Warren Buffett’s track record as an investor has been built on a number of solid foundations. For example, he has a huge amount of patience and is able to hold shares for decades. He also has discipline in terms of investing only in stocks and sectors which he fully understands. And he has been able to recover from mistakes without loss of optimism for future gains.
As such, he has become one of the richest people in the world. However, could his focus on one simple idea be the biggest reason for his success? And how could you apply it when managing your own investment portfolio?
A simple idea
Warren Buffett’s ability to focus on finding great companies at fair prices could be his biggest strength. While this may sound like a rather simple idea, when applied over a long period of time it could lead to exceptional performance for any investor. The reason for this is that the company itself is viewed as more important than its valuation, which arguably goes against the methods encouraged by many value investors. For them, price is the most important consideration, with a company able to improve its products, services and business model.
Risk reduction
However, for Buffett, the company is what matters most. In focusing on the strength of a company rather than its valuation, he may be reducing the risk profile of his investments. After all, a great company is usually made of specific key elements, such as a sound balance sheet, competitive advantage versus rivals and bright future outlook. If a company possesses those qualities, the chances of it reporting a profit warning or struggling at some point in future are significantly reduced.
In contrast, a business which is cheap but has a number of problems in those and other areas may be more likely to report disappointing financials and experience a falling share price. As such, by focusing on the quality of a business and not demanding a particularly cheap valuation, Buffett may be improving his risk/reward ratio. This could lead to higher and more consistent returns, which can be compounded over the long run.
Application
Of course, assessing whether a company is ‘great’ or not is highly subjective. While Buffett has dropped hints at how he makes the assessment of a company’s quality, all investors will have their own, unique approaches.
However, focusing on the competitive advantage between a company and its rivals could be a sound place to start. It may provide a guide as to how well it will cope with industry downturns. In the long run, such events will affect all investors and are almost inevitable. Similarly, finding companies with strong balance sheets and capable management teams could also reduce the overall risk within your portfolio.
By reducing risk, your returns may improve in the long run. Therefore, there may be less of a requirement to find cheap stocks, since the best stocks at a fair price may be sufficient to deliver market-beating returns over a long period of time.