I’m certain Warren Buffett’s tips have helped me make more money as an investor. Today, I want to share four gems I use to help me pick winning stocks and avoid costly mistakes.
Paying the right price
“Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down”.
Even an excellent company can be too expensive. If I pay too much upfront, then I won’t benefit from future growth.
Buffett’s tip here is to focus on value, not just the share price. A company’s value is linked to its future earnings and cash flow. Usually, this only changes slowly. On the other hand, a company’s share price can move around quite quickly.
What I’m looking for are situations where the share price is below my estimate of fair value.
Calculating the value of a business isn’t always easy. Sometimes I can’t do it. When that happens, I follow Buffett’s advice and “never invest in a business you cannot understand”.
“Our favourite holding period is forever”
Buffett is known as a very long-term investor. One of his most famous quotations is that “when we own portions of outstanding businesses with outstanding managements, our favourite holding period is forever”.
No one can predict the short-term movements of the stock market. But Buffett believes that good businesses tend to do well over time. He reckons that patient long-term investors can profit from this by simply doing nothing.
There’s a technical term for this — compounding. What this means is that by holding shares for long periods, investors can benefit from the growth that comes from reinvested profits. Over time, this can snowball.
On the other hand, companies that fail to reinvest successfully can destroy shareholder wealth. For this reason, one of the first things I look for in a potential investment is evidence that the business can generate attractive returns on invested capital.
What to do when things go wrong
I’ve made plenty of bad investments and so has Buffett. What I’ve learned from him over the years is to focus on cutting my losses.
One of my favourite Buffett quotes is that “problems in a company are like cockroaches in the kitchen. You will never find just one”. What this means for me is that when I realise something has gone wrong with a business, I don’t hesitate to sell.
In the past, I’ve often held on too long. I’ve thought that a problem looks manageable and should soon be fixed. What usually happens is that the situation gradually gets worse, as the full truth emerges. And the shares keep falling.
I’ve learned the hard way that it’s much safer to get out quickly. After all, I can always re-buy the shares if I’m wrong. But if I lose money by holding on too long, I can never get that cash back.
One final Buffett tip
Things don’t always go quite to plan. So Buffett always looks for investments which offer a “margin of safety”.
What I’ve learned from this is to look for fewer, better, share-buying opportunities. I know that I don’t need many good investments in my portfolio, as long as I avoid the bad ones.
Roland Head has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
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