Warren Buffett’s “secret sauce” for investment success

Warren Buffett, CEO of Berkshire Hathaway, attends the 2019 annual meeting of shareholders in Omaha, Nebraska, on May 3, 2019.

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Berkshire Hathaway founder Warren Buffett – one of the most successful investors in the world – says he and Vice Chairman Charlie Munger are not “stock pickers; we are business pickers.”

In the company’s annual shareholder letter published over the weekend, Buffett explained that the “secret sauce” to their investment success is making “investments in businesses with both long-term favorable financial characteristics and reliable managers.”

This approach is known as value investing, where the goal is to hang on to a top-performing stock rather than trading stocks based on short-term price fluctuations, otherwise known as active investing.

Of course, it is not easy to choose winners. But Munger has previously outlined four rules that the two Berkshire Hathaway executives follow when choosing whether to invest in a company.

Aside from Buffett’s No. 1 rule, “don’t lose money,” here are four questions Munger and Buffett ask when deciding whether or not to invest in a business.

Aside from knowing how a business operates and what it offers to consumers, you also want to have an idea of ​​where a company is going to be in 10 years, if not decades, Buffett says. “If you’re not willing to own a stock for 10 years, don’t even think about owning it for 10 minutes,” he wrote in his 1996 letter to shareholders.

Berkshire Hathaway famously missed out on tech companies Google and Amazon in the early 2000s because Buffett wasn’t sure he understood the businesses in terms of their long-term profitability. This made it more difficult to determine the value of their shares.

While Berkshire may have passed on Google and Amazon, other investments in blue-chip companies such as American Express and Coca-Cola have paid off over time.

This cautious approach may mean missing out on more speculative opportunities, but Buffett has said that he and Munger are “missing a lot of things, and we will continue to do so.”

Buffett has said that the “most important” factor in choosing a successful business investment is the company’s competitive advantage, which he likens to a “moat” around a “financial castle.”

The more secure the competitive advantage, the more likely the company will prosper over decades.

A competitive advantage may be a powerful brand that people are always willing to pay for, such as Coca-Cola, or it may be a unique business model, such as selling insurance directly to the consumer rather than through insurance brokerages, as is the case with Geico.

Buffett has said that he looks for three things in a leader or manager: intelligence, initiative and integrity. But integrity matters most of all, “because if you’re going to get somebody without integrity, you’re going to have them lazy and stupid,” he said in a 1998 speech.

“We do not want to associate with managers who lack admirable qualities, no matter how attractive the prospects for their business,” Buffett wrote in a 1989 shareholder letter. “We have never succeeded in making a good deal with a bad person.”

With integrity comes trust. That means Buffett and Munger don’t have to spend a lot of time micromanaging every decision a manager makes.

“The important thing we do with managers, in general, is find the .400 hitters and then not tell them how to swing,” Buffett said at the 1994 Berkshire annual meeting.

As passive investors, Buffett and Munger seek out companies that appear to be trading for less than their intrinsic value.

While there is no universal measure of value, companies with long-term earnings potential tend to have consistent earnings, good cash flow and low debt. When a share price seems low compared to the company’s value, there is an opportunity to buy.

But that doesn’t mean that Buffett and Munger are looking for the best bargains based on the stock price alone. Simply getting a fair price for a company’s stock can also be an effective strategy. You are investing in the business for the long term, not just the share price at the time of purchase.

“It is far better to buy a great company at a fair price than a fair company at a great price,” Buffett wrote in his 1989 annual shareholder letter. “When we buy companies or common stocks, we look for top-notch businesses accompanied by top-notch management.”

Get CNBC’s for free Warren Buffett’s guide to investingwhich distills the billionaire’s #1 best advice for ordinary investors, dos and don’ts, and three key investment principles into a clear and simple guidebook.

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