Great Investors: the Warren Buffett approach

For each article in this series, I'm looking at a master investor, introducing you to their approach and running a stock screen to unearth examples of the type of company their approach produces.

So far, I've looked at Ben Graham, the pioneer of value investing, and Phil Fisher, an early growth guru. Today, it's the turn of the world's greatest living investor, Warren Buffett — the Oracle of Omaha — who has been influenced by both Graham and Fisher.

Reading the Oracle

Millions of words have been written about Warren Buffett's approach to investing, including books by his former daughter-in-law Mary, old colleague David Clark and fund manager Robert Hagstrom.

Buffett himself has never written a book, but his annual shareholder letters to investors in Berkshire Hathaway (NYSE: BRK-A, BRK-B) are essential reading, providing many insights into his approach, even if they don't amount to a step-by-step guide to identifying a Buffett stock.

In addition, Buffett has commended The Essays of Warren Buffett by Larry Cunningham as "a coherent rearrangement of ideas from my annual report letters".

Buffett's roots

Many years ago, Buffett said: "I'm 15% Fisher and 85% Benjamin Graham." What did he mean by that?

In common with Graham, Buffett is a big believer in having a 'margin of safety' — buying shares when they're trading below their true value, typically when they're out of favour with Graham's fickle and impatient "Mr Market". Buffett believes the margin of safety principle, so strongly emphasised by Graham, to be "the cornerstone of investment success".

From Fisher, Buffett learned an appreciation of the importance of strong management in a company, and of what Fisher referred to as "management of unquestionable integrity".

Also like Fisher, Buffett advocates investing with a long-term horizon: "If you aren't willing to own a stock for 10 years, don't even think about owning it for 10 minutes."

Finally, Buffett is in accord with Fisher on portfolio concentration, going as far as to say:

"If you are a know-something investor, able to understand business economics and to find five to 10 sensibly priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk."

Moats and cash

The idea of investing in companies with 'important long-term competitive advantages' is quintessential Buffett. Companies with a big 'economic moat', such as those with strong consumer brands — Coca-Cola (NYSE: KO) is a Buffett stock par excellence — have good pricing power and give shareholders a high return on equity.

Buffett avoids industries he doesn't understand — that are outside his 'circle of competence' — sticking to businesses that are "relatively simple and stable in character", not least because: "If a business is complex or subject to constant change we're not smart enough to predict future cash flows."

Buffett is dismissive of common valuation yardsticks, such as price-to-earnings and price-to-book ratios, and dividend yield, "except to the extent they provide clues to the amount and timing of cash flows into and from the business". Cash is king for Buffett, especially a cash-flow measure he calls "owner earnings".

A Buffett screen

Buffett aficionados and apostles have come up with innumerable stock screens, using sophisticated combinations of financial statement numbers and valuation metrics, to try to capture the universe of stocks Buffett might consider investing in.

For a manageable list of companies for this article, I've screened all ASX listed companies with a market cap over $100m using just two criteria: an average annual return on equity of 15% plus over five years and compound annual net income growth (CAGR) of 10% plus over ten years – the latter in the absence of an owner-earnings facility on the screener.

The screen returned 59 stocks — of which I've listed the top 10 below, ordered by return on equity. I've also excluded resources and mining related companies, as Buffett has tended to avoid those types of companies.

Other notable companies that made it through the screen include CSL Limited (ASX: CSL), Breville Group Limited (ASX: BRG), Cabcharge Australia Limited (ASX: CAB) and Cash Converters International Ltd (ASX: CCV).

Foolish bottom line

Buffett's approach to investing has perhaps been most succinctly summed up by the Oracle himself:

"Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily understandable business whose earnings are virtually certain to be materially higher five, 10 and 20 years from now."

The master investor we'll be looking at in the next article in the series shares that view, having said "a share in a stock is not a lottery ticket, it's part ownership of a business", but he has his own distinctive approach to investing.

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More reading

• 7 stocks I'll retire on
• Great investors: The Philip Fisher approach
• Why I'm avoiding the banks

Motley Fool contributor Mike King owns shares in Cochlear, CSL, JB Hi-Fi, Woolworths & OrotonGroup. The Motley Fool's purpose is to help the world invest, better. Take Stock is The Motley Fool's free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. Click here now to request your free subscription, whilst it's still available. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

A version of this article, written by G A Chester, originally appeared on fool.co.uk.