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Lesson 17: Warren Buffett’s 4 RulesCamille Alcera2021-10-04T09:50:30-04:00
TIP Academy
MODULE 2 | LESSON 17:
LESSON SUMMARY
This very short lesson outlines the 4 rules that Warren Buffett uses when he selects stocks. The video emphasizes the following points that all rules with no exception have to be met. The rules are:
- Stock must be managed by vigilant leaders
- Find a stock/business that has great management. This goes without saying, but leadership has a compounding impact on a business. Without selecting a great manager, the company will likely suffer over time. We have made an entire video to help you find and select a great CEO.
- Stock must have long term prospects
- Next, Buffett tries to find a business/stock he can own forever. Now that might sound counter-intuitive to many day traders, but the purpose is very simple. Stock is nothing more than owning a business. Think of a stock like a mini-business. Owning 1 share is no different than owning every share because each share is proportional. As a result, you wouldn’t want to buy a business on the main street, only to sell it to another person the next day. That doesn’t make any sense. Even if you were able to make a quick profit, you’ll pay enormous capital gains for the sale. Investors who don’t understand the essence of what a stock is – a real business – have a tendency to trade from day to day. Warren Buffett tries to buy companies he can hold forever because he doesn’t want to pay capital gains tax – not to mention he wants to collect all the profits the business is making.
- Stock must be stable and understandable
- Buffett tries to find stocks that are stable and understandable. By implementing this rule, Buffett can generally assess the value of a stock because he can somewhat predict its cash flow and earnings power. For example, if you were going to buy a company on Main Street, would you consider buying a company that made unpredictable profits, or would you find the company that generally produces similar results from month to month? Seems like a simple question when you look at it from that perspective. When a company makes similar profits from month to month, you can assess how much money it will make in the long-run, and properly assess a price or value. This is why Buffett tries to find businesses that are stable and predictable.
- Stock must be undervalued
- You guessed it, Buffett determines a price that he thinks the stock is worth. Think about it like this; would you go and buy a business on Main Street without determining a value that you thought it was worth? That sounds like a crazy idea – right? Well, every time a person purchases a stock on the stock market without determining a value for what THEY think it’s worth, they’re doing exactly that. Buying a business with no expectation for its value. In Course 3, lesson 35, we introduce the student to a method for determining the intrinsic value of a stock. We use a discount cash flow calculator– like Buffett. If you want to check it out (because you probably don’t believe it’s free) please do. With that said, we highly recommend you don’t start here. There are many other things you need to learn first before having fun with that calculator!
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Warren Buffett's investment principles are a cornerstone of value investing, and they're backed by a wealth of evidence from his successful career. Let's dive into each concept:
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Vigilant Leadership: Buffett places immense importance on the leadership of a company. His method involves evaluating not just the current CEO but also the company's overall management. He looks for leaders who are competent, honest, and have a clear vision for the company's long-term success. This isn't just a theory; Buffett's success with companies like Coca-Cola and American Express highlights his knack for identifying and relying on strong leadership.
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Long-Term Prospects: Buffett's perspective on buying stocks for the long haul reflects his belief that a stock represents ownership in a business, not just a ticker symbol to trade. His investment in companies like See's Candies and Geico demonstrates his commitment to holding onto stocks that have enduring prospects, allowing their value to compound over time.
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Stability and Understandability: This principle is about investing in businesses with predictable earnings and understandable operations. By choosing companies with consistent cash flows and businesses that are easy to understand, Buffett minimizes uncertainty in his investments. His bets on companies like Procter & Gamble showcase this approach, as he favors businesses with straightforward models and predictable revenues.
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Undervaluation: Buffett's strategy revolves around finding stocks that are undervalued in the market. He determines the intrinsic value of a stock and waits for it to trade below that value. His use of fundamental analysis, like discounted cash flow models, emphasizes the importance of understanding a company's worth. His successful investments in undervalued companies such as Wells Fargo and IBM underscore the effectiveness of this approach.
Each of these principles has contributed significantly to Warren Buffett's success as an investor. His track record and the performance of Berkshire Hathaway over the years serve as evidence of the effectiveness of these strategies.
