The Sage of Omaha, Warren Buffett, is arguably the best investor who ever lived which explains why 70,000 fans flock to Nebraska every year in the hope of discovering his investment secrets and insights.

I have been following Buffett since the early 1990s when a colleague gave me a copy of the Outstanding Investor Digest.

A large chunk of the publication was devoted to the questions and answers session from Berkshire Hathaway’s (BRK-B:NYSE) annual shareholder meeting.

I have since consumed many books about Buffett and two written by his business partner Charlie Munger, including his magnum opus Poor Charlie’s Almanack (see books section later in the article).

What follows are three investment principles which best define Buffett’s investment approach and underpin his track record.

NO 1: THE STOCK MARKET IS THERE TO SERVE YOU

At a presentation to students at Columbia Business School in the 1960s, Buffett unveiled a simple, but remarkably insightful observation.

Citing data from research and publishing firm Value Line which tracks around 1,700 publicly traded stocks, Buffett noted the average difference between a stock’s 52-week high and low was nearly 80%.

Buffett told the audience that business value does not change by 80% in a single year, implying stock prices can swing wildly away from fundamental values at times. Rational investors should embrace this feature of stock markets, not fear it, said Buffett.

The observation supports Benjamin Graham’s idea that the stock market is there to serve investors, not guide them.

Fear and greed drive stock prices away from fair value over the short term, but over longer periods, stock prices are driven by cash flow and profits.

This idea was encapsulated in Graham’s quote that the stock market is a voting machine in the short term and a weighing machine over the long term.

KEY TAKEAWAY: Price turbulence is your friend in investing as long as you have a sound understanding of a company’s economic strengths and the courage to act on your convictions.

NO 2: INVEST IN BUSINESSES YOU UNDERSTAND

Buffett will only contemplate buying a business if he fully understands its economic strengths and weaknesses and the competitive landscape in which it operates. Buffett refers to this as his ‘circle of competence’.

Defining an accurate perimeter comes down to having a realistic understanding of one’s own capabilities. Some people instinctively know when they are straying away from what they know, but it is not easy, and for many investors the lines are blurry.

Even Buffett has strayed from this principle from time to time, usually resulting in a poor decision, as he has freely admitted.

Being humble is an asset in the investment business because the future is unknowable, and mistakes are commonplace. At the other end of the spectrum, overconfidence can be very dangerous.

Buffett and Munger have learned how to think in terms of probabilities rather than absolute certainties. This helps to develop a flexible mindset which embraces uncertainty rather than ignoring it.

In their excellent book Super-Forecasting: The Art and Science of Prediction, Philip Tetlock and Dan Gardner describe how the best forecasters constantly make small iterative changes to reflect new information.

It may sound counter-intuitive, but having access to more information is not necessarily helpful in investing. Knowing the few things which are important is far more valuable than knowing a lot of irrelevant things.

This is where Buffett and Munger have excelled, and it all comes back to having a good grasp of your own circle of competence.

In this context it is worth being aware of a cognitive bias called the Dunning-Kruger effect which is where individuals with low competence overestimate their skills, and highly competent individuals often underestimate their abilities.

KEY TAKEAWAY: Having a realistic understanding of what you know and how much you know relative to other investors is important in developing insights and an investment edge.

NO 3: MOATS PLUS MARGIN OF SAFETY

Many people might think the key to investment success has something to do with finding high growth companies, but growth by itself cannot protect a business from competitive forces.

High growth businesses tend to attract competition, which puts more of a premium on building protection strategies.

The best investments tend to possess economic moats which protect returns on capital and allow a business to compound earnings over many years.

The longer a business can continue to earn superior returns, the greater its value to an owner who is willing to hold on to the shares for the long term. To illustrate we introduce a current Berkshire holding.

Berkshire Hathaway received a stake in bond rating agency Moody’s (MCO:NYSE) when it was spun-off from Dun & Bradstreet in September 2000. Buffett revealed a stake of 24 million shares in his 2001 annual shareholder letter for a cost of $499 million.

Moody’s has been around for more than a century and Buffett liked the firm’s capital-light business model, the fact it operated with few competitors, (Moody’s, Standard & Poors and Fitch control 95% of the global credit rating market) and strong pricing power.

Had Buffett decided to take a profit when the stock doubled within two years, he would have made a big mistake.

The stock price recently surpassing $500, equating to a 50-fold return, while dividends have increased 13-fold. Berkshire Hathaway has purchased and sold shares in Moody’s over the last quarter of a century and at the time of writing held a 13.75% stake, with a value of $12.5 billion.

The investment in Moody’s demonstrates Buffett’s approach of waiting for a ‘fat-pitch’ and betting heavily when the odds seem to be in his favour.

While Buffett and Munger have probably made thousands of investment decisions over the last half century they freely admit that most of the wealth they have created is due to the outsized returns in just a handful of investments.

In this context, it is worth noting that the asymmetry experienced by Berkshire has been corroborated by academic researcher Hendrik Bessembinder, who conducted a study of global stock market returns between 1900 and 2018.

Bessembinder found that just 1.3% of stocks contributed all of the net gain relative to the performance of US treasury bills, implying that most companies do not add value.

THE PRICE IS RIGHT

Calculating the intrinsic value of a business should never be a precise calculation, but rather a ballpark estimate of earnings power, based on conservative assumptions.

‘It is better to be roughly right than precisely wrong,’ insists Buffett.

Buffett has often articulated his framework for thinking about intrinsic value in terms of a discounted cash flow calculation. Famously Buffett only uses a computer to play Bridge, therefore all the relevant calculations are made in his head, not in a spreadsheet.

If it isn’t clearly obvious to Buffett and Munger after looking at the relevant variables they ‘pass’ and move on to the next investment.

Later we illustrate how to calculate a discounted cash flow using Moody’s as an example.

Before that, it is necessary to introduce the idea of ‘margin of safety’ which Buffett has said are the three most important words in investing.

The idea was introduced by Ben Graham in his seminal 1934 book Security Analysis and makes an appearance again in the more digestible 1949 book The Intelligent Investor, which remains one of Buffett’s favourite books.

Graham’s view is that investors should look at the downside risks before considering the returns. Applying a discount to intrinsic value can protect an investor from uncertainties and errors of judgement.

So, what is intrinsic value?

Buffett believes the intrinsic value of any business is the equivalent of adding up all the free cash flows it could produce over its life, discounted at an appropriate discount rate.

The discount rate is comprised of the risk-free rate plus a premium to account for uncertainties. Long-term government bond yields are a good proxy for the risk-free rate.

For businesses with reasonably stable cash flows, Buffett might typically apply a 10% discount rate but his does depend on the prevailing level of government bond yields.

STEP-BY-STEP GUIDE TO MOODY’S DCF

Make a forecast for free cash flow growth.

Moody’s has historically grown free cash at 11% a year, and we have assumed a lower 9% rate for the next 15 years. In 2024 the company generated $2.52 billion of free cash.

We have a applied a 10% discount rate. Why apply a discount rate?

The idea behind discounting is related to the value of cash today versus cash in the future and opportunity cost.

Cash today can be invested, either in risk free government bonds or in riskier assets. This means it has greater value than the same cash flow received in a year’s time.

Free cash flow is divided by the discount rate. In our example, year one cash flow of $2.75 billion is divided by 10%. (2.75 / 1.1) = $2.5 billion.

Year two cash flow is discounted by 10% x 10% or 1.1 x 1.1 = 1.21. Note this is higher than 10%+10% (20%) because we have multiplied the rates, not added them.

We continue to do this for all 15 years of cash flow. Year 15 cash flow of $9.19 billion is discounted by 4.17 (1.1^15) = $2.2 billion.

The discounted cash flows are added together ($35.2 billion).

In theory companies can generate cash flows forever. To calculate what cash flows beyond 15 years are worth we need to estimate a terminal or perpetuity growth rate. It should be a conservative, sustainable growth rate.

For Moody’s we have assumed the business can sustainably grow at 6% which, is faster than the economy (3% to 4%) due to Moody’s strong competitive position and sticky demand for debt rating services.

We subtract our assumed 6% long-term growth rate from the discount rate to arrive at a capitalisation rate. (10%-6% = 4%)

Year 16 cash flow is $9.19 billion x 1.04 =$9.56 billion.

Year 16 cash flow is divided by the capitalisation rate (9.56/0.04) which equals $239 billion. The terminal value is discounted by the year 16 discount rate of 4.59 which, equals $52.1 billion.

We now add the two discounted values (35.2 + 52.1) to arrive at intrinsic value ($87.3 billion). We compare this value to the company’s current market capitalisation of $90 billion.

We had no idea what the result would reveal before calculating intrinsic value, so it is interesting that we ended up roughly at the current market value. This means there is no margin of safety based on the growth assumptions we have applied to Moody’s.

Buffett typically demands a margin of safety to justify an attractive entry point.

KEY TAKEAWAY: Focus on companies which possess durable economic moats and try to buy with a margin of safety and hold on for the long term to benefit from the compounding of profits.

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