Friday, July 29, 2011

Asset allocation methods from the masters part III: Warren Buffett

In this last article of this 3 part series, I will be talking about the asset allocation method of the world’s greatest investor: Warren Buffett. If you haven’t checked out part 1 or part 2, please do so if you’re interested.

Warren Buffett’s investing strategy mainly centers on investing in good businesses (either in the form of private business as a majority or 100% owner or in the form of shares of stock as a part-owner) with durable competitive advantages and competent management at attractive or at least reasonable prices. Warren Buffett’s private companies (and certain of his stock holdings) generate lots of cash  for him to invest in more private companies and more stocks that either throws off lots of cash or have lots of opportunities to reinvest profits and grow.

Warren Buffett’s company Berkshire Hathaway also holds quite a lot of cash on its balance sheet to tide the company over rough times and to allow the company to seize attractive investment opportunities when they present themselves.

Side note: While it’s true that Buffett has also invested in assets other than stocks or private businesses, it’s through businesses that he created most of his wealth and the wealth of Berkshire Hathaway shareholders.

Here’s how an investor can allocate the assets in his portfolio like Warren Buffett:

Invest in shares of good companies you understand or start good businesses that generates lots of cash (car washes, caf├ęs, or whatever you understand and have enough capital to start). But what exactly is a good business? A good business first of all needs to generate strong profits for shareholders or it wouldn’t be considered a good business. I think Warren Buffett requires a company to generate at least 15% returns on equity before he considers investing in the company; a return on equity of at least 15% (the company should not have achieved this return by taking on too much debt) would be a good place to start when searching for companies for potential investment or when deciding on the feasibility of a business venture.

The reason why a company earns superior long-term profits is because it has a durable competitive advantage over its competitors. A competitive advantage can come in the form of a strong brand, an important patent, being the low-cost producer and etc. Buffett also looks for companies with honest and capable management. Investors looking to construct a portfolio the Warren Buffett way should look for companies with strong competitive advantages which allow those companies to earn superior profits and protects the profitability of those companies; investors should also look for companies that have good management as management are the stewards of the investors’ capital and they can help create great wealth for shareholders or destroy the company’s intrinsic value.

Buffett is also known for his patience and discipline in terms of investing in a company only when he believes it is undervalued or at least valued at a reasonable price. Never overpay for a stock, buying a good company at a great price is not a recipe for good returns.

Now we know the things Buffett looks for in a company, the companies we invest in can fulfill either 1 of these 2 roles: cash cows or future cash cows. The cash cows are usually shares of good companies that don’t have a lot of room to grow or don’t have any plans to expand but generate tons of cash that it pays out as dividends and buyback shares; in terms of a private business, a cash cow can be a very profitable ice-cream shop that you don’t plan to expand. Future cash cows are companies that generate lots of cash but reinvest most of that cash for future profits; it could be shares of a good young company with fast growth or a private ice-cream business that plans to reinvest most of the profits to open more ice-cream shops. The basic idea is for the investor to use the income he gets from the cash cows in his portfolio to invest in future cash cows or other cash cows (or more shares of the same cash cow companies held in the portfolio) to further increase the future cash flow generated by his portfolio.

If Warren Buffett can’t find any attractive investments, he is content to just build up cash to take advantage of attractive opportunities when they present themselves. So, if you can’t find any attractive opportunities, don’t throw good money after bad, build up cash and wait for good opportunities to show up.

This concludes the asset allocation method from the masters series, I hope you enjoyed it. If you have any questions or have anything that you would like to share please feel free to comment. Thank you for reading, and may you always sustain good returns on your portfolio. Take care.

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