Better stock-picking: 3 pieces of investing advice from Warren Buffett

Warren Buffett has made billions of dollars, and may have dispensed as many words of investing advice. Okay, maybe the latter’s an exaggeration. But his writings, speeches and interviews certainly add tremendously.

Here are three pieces of advice from Buffett that have fundamentally shaped my own approach to investing. I think they’ve helped me make better decisions about which stocks I should consider buying and which I should avoid.

A matter of business

First and foremost, Buffett approaches investing as a businessman. A key piece of advice I’ve taken from him is don’t buy a single share in a company unless I’d be willing to buy the entire business, if I had sufficient capital.

Now, Buffett can afford to purchase companies outright, and sometimes does. But he applies the same principles when buying a minority stake in a business. Like him, I try to visualise myself as a part-owner of the company.

Virtuous circle

Viewing myself as a part-owner makes sense to me. After all, a good business is managed for the financial benefit of its owners. Management may reinvest some, or all, of each year’s profit to increase the profit in subsequent years. This means my stake in the company becomes more valuable.

If the business makes profits over and above its investment needs, management may opt to buy back and cancel a portion of the company’s shares. If I’m a continuing shareholder, I will then own a larger part of the business. Again, this means my stake in the company becomes more valuable.

Instead of share buybacks, or in addition, management may distribute surplus capital to shareholders in the form of dividends. If I use those dividends to buy more shares, the portion of the business I own again enlarges. And becomes more valuable still.

Over time, if the company continues to be successful, the virtuous circle of compounding will grow my wealth like a snowball.

Warren Buffett’s advice #2

‘Over time’ is the key. It takes time for compounding to do its wondrous work. Ordinarily, Buffett makes no attempt to buy a stock for an anticipated favourable share-price movement in the short term.

As he’s said, and as I’ve taken on board: “If you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes.”

No sweat

Buffett doesn’t pay much attention to the widely-used valuation ratio of price-to-earnings (P/E). He’s far more interested in return on equity (ROE).

ROE is the amount of net profit a company generates on every dollar of shareholders’ funds, although Buffett uses a modified version of net profit he calls ‘owner earnings’ (described in the last-but-one section of a letter to investors in 1986).

If a business generates a high ROE (say, 15%+) over two or three decades, even if you pay an expensive-looking price, you’re very likely to have a far better outcome than buying a low P/E stock that’s only ever capable of producing a low ROE (say, 5%).

So the third piece of investing advice I’ve taken from Buffett is not to sweat too much about the P/E ratio.

Overall, I think the three pieces of advice I’ve discussed have helped me make better decisions about which stocks I should consider buying. And which ones I should avoid.

G A Chester 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.