The master investor, who bought his first stock at the age of 11, doesn't just buy securities now, but prefers buying controlling stakes in companies, assimilating them into the huge sprawling empire that is Berkshire Hathaway.
The growth of his company, which has been beating the S&P 500, almost continuously for decades, is testimony to the sound investing principles and mental framework that has helped him choose winners more frequently than others.
In the 1990s, he avoided the Dotcom bubble, by eschewing Internet-based businesses, whose future prospects, he did not fully comprehend. Because he bases his decisions on understanding an industry, instead of relying on hearsay, he has been insulated from the speculation-driven insanity that periodically grips the markets. While this approach has also led to him missing out on a few good opportunities, it has largely saved him from large-scale losses.
Ergo, invest in your circle of competence, it being the set of business sectors whose products and services, as well as market value, are comprehensible to you, through personal experience. Only in this circle, can you have the conviction to make future predictions. While this may not always lead to winning bets, it will protect you from the pitfalls of speculative (the-quest-of-the-next-big-miracle) investing.
An example from Buffett's portfolio is Gillette, a market leader in personal care products, primarily including men's razors. Since the 1980s, it has been a household brand with a proven market share. It is known for constant innovation and predictable market earnings. In 1989, Berkshire Hathaway invested US$600 million in Gillette, an investment which grew to US$850 million within two years, besides earning a handy US$52.5 million dividend yield. When Procter & Gamble bought Gillette, Berkshire Hathaway being the largest shareholder, earned a handsome profit of US$645 million.
Another such example is See's Candies, a manufacturer of candy and chocolates, whose products have been in high demand, throughout United States. Berkshire Hathaway's US$57 million investment in the company has earned more than US$1.35 billion, in the ensuing years.
- Low Price-to-Book Ratio: This ratio (= Stock Price/Total Assets - Intangible Assets - Liabilities) allows you to screen stocks that are trading below their book value, a.k.a. undervalued stocks, which are bound to appreciate to their true value, in the future.
- Low Price-Earnings Ratio: This important ratio (= Market value per share/Earnings per share) can only be used to compare companies within the same sector, to separate those with high earnings, trading at relatively low prices. This parameter should never form the only screening criteria, as not all low P/E ratios indicate undervalued high-performance companies.
- Low Price-to-Sales Ratio: This parameter (= Stock price/sales per share) can be indicative of an undervalued stock. It determines the value of each dollar earned in sales per share, for a company. Again, this indicator shouldn't be used in isolation, but only as part of a broad analysis of the company's financial fundamentals.
- High Dividend Yield: The yield (= Annual dividends per share/Price per share) can separate out companies that pay out high dividends for every investor dollar put in.