One of the most legendary investors of all time is Warren Buffett. He is famous not just for buying companies but also picking individual stocks and shares.
As an investor I think I can learn a lot from Buffett. Here are five principles he applies when investing.
Invest in what you understand
Buffett is focussed on industries he understands, such as insurance, retail, and transportation. Instead of trying to find the largest possible return by widening his search field, Buffett only invests in shares of companies when he feels comfortable that he knows how its industry works. That doesn’t mean he doesn’t still make some bad choices, of course. But it stops him from falling into a common investing mistake, of buying shares in a company without understanding what it does in detail.
Size matters
Another interesting facet of Buffett’s investment approach that often isn’t discussed is that he tends to shun investing in shares of small companies. Many of his key holdings, such as Apple, American Express, and Bank of America, are huge listed companies.
Sometimes it is harder for a massive company to sustain growth than a smaller one. So why does Buffett focus on large companies? One explanation is that he is deploying vast sums of cash, so only large companies offer enough opportunity to meet his investment objectives. Focussing on finding just a handful of companies in which to invest can free up research time compared to looking into hundreds of different small firms.
Warren Buffett on management
As an investor, Warren Buffett certainly appreciates good management. Indeed he often publicly compliments executives whose work he appreciates. But he doesn’t buy shares purely because he likes a company management. As he pithily said, “I try to invest in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will.”
In practice, what that means is that he looks for companies with a competitive advantage distinct from its top talent. For example, that could be a proprietary product as with Coca-Cola, or an entrenched business ecosystem which is hard to replicate, like American Express enjoys.
Watching for red flags
I find Buffett’s approach to risk management interesting too. Some investors weigh pros and cons, and if the potential returns seem good enough, have a high tolerance for risk. Buffett, one of the most successful investors in history, doesn’t do that. He walks away from a company even if there’s a single red flag that’s alarming enough. When Lehman Brothers wanted Buffett to invest in their failing business, he took an evening to read their publicly available financial filings and that was already enough for him to walk away from any deal.
Warren Buffett’s eggs in different baskets
Buffett also follows another form of risk management: he diversifies. While he owns some great seeming shares, Buffett is always careful to make sure his portfolio is not too dependent on any single company. That is a principle I apply in my own investment decisions too.