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It should come as no surprise Microsoft founder Bill Gates' 13 year streak as Forbes world's richest person has come to an end. He's a $57-billion (U.S.) one-trick pony when you put him up against Warren Buffett. Weighing in at $61-billion the Oracle of Omaha's return to the throne is vindication for legions of financial advisors who have held him out as the poster-boy for prudent investment planning.
Buy low, sell high
The 77-year-old Buffett owes his success to sticking with the basics. His first rule: buy low. Warren Buffett does not buy anything that is not well below its true market value. To identify a bargain he implements a value model passed down from his mentor, legendary value investor Benjamin Graham.
A value investor assesses a security from the bottom up. In the case of a company stock Warren Buffett starts by looking at the company's books to compare things like costs to revenue, debt to equity, earnings to debt, stock price to earnings and the firm's ability to recover from an earnings disappointment. He also looks at earnings trends and how much of those earnings are invested in growth to determine how likely profit is attainable in the future.
Earnings are often determined by the broader sector and the even broader economy. Mr. Buffet will ask if other companies offer a similar product for a similar price and if the company being considered may have an edge through a brand name with a solid reputation. He will also ask if the market for the product can support that level of competition and — more important — growth.
On a macro level he looks at how the company's bottom line will react to the broader market climate. How will demand be influenced by things like recession, inflation, interest rates or government policy?
From there he determines what the company and stock are worth and if the current market value is lower it's in play because the value investor believes the free market will eventually catch on and bid the price closer to — or beyond — its true market value.
Inversely, when his model tells him the market value of his stock is near or higher than his model price, he sells.
Only buy what you understand
Warren Buffett's reputation as an oracle was solidified by his emergence from the technology tumble of 2001 relatively unscathed. The truth is he never bought into the dot-com boom because he could never quite figure out how to estimate future cash flow from companies with few assets and no apparent source of revenue. Measuring dot-com companies to his value model was like trying it fit a square peg in a round hole.
As a result he may have missed out on the boom portion of the technology bust but his rule of never investing in something he doesn't understand served him well.
For the same reason, Warren Buffett generally avoids investing in gold because bullion itself has few practical uses.
Know when to hold 'em
Waiting for the market to realize it has undervalued a stock, and waiting for the correction, often takes patience. Warren Buffett's value mindset can best be summed up by the fact that he is still living in the Omaha, Nebraska house he purchased in 1958 for $31,500. The house has recently been valued at $700,000 but the personal value he places on the home is obviously higher.
You might think the recent stock market plunge would expose a treasure-trove of bargains for the value investor but Mr. Buffet recently went on record saying he was holding off on many investments because stocks have more room to fall as a result of the ongoing sub-prime crisis in the United States.
Patience is often the core theme of Mr. Buffett's popular annual letter to Berkshire Hathaway shareholders (Warren Buffet is the largest stake holder at about 38 per cent). In his latest letter he announced quarterly profit fell 18 per cent and told shareholders to brace for further declines in 2008. On the bright side he mentioned revenue rose 7 per cent to over $28-billion — providing him with enough cash to make a major acquisition at some point in the future.
Know when to fold 'em
Warren Buffett actually has broken one of his own cardinal rules: "never lose money". His loses aren't widely known but he has admitted to making mistakes including a $433-million purchase of Dexter Shoe Company in 1993 that turned into a $220-million sale. The point is he admitted he underestimated the competition in the shoe business and got out.
More recently, earlier this month he withdrew his offer to re-insure $800-billion of municipal bonds guaranteed by MBIA, Ambac Financial and FGIC after determining there was more downside to the credit market. Berkshire still managed to make money from the crisis by starting its own bond insurer.
Diversify, diversify, diversify
Since 1965 Mr. Buffett has grown Berkshire Hathaway into a $216-billion conglomerate not because he has supernatural abilities to see into the future, but rather because he can effectively manage risk through diversification.
Berkshire has always been a conglomerate with roots in the insurance industry but if you look at the actual holdings it's a variety of value sector plays. Nearly 40 per cent of the portfolio is invested in consumer goods such as Kraft Foods, Coca Cola and AnheuserBush. 32 per cent is invested in financials such as Wells Fargo and American Express. The remaining 28 per cent is invested in industrials, health care and a tiny 2.3 per cent weighting in oil & gas - a signal from the oracle that energy stocks could be overvalued.
Investors wanting to get into Berkshire Hathaway can get first hand experience in patient investing. One share costs over $133,400
Dale Jackson has been a producer at Report on Business Television since its launch in September 1999.