Warren Buffett’s seven routes to riches

Warren Buffett’s annual letter to the shareholders in his investment vehicle, Berkshire Hathaway, is one of the most eagerly anticipated bits of news for investors across the world.

Every year people trawl over it, looking to uncover pearls of wisdom from a man who is one of the most successful investors who ever lived. And this year’s is perhaps one of his best letters yet.

In an excerpt in Fortune magazine, Buffett talks about what investors can learn from his experience. Here are seven lessons you can draw from his story.

1. Learn to love falling prices

The best time to make an investment is when times are bad and prices are falling. Firstly, when people see falling prices, they often panic and sell, exacerbating the overall slide in the market.

Secondly, when prices are falling, there are also investors who have overstretched themselves, and have to sell because they are in financial trouble (‘distressed’ sellers). These two factors together mean that there are often lots of bargains to be had amid the chaos.

In 1986, for example, Buffett bought his farm in Nebraska after prices had collapsed. The $280,000 he paid was less than the bank loan outstanding on the farm. In 1993, he bought a stake in a New York retail property, again after prices had collapsed following a recession.

2. Investing is all about yield

In both cases, Buffett didn’t invest until he had put together a conservative estimate of the future potential earnings of the properties. He learned this technique from his mentor Benjamin Graham (often described as the ‘father of value investing’).

It’s similar to viewing the long-term potential of a stock market, based on the cyclically-adjusted price/earnings (Cape) ratio. Once you have your estimate, just divide the expected future average earnings by the asking price, to get an estimated yield (or interest rate, essentially) on the investment. If it’s high enough given the risks involved (and on both of Buffett’s purchases, it was above 10%), then you should invest.

An important point to note is that Buffett ignores the effect of debt (or leverage) when calculating sustainable earnings. This is good advice. That’s because you can artificially boost returns on an asset by using debt to buy it, but debt also increases your potential losses, and therefore the riskiness of any investment.

You can calculate the unleveraged (or debt-adjusted) interest rate on an investment by dividing its operating profits by its enterprise value (the market value of its equity, plus its net debt).

3. Don’t worry about the backdrop

No one can accurately predict what will happen in the future and you shouldn’t listen to people who tell you that they can. So if you’re looking at an individual investment, then forget about war in Ukraine, Scottish independence, or the long-term path of interest rates. The long-term value of an investment is based on the profits it can produce.

So, when you invest, act like the part owner of the business that you are. As long as the business itself is performing reasonably, you should not have any other concerns, regardless of what is happening to stock prices in the wider market.

4. Volatility is your friend

Share prices move up and down a lot. This is known as volatility. The stock market will quote you a different price for your investment every single day, depending to a great extent on what mood other investors are in.

You should buy when other investors are feeling nervous or gloomy and so are offering you good businesses at low prices. And you should sell or do nothing when they are euphoric and quoting high prices.

The point is that the value of a business changes very slowly. Take consumer goods company Reckitt Benckiser (LSE: RB), for example. In the last year its share price has ranged from 3,235p a share to 5,112p – a difference of 58%. There’s no way that the value of the underlying company has changed that significantly over that period.

In all likelihood, within that range is a cheap price, an expensive one and a fair one. You want to buy when it’s cheap and sell when it’s expensive. And it’s always handy to have some cash on hand to take advantage of this volatility.

5. Invest for a long time to get rich

As long as a company is doing well, don’t be afraid to just sit on your hands. The financial services industry wants you to trade a lot so that they can earn a living. But you’re far better off being as inactive as possible, and simply letting the wonders of compound interest roll up over the years ahead.

Buffett is one of the best examples of this at work. He’s built huge wealth by holding on to his investments and reinvesting his profits and dividends.

6. You don’t need to be a genius

Buffett argues that good businesses will continue to do well. Profits and dividends will rise and share prices will be higher in the future. But it’s not easy for individuals to pick winners – even the professionals rarely manage it. So Buffett suggests that most private investors should just invest in a basket of businesses (he suggests tracking the S&P 500 index) via a low-cost tracker fund.

By investing on a regular basis, and holding on through good times and bad, you accept that you can’t predict the future, and so won’t damage your returns by frantically buying and selling.

And by keeping your costs low, you’ll boost your returns massively: the founder of passive tracker fund specialists Vanguard, Jack Bogle, reckons that professional managers eat up around 2.2% a year more in costs than a simple tracker fund.

7. Buy The Intelligent Investor

Buffett still reckons that Ben Graham’s book is the best book on investing ever written (and I’d agree). Read chapters 8 and 20 and you won’t go far wrong.

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