Exploring Investments Part 4: Buffett Style Investing

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We’re pleased to share this five-part series on investment, from one of our Directors, Paul Reilly. Paul has had a long-standing career providing financial advice and in this series digs into some important investment principles to increase your understanding of sound investment.

EXPLORING INVESTMENTS: ARTICLE 4 – BUFFETT STYLE INVESTING

At Financial Framework, one half of our direct Australian Share component is actively managed.

The investment style applied to this part of the portfolio draws from the Buffett-style of value investing, the best way to describe this style is that it’s about buying good value businesses, not trading stocks.

Let’s explore what that means.

Profits From Growth

This style of investment is not about trying to beat the share price. It means profiting from a growth in earnings over time. It’s not about jumping back and forth between companies in the short term, because companies don’t grow their earnings over a three-month time period.

If the intention is to invest in quality companies that are good value, with the potential for consistent growth over time, then the default position is an intention to hold these companies for the long term, to give them time to realise their true value.

That also means that investment isn’t made in just any company. Of course any company can go from being dirt cheap to slightly less cheap. But to truly profit from this style of business, investment needs to be made only in quality companies.

What’s A Quality Investment?

There are a range of factors that would contribute to a company being regarded as a quality investment.

When looking at a market made up of in excess of 2000 companies it is important that there is a disciplined approach to identifying those companies that meet the definition of value. A value style of investment looks for companies that are trading at less than their inherent value and exhibit characteristics such as strong cash flow, operational efficiency, good corporate governance and management and a competitive edge.

It also means companies that have stable earnings, not ones with earnings that fluctuate wildly year-to-year. Investments are about making a prediction about the future. And a proven track record of stable earnings would indicate that all things being equal this should be achievable in the future.

That’s also why this is called “Buffett style” investing – the U.S. business magnate Warren Buffett’s fundamental investment methodology is to invest in “boring,” profitable, growing businesses and then giving them the time to actually perform.

The companies to look for have high and stable return in equity, achieved with little or no debt, with a history of growth and stability of earnings per share. The companies that have achieved those characteristics historically are around five and a half times more likely to achieve them in the future than a company that hasn’t achieved them.

While this is not a guarantee, it does put the odds in the investor’s favour. When looking for a business that’s going to be profitable, stable and growing, the single best thing to do is invest in a company that has historically been profitable, stable and growing.

Looking For Growth

Let’s look at an example of why this correlation happens. Remembering that the focus is on buying into a business and not trading stocks, so the business that continues to grow in this way probably has a product or service in growing demand.

One of the companies in the Financial Framework portfolio is in health care. With an aging population in Australia and in fact much of the world, more health-related services are being consumed. Therefore well-run healthcare companies have been tending to grow their earnings consistently over the last 20 years.

It’s not really surprising that their products and services are in growing demand. When looking at the demographics of the Australian economy, as well as Europe and North America, the aging of the population is going to continue for the next 20 years.

Final Thoughts

At Financial Framework, we engage with investment managers that utilise this kind of analysis to ensure a quality investment portfolio that works for our clients.

Contact us today to find out more.

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