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How to channel your inner Warren Buffett

Published: Jan 16, 2013 10:01 a.m. ET


Commentary: 5 rules about value stocks that can make you money


SooChuen Tan

Famed value investor Warren Buffett, chairman of Berkshire Hathaway Inc.

STAMFORD, Conn. (MarketWatch) — Benjamin Graham wrote that investment is most intelligent when it is most businesslike. Like many other ideas from this great value-stock buyer, this assertion is astoundingly profound in its simplicity.

Let us try to figure out what he meant. Imagine getting a phone call from a CEO you know casually, offering to sell you his publicly traded company at what seems like a low price. What would you say?

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A natural reaction would be: Why are you selling? Why am I getting a deal?

The next questions might include: What does the company do? What are its products? How does it make money? Why do consumers buy its products and not that of competitors? Who are its competitors, and how do they behave? Why are there not more competitors?

If the company sells overseas, you’ll want to ask about the countries where it competes. What happens if bad things happen in these countries? Also, how dependent is the company on its suppliers? What happens if consumer tastes change? Can you trust the managers running the company?

If you are satisfied with the answers to these questions, then you can ask about the numbers. For example: How much cash profit does the company generate each year on average? How much in a good year? How much in a bad year? What explains this discrepancy?

Then you’ll want to know how the company does under different economic conditions. If the economy suffers from deflation, can the company hold prices? Can prices rise with inflation?

You’ll then try to justify the purchase price. How long would you need to own the company before you recoup your initial investment? If the business goes under, what can you liquidate, and how much money can you get back? If the business continues to grow, how much capital needs to be plowed back in, and at what rates of return? Is this return better than other uses for your money?

Questions unsaid

What is most interesting are the questions not asked, including:

Soo Chuen Tan

What is the company’s stock price? Where was the stock trading last year? Where will it trade next month — has it already had its “run”?

Does the stock chart form a “bearish diamond,” and has it fallen through its “support level”? What will be next quarter’s earnings per share, and is this higher or lower than Wall Street consensus? How does the stock’s P/E or PEG ratio compare with its peers, or the market?

What is daily liquidity in the stock? How many analysts have “Buy” recommendations on the stock, how many have “Hold,” and how many have “Sell”? What is the stock’s “beta”? Do the shares “zig” while others “zag”?

You would not have asked these questions because you were thinking like a business person. The decision before you was whether this business was worth buying at the price offered to you. If not, you would thank the CEO politely and keep your cash. This company simply was not cheap enough for you.

Such questions illustrate an important set of rules for value investors. You must maintain investing discipline by reminding yourself of the key principles that underpin our craft:

1. Be greedy when others are fearful

Warren Buffett, in his 1994 Berkshire Hathaway shareholder letter, wrote the following:

“We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen,” he said.

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