What Warren Buffett Can Teach You About Finance

When financial markets hit the skids everyone’s got an opinion – one they’re usually trying to sell you.

Instead of subscribing to a stock-tipping newsletter, today we’re going straight to the top to find out what the richest man in the world is doing with his money – and what his advice is for you.

This week it was announced that legendary US investor Warren Buffett had regained his place on top of the world’s rich list, pulling in a tidy $US10 billion from his investments last year alone. His company Berkshire Hathaway is part of investment folklore, having returned more than 400,000 per cent for its shareholders over the past 40 years.

Incidentally, the third-richest man, Bill Gates, is a director of Berkshire – and gets paid a whopping $US900 for his work (lucky Bill isn’t short of a buck).

Buffett didn’t achieve these amazing gains by investing in high-risk start-ups, dodgy calls from stock-tipping newsletters or trading Contracts For Difference.

Two simple finance rules

Rather he has two simple rules that guide his investment decisions: “Rule number one: don’t lose money. Rule number two: don’t forget rule number one.”

It’s this simple, straightforward advice that makes his annual investment letter to his shareholders worth its weight in gold (or perhaps more aptly, Berkshire shares). In this year’s letter he discusses what kind of businesses turn him on.

Four fundamentals

“I look for companies that have: (a) a business that I understand; (b) favourable long-term economics, defined as a long-term competitive advantage in a stable industry; (c) able and trustworthy management; and (d) a sensible price tag.”

Fundamental to his investment philosophy is that a truly great business must have “an enduring moat that protects excellent returns on invested capital”. This protective barrier might come in the form of being a low-cost producer of goods, or from a company’s dominant brand (think Coca-Cola).

Applying to Australia

Using these principles as a guide to invest in Australian companies, which stocks would fit the bill?

Woolworths (WOW) has a dominant share of total retail spending. More importantly the bulk of its revenue comes from relatively recession-proof spending on groceries.

Westfield Group (WDC) is an Aussie success story that has become the largest shopping mall operator in the world. Its long-term growth record is almost as impressive as Berkshire Hathaway’s.

The world’s largest diversified resource company, BHP Billiton (BHP), is in the box seat to exploit the global commodity boom.

Despite rumours of impending foreign competition the Australian Securities Exchange (ASX) still has all but a monopoly in share trading and domestic large-scale capital raising.

Our largest bank – Commonwealth Bank (CBA). Have you looked at your bank statement lately? Little fees across millions of accounts add up to a billion-dollar cash cow – when it’s not dropping it on dud loans to Centro, City Pacific, Allco and ABC Learning of course.

Watch for bargains

However, as a classic value investor, most of these stocks would fall down on point (d) “a sensible price tag”.

Better to be a Buffett and watch for bargains as already wobbly share markets head lower. We can expect this because the sub-prime woes are far from over.

With falling housing prices in the US, the dent to consumer confidence will hit the world’s biggest economy and flow on to all financial markets.

“You only learn who has been swimming naked when the tide goes out – and what we are witnessing at some of our largest financial institutions is an ugly sight,” Buffett warns.

He believes that investors (and their advisers) are in need of a reality check. To repeat the 10 per cent returns we are used to earning for the rest of the century the Dow Jones index would need to hit 24 million by 2100 (it’s currently 13,000). This seems as likely as Natalie Bassingthwaighte winning a Logie.

Buffett suggests that many advisers are apparently direct descendants of the queen in Alice in Wonderland, who said: “Why, sometimes I’ve believed as many as six impossible things before breakfast.”

Of course they want us to believe the market will continue to rocket along – their lifestyle depends upon it.

According to the Economist magazine, globally “investors are shelling out $1 trillion a year to the custodians of their cash” – much of that money goes into greasing the palms of the investment community.

Buffett’s best advice

The best advice Buffett has for small investors is to put their dough into index-tracking funds because of their broad diversification and low costs. “A very low-cost index is going to beat a majority of the amateur-managed money or professionally managed money,” he said.

Research from John Bogle, founder of the US-based fund giant Vanguard, backs this up. Bogle looked at the returns of investing $10,000 over a 25-year period. If you had invested the money in an actively managed retail fund your $US10,000 would have grown to $US48,200. However, putting the same amount into a broad index-tracking (US) fund with low fees would have grown to $US170,800 – a difference of $US120,000.

This discrepancy is made up of high entry fees, kickback sales commission to advisers, the costs associated with churning of the portfolio, and poor market timing. Buffett warns investors to “beware the glib helper who fills your head with fantasies while he fills his pockets with fees”.

Two things investors control

As investors there are only two things that we can control: the fees we pay, and the asset class we invest in.

Experts have found that these two factors determine the bulk of our investing returns (day traders take note). This is the reason I’m a big fan of Exchange Traded Funds (ETFs), which are ultra-low-cost index funds that trade on the share market just like other shares.

With one simple investment, in an ETF such as ishares you are able to purchase a share that gives you exposure to the biggest companies in China, India, and a whole host of other countries.

The Buffett letters are required reading for all serious investors – and unlike share-tipping newsletters this advice is absolutely free.

Don’t let the cheap-looking website deter you from seeking out each investment letter dating back to 1977 at www.berkshirehathaway.com – it’s all part of his charm.

Get started in investing right here – with my straightforward guide to getting started in the share market.

Tread your own path!

Scott Pape owns shares in Berkshire Hathaway.

Photo: www.flickr.com/photos/doomed/3208476674/