of safety”. He bought when it was much cheaper.
All companies face risks and Apple is no exception. Trade disputes threaten to drive up the price and complexity of its supply chains, while cheaper Chinese rivals are producing increasingly sophisticated phones.
Buffett retains a sizeable Apple stake but he has sold a lot of its shares over the past year. I do not know why, but he realises that successful investment is about price paid, not just the shares purchased.
