In the first part of this series, How to Invest Like Warren Buffett: Fear and Greed we looked at when Buffett makes his purchase. He does so at the opposite time of most amateur investors, when an investment isn’t the most popular and in fact when it is probably out of favor.
One good example was Buffett’s multi-billion dollar investments in Goldman Sach and General Electric during the market meltdown in late 2008. At a time when it wasn’t clear that the financial system would survive, he invested billions of his cash in quality companies that were unpopular at the time.
After looking at when to buy, the next logical question is what to buy.
Warren Buffett has some simple principles that he uses to determine what to buy. The first is to buy quality and in fact a quality company that he could hold forever (he says his favorite holding time period is forever).
So, what are the components and characteristics of a quality company?
1) A simple business model that Buffett says that he can understand and that will be roughly the same in 10 years or more.
- This business must have an economic moat of some sort that keeps out a plethora of competition. This moat allows the company to earn a high return on equity.
2) The company must produce consistent cash flow — this characteristic follows from the first above. Buffett is talking about real cash flow, not just theoretical earnings based upon extending generous terms or loans to the customer to buy the product or service.
- An example of “faking” cash flow would be Lucent Technologies, which, during the tech bubble of the late 1990′s, inflated their book earnings by selling to customers through credit terms which the customers could not repay. They also manipulated their financial statements to report better numbers than were true.
- Buffett would reject investing in a company like Lucent because the business requires constant innovation, it was sufficiently complex that the true financial health could be hidden by financial chicanery, and there was not cash flow, just paper profits (which never materialized).
3) A management team that can be trusted.
“When hiring, you look for three qualities: integrity, intelligence, and energy. And if you don’t have the first, the other two will kill you.”
- A management team without integrity is very likely to put their personal priorities ahead of the business’s which will ultimately lead to disaster for the company.
A summary for the concept of what to buy is contained in Buffett’s quote below:
“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price,” because “time is the friend of the wonderful company, the enemy of the mediocre.”
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