Warren Buffett is without doubt the most successful investor in the world today. His methods have been well publicised in recent years, making it a comparatively easy task to fully understand his approach. 

I have read all the annual reports of Warren Buffett's company, Berkshire Hathaway, his biography by Roger Lowenstein, The Warren Buffett Way by Robert Hagstrom and Warren Buffett Speaks. As a result, I feel I know him very well. 

Any serious investor who could not write an off-the-cuff two-page essay on Warren Buffett's approach to investment should read Buffettology without delay. This new book is the most recent offering on Buffett and is written by his ex-daughter-in-law, Mary. 

She summarises Warren Buffett's approach step-by-step and explains it in an easily readable way. Any moderately experienced investor reading this book could not fail to completely understand Warren Buffett's principles. 

Warren Buffett searches for companies that have a strong competitive advantage. He spurns commodity-type businesses which have lots of competitors - paper and steel companies come to mind immediately. He likes businesses with excellent economics and some kind of consumer monopoly, usually a branded product or a service that consumers believe offers superior advantages over the competition. He looks for the kinds of products that retailers are compelled to stock - for example, Gillette razor blades, Coca Cola and Disney videos and toys. On the service side, the only newspaper in town or a well-placed TV station illustrate his theme. 

The key point about these kinds of businesses is that they can price their products to keep up with inflation and they are relatively immune to competition. This means that their earnings per share growth is more predictable than most other businesses. Because growth is so reliable, Warren Buffett can look at any company of this nature as a kind of bond. However, unlike a bond, a successful company has an increasing intrinsic value - retained earnings are ploughed back into the business and employed at a very much higher rate than bonds enjoy. 

With this approach, you can see why a high return on equity is a key characteristic of Buffett's investments. The average ROE of American companies is about 12%, but to give himself a margin of safety he looks for businesses generating 15% or more. 

Buffett dislikes managements that are diversifying from the proven core activity of their businesses and loves those that concentrate on what they know best and buy in the company's stock to lift the overall ROE and speed up the compounding process. 

Warren Buffett only invests in companies with products or services that he can fully understand. Once he has identified one that he likes, he then concentrates on buying it at the right price. The lower the price, the better the long-term return. He therefore often waits for weak markets or a short-term adverse happening that affects the share price for a while but barely touches the core business. 

Needless to say, it is not quite as straightforward as I have made it seem. However, Buffett's basic ideas are superb so let us examine how applicable they might be to the UK market. 

The short answer is not very. Warren Buffett has been spoiled in America. The home market there is five times bigger than here, so, for example, any worthwhile retailing concept (or quasi-monopoly) can be rolled out in the US for decades rather than years. 

Also, because of the US's far bigger home market, companies with a very strong domestic base like Coca Cola, Gillette, McDonalds and Disney have a much easier job of becoming international giants. Buffett's only excursion into the UK market was Guinness, which he sold a few years later. In his terms, it was not a successful investment. 

In this country, I believe that the best way to benefit from Buffett's approach is to find companies with a high return on equity which are riding a wave and rolling out a concept which still has a long way to go. 

Further facets of my approach that correspond with Warren Buffett's include the following: 

  1. My quest for shares with low PEGs results in buying into companies on multiples well below their EPS growth rates. This establishes a margin of safety and future growth is bought at a reasonable price. 
  2. My insistence on high cash flow per share when compared with EPS ensures that the chosen companies have plenty of cash for further expansion. 
  3. Demanding low gearing adds to the margin of safety. Cash generative businesses with a strong competitive advantage usually have a strong cash position. 
  4. I, too, like shares with strong retained earnings to fund expansionary capital expenditure. 
The most important lesson that Buffett has taught me is that, once a great business has been identified, it pays to let compounding do its magical work for as long as possible. There are very few shares that qualify and it is vitally important to extract the maximum from them in a tax-efficient way. 

In the UK, the supergrowth of these kinds of businesses is in most cases far more restricted than in the US, but can still be rewarding to long term shareholders. However, a much keener eye has to be kept on them as they near maturity. 

Excerpted from:
The Previously Unexplained Techniques That Have Made Warren Buffett The 
World's Most Famous Investor 
by Mary Buffett and David Clark