"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
Two words for the efficient market hypothesis: Warren Buffett
An interesting academic study illustrates Buffett's amazing investment genius. During the period from 1980 to 2003, the stock portfolio of Berkshire Hathaway (NYSE: BRK-B) beat the S&P 500 index in 20 out of 24 years. During that same period, Berkshire Hathaway's average annual return from its stock portfolio outperformed the index by 12.24 percentage points. The efficient market theory predicts this is impossible, but the theory is clearly wrong in this case -- and, as Casey Stengel said, "You can look it up."
Buffett has delivered these outstanding returns by buying undervalued shares in great companies such as Gillette (now owned by Procter & Gamble). More recently, he has taken a chance on companies such as POSCO (NYSE: PKX), PetroChina (NYSE: PTR), and Wal-Mart (NYSE: WMT). Indeed, his investment in Gillette increased threefold during the 1990s. Who'd have guessed you could get such stratospheric returns from razors?
The devil is in the details
So buying great companies at reasonable prices can deliver solid returns for long-term investors. The challenge, of course, is identifying great companies and determining what constitutes a reasonable price. Buffett recommends that investors look for companies that deliver outstanding return on capital and produce substantial cash profits. He also suggests that you look for companies with a huge economic moat to protect them from competitors. You can identify companies with moats by looking for strong brands alongside consistent or improving profit margins and returns on capital.
How do you determine the right buy price for shares in such companies? Buffett advises that you wait patiently for opportunities to purchase stocks at a significant discount to their intrinsic values -- as calculated by taking the present value of all future cash flows. Ultimately, he believes that "value will in time always be reflected in market price." When the market finally recognizes the true value of your undervalued shares, you begin to earn solid returns.
Do-it-yourself outperformance
Beginning investors will need to develop their skills in identifying profitable companies and determining intrinsic values before they'll be able to capture Buffett-like returns. In the meantime, one place to look for stock ideas might be among Berkshire's own holdings. According to The New York Times, the company has recently disclosed "its sizable new holdings" in ConocoPhillips and US Bancorp (NYSE: USB). Berkshire has also increased its positions in Moody's (NYSE: MCO) and American Express. Last year, he significantly increased his position in USG (NYSE: USG). At the very least, you might consider taking a closer look at some of these stocks.
Another place to find great value stock ideas is Motley Fool Inside Value. Philip Durell, the lead analyst for the investment service, follows a very similar investment strategy to that of Buffett. He looks for undervalued companies that also have strong financials and competitive positions. This approach has allowed Philip to outperform the market by more than six percentage points in just under two and a half years. To see his most recent stock picks as well as the entire archive of past selections, sign up for a free 30-day trial today.
If investing in wonderful companies at fair prices is good enough for Warren Buffett -- arguably the finest investor on the planet -- it should good enough for the rest of us.
