With all the lessons in value investing of the Oracle just a google search away, most of them containing hard to understand words, let me give my take on the 4 rules of value investing according to Warren Buffett and Charlie Munger.
Rule # 1 – Know Your Circle of Competence by Investing in Businesses that you Understand
Knowing what you know means, knowing what you can confidently invest in. Businesses that you can accurately (or somewhat more accurately) predict its future. Your circle of competence will dictate what kind of stocks are available to you that you can confidently invest in. If Warren avoids technology and invest in consumer goods, that’s not because most opportunities are in consumer goods, its just that he understands it better. That is where his circle of confidence is. If you know technology, then you have a circle of competence investing in technology companies. Knowing your circle of competence and knowing its boundaries makes you aware of the potential rise and fall of an industry you know.
As Peter Lynch said, “Invest in what you know.”
Rule # 2 – Management with Integrity and Talent
On the search for quality companies, comes the search for quality management. If you’re going to be car racing using a Ferrari, you don’t want a cab driver driving that car, you want a professional high quality racer to make use of it or it will just be a waste. The same idea with companies. You want to know how the managements are doing. Are they with the highest integrity? Are they capable? A great quality business have both capable and trustworthy people running it.
Rule # 3 – Durable Competitive Advantage
Value investing involves investing for the long haul. Meaning, buying a business and holding it forever. But forever is a long time. Would the business survive that long? It might, if it have a durable competitive advantage. A durable competitive advantage is a “moat” that protects the “castle” in this case, the business, from invading forces or market forces. Its a concept that gives a business a monopoly-like advantage against its competitors. It can be a brand, a patent, a regulation that protects the business from outside forces.
Rule # 4 – Fair Price
These rules are easy to follow. Everybody can spot the great businesses. And so, these businesses sell at the market at a premium. A value investor must not overpay. No business is worth an infinite price no matter how great the business is. What will ultimately affect your investment results is how much you paid for the value that you get. So you must know and buy a company at a fair or discounted price.
Wonderful business at fair price is better than a fair business at a wonderful price. But its insanely good if you bought a wonderful business at a wonderful price.