Tom's Life Bits

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===== 10 investing basics from Buffett =====

The Oracle of Omaha became one of the world's richest people by adhering to simple but critical tenets. Here are his rules for smart living and savvy investing.

By Michael Brush
MSN Money

Last year's market madness didn't just flush away wealth. It also washed away a lot of investors' confidence.

So let's consider a dose of optimism, wisdom and insight: the basics as taught by that perennial investing Yoda, Warren Buffett.

For new investors or those now starting over, there's good news here because Buffett's investment success comes from some easy-to-grasp human qualities as much as sophisticated expertise in balance sheets.

Buffett would be the first to say his homespun and positive philosophy played a big role in his becoming the richest person in the world (before he gave most of his loot away).

Changing your basic psychology can be tough, so new investors may have a leg up here because they don't have ingrained bad habits. But for anyone, a psychological makeover is worth the effort if you hope to recover your losses in the market's next leg up -- and then make the right moves for the rest of your life.

My tour of the essence of Buffett's wisdom starts with the simple psychological lessons taught by the master, many of which are applicable in life outside investing.
Lesson No. 1: Be frugal
If the economic downturn is forcing you to live simply, look on the bright side: It's making you more like Buffett.

Buffett lives in the same modest house in Omaha, Neb., that he bought more than five decades ago. He drives his own car.

How does this make him a better investor? First, it gives him more to invest.

Second, a frugal investor will demand this quality from managers. Buffett is leery of corporate waste. Excessive executive pay or silly perks are red flags. Buffett once quipped that companies stack pay committees with "sedated Chihuahuas."

Third, frugal people don't need fast returns to support extravagant lifestyles. This leaves them free to think more clearly about when to buy and sell stocks, making them much better investors, believes Stephen Shueh, a Buffett expert and managing partner of Roundview Capital in Princeton, N.J.
Lesson No. 2: Wait for the 'fat pitch'\\
Resist the itch to constantly buy or sell stocks.

"Lethargy bordering on sloth remains the cornerstone of our investment style," quipped Buffett in his 1990 annual report to Berkshire Hathaway (BRK.A, news, msgs) shareholders. Have the patience to wait a long time until some market turbulence brings the "fat pitch," as Buffett calls it, or stocks of great companies trading at really cheap valuations.

Lesson No. 3: Be a contrarian\\
A great way to make money is to go against the crowd. "We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful," Buffett explained in a 1986 letter to shareholders.

So be skeptical of the conventional wisdom. Not because the crowd is always wrong but because the crowd's wisdom is probably already reflected in market prices, says Todd Lowenstein, a portfolio co-manager of the HighMark Value Momentum Fund (HMVMX).

When the investing public is extremely negative, it's usually a good time to buy stocks. When investors are confident, be careful.

Lesson No. 4: Stick with what you know\\

One of Buffett's basic rules is: If you don't understand a company's product or how it makes money, avoid it. He calls this "staying within your circle of confidence."

This isn't always easy. During the late 1990s boom, Buffett famously avoided tech companies, confessing that he could not understand what they did. He looked dumb until the bubble burst. "Ultimately, when it came full circle, he was proven right," Lowenstein says.

Lesson No. 5: Don't depend on others to say you're right\\
If you are in need of constant affirmation about your investment decisions, particularly from the stock market, you won't be able to invest like Buffett, points out Legg Mason (LM, news, msgs) money manager Robert Hagstrom in his book "The Warren Buffett Way."

That's because Buffett makes outsized returns by purchasing disliked value stocks that are so beaten down they're often virtually ignored by the talking heads. They won't be on TV every week telling you that you made the right choice.

Lesson No. 6: Buy companies cheap\\
This is the essence of being a value investor. The first step involves calculating what Buffett calls an "intrinsic value" for a business -- either by examining what similar companies sell for or calculating the present value of all the cash that will be generated by a company in the future. For more details on how to do this, you'll have to consult books such as "The Warren Buffett Way" or "The Market Gurus" by Validea's John Reese.

Next, build in a "margin of safety" by purchasing a stock well below its intrinsic value.
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Buffett doesn't pay much attention to earnings per share, a common measure of value. Instead, he likes to see companies with good return on equity, solid operating margins and reasonable or no debt. He also likes to see that companies generate a lot of cash and that they invest it well or return it to shareholders in the form of dividends or buybacks.

The key throughout this analysis is to look back over five years or more. Buffett wants to see a consistent operating history; he's not into startup companies. He also prefers to gauge how well a company does in different kinds of markets, not just the good times or the latest quarter.

Lesson No. 7: Look for companies with economic moats\\
A key characteristic supporting consistent operating history is a sustainable competitive advantage. In other words, a company should have a barrier to entry -- or a kind of moat -- that keeps potential competitors at bay.

This could be a patent protection on drugs, high costs to get into a business or simple brand power, fund manager Lowenstein says. "Franchise" businesses like these can do well because they have the power to raise prices. In contrast, companies in "commodity" businesses have to take whatever price is set by a competitive market -- which can crush profits during hard times.

BNSF Railway is a great example of a "franchise" business. It's pretty hard for anyone to lay enough track in North America to start a competing railroad. Coca-Cola (KO, news, msgs), another long-term Buffett holding, has barriers to entry in the form of a strong global brand and distribution system that is hard to replicate.
Lesson No. 8: Buy big, concentrated positions
Most professional money managers protect against risk by diversifying. Buffett goes against the crowd here, too. When he finds a company he likes, he piles into it big time.

This is crucial to his success. Money manager Hagstrom calculates that if you eliminate a dozen of Buffett's best investment choices over his career, he's only an average performer. Buffett thinks his risk protection comes from understanding a business better than the market does and then being patient enough to buy it at the right price.

Lesson No. 9: Hold for life\\
Buffett quips that his favorite holding period is "forever." Embedded in this concept are two key Buffett tenets I've already alluded to. First, it's worth investing only in companies that are good enough to outperform for decades. Next, you have to think on your own and avoid the madness of the crowd.

"Buffett believes that unless you can watch your stock holdings decline by 50% without becoming panic-stricken, you should not be in the stock market," Hagstrom says.

This doesn't mean buy and forget. Buffett tracks his investments closely and gets out when he thinks that they are fully valued or that trouble is on the way, points out Pat Dorsey, the director of stock analysis at Morningstar (MORN, news, msgs). A few years back, Buffett sold big positions in Fannie Mae (FNM, news, msgs) and Freddie Mac (FRE, news, msgs), the home mortgage companies that blew up last year.
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Buffett is not infallible, however. He still owns big positions in Gannett (GCI, news, msgs) and Washington Post (WPO, news, msgs) even though he forecast at his 2004 annual meeting that the newspaper business would see nothing but trouble for decades.

The price of his company's stock -- always a major part of his wealth -- dropped 31% in 2008 and continued to follow the market down early this year. Since, it and the market have rallied strongly.

Lesson No. 10: Believe in America\\

Unlike most investors, Buffett doesn't tweak his portfolio depending on which party is coming into office or where we are in the economic cycle. This may make him seen naive. But it also has him putting money to work now, when many others have lost faith in the U.S. economic system. It's a move that will likely make him a winner down the road yet again.

After all, the current fears about the long-term prosperity of U.S. companies make no sense, he wrote in an October op-ed column in The New York Times. That's why he was buying stocks before the current rally began.

"These businesses will indeed suffer earnings hiccups, as they always have," he wrote. "But most major companies will be setting new profit records five, 10 and 20 years from now."

At the time of publication, Michael Brush did not own or control shares of any company mentioned in this column. This article was updated June 17 2009.

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