Question

Part I: Find and read some investment stories of Warren Buffett. Based on your reading, address the following questions: 1. What is Warren Buffett’s principal investment strategy? 2. What kinds of stocks does Warren Buffett typically buy or not buy? What are his usual justifications for his choices? 3. What do you learn from Warren Buffett about investments? Part II: Find five stocks as well as their risk and return properties. Would you recommend to (or not to) buy the stocks? Explain why. Part III: If you are given $100,000, how would you invest the money? Justify your approach. Pick a portfolio from the CML. We find the CML line first we need to find the risk free investment line on the vertical line of the graph and find portfolio M (world market).

Answer 1

Note: As per answering guidelines, only the first question can be answered.

Solution part I:-

Warren buffet started actively managing money in early 1950s. This was an era of cheap stocks as the US economy was still not out of the great depression and world war 2. The cheap stock valuations made him start his career using the strategy of buying stocks at a deep discount to their book values. He learnt this from his guru and teacher Benjamin Graham who taught him to find companies that traded at less than the value of net working capital less debt. The focus was not on finding great quality businesses but to find any business at a great price (i.e. discount to its book value)

However when markets went up during the 50s and 60s, Buffett could no longer find opportunities using that strategy as the valuations were no longer dirt cheap. This is the time he met his partner Charlie Munger and his investment strategy evolved. He started to focus on the quality of businesses rather than their discounts to value. In simple words, he now buys great quality stocks at good prices rather than his earlier strategy of buying good stocks at great prices.

Further, he defines a great quality business as the one which enjoys a durable competitive advantage (moat) in the industry it operates in. The moat ensures that competitive pressures stya away, margins are maintained and he can enjoy high returns on investment.

What kind of stocks does he buy and not buy?

Buffet invests in stocks who are into businesses whose cash flows can be forecasted with reasonable certainty. These would be the businesses that are not subject to much change but rather the industry is expected to be more or less unchanged in the long run. Businesses like chocolates, railroads, insurance, beverages, etc. On the contrary he stays away from technology stocks as those businesses change very rapidly and their cash flows can't be predicted with reasonable certainty.

His justification for his strategy is that he believes an investor should stay within the circle of competence. So, only the industries that offer reasonable certainty of future cash flows fall under his competence and vice-versa.

What do we learn from him:-

Warren buffet teaches us to stay in our circle of competence, only invest in businesses that we understand and stick to the strategy with discipline. He has also taught us to not get influenced by popular perceptions in the market and rather find good value opportunities when everyone else is bearish.