Though his illustrious investing career has spanned decades and his stock purchases have covered the gamut of every business sector in diverse market conditions, Warren Buffett (Trades, Portfolio)’s underlying investment strategy has remained unaltered. In his 1977 Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) annual letter to shareholders, Buffett explained four fundamental investment principles from which he has never wavered, regardless of the underlying market environment.
By listing in the letter the criteria a company must meet before it will be considered for purchase, Buffett provided a synopsis of the underpinnings upon which all successful value investing is based. Buffett explained his methodology:
“We select our marketable equity securities in much the same way we would evaluate a business for acquisition in its entirety. We want the business to be (1) one that we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) available at a very attractive price. ”
As an ardent disciple of Benjamin Graham, Buffett’s investment decisions are not informed by prevailing market conditions, but rather, by whether the stock in question can be had for a price that is well below its true value, or its potentially favorable future earnings capacity. As Buffett noted:
“Long ago, Ben Graham taught me that ‘Price is what you pay; value is what you get.’ Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”
The 1977 letter elaborates on another important factor in Buffett’s investment strategy: the idea of investing only in a business or sector you understand, or “Invest within your circle of competence.” In his 1996 letter to shareholders, Buffett explained why this is important for successful investing:
“What an investor needs is the ability to correctly evaluate selected businesses. Note that word ‘selected’: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.”
One of the key distinguishing attributes of Buffett’s value investing strategy is that he doesn’t buy stock, he buys an interest in a business. As such, short-term market movements amount to nothing more than a blip on a value investor’s long-term radar screen: “We ordinarily make no attempt to buy equities for anticipated favorable stock price behavior in the short term.”
If the business itself continues to offer excellent profit prospects for the long term and should market conditions provide an opportunity for acquiring more stock in a company at a price even lower that the original purchase cost, Buffett has no compunction in adding to his position:
“In fact, if their business experience continues to satisfy us, we welcome lower market prices of stocks we own as an opportunity to acquire even more of a good thing at a better price.”
In the 1977 letter, Buffett implicitly stated one of the core maxims of value investing: if your view of the business hasn’t changed, capitalize on the courage of your convictions —even if it means going against the conventional wisdom of Wall Street. Thus, when others are engaged in panic-selling due to a precipitous drop in the market and an otherwise sound business with excellent long-term prospects can be bought for a price well below its true value, Buffett will confidently increase his stakes:
“When prices are appropriate, we are willing to take very large positions in selected companies, not with any intention of taking control and not foreseeing sell-out or merger, but with the expectation that excellent business results by corporations will translate over the long term into correspondingly excellent market value and dividend results for owners, minority as well as majority.”
Buffett’s response to those who presently criticize his inordinate large cash position is consistent with those principles enunciated in the 1977 letter. Even though value opportunities may be fewer, should the right business provide a margin of safety in conjunction with highly favorable prospects for the future, Buffet would have no aversion in investing so as to capitalize on appropriate opportunities that may arise.