Eager amateur investors look to experienced, wealthy investors such as Warren Buffett for tips and advice regarding making a profit investing in other businesses. In this infographic, we’ll look at the three principles Buffett uses when making an investment decision, and how entrepreneurs can apply these principles to their own startup ventures.
To learn more, check out the infographic below created by the Washington State University’s Online MBA program.
Look for Business with a Moat
A main principle guiding Buffett’s investment decisions is the enduring “moat.” If a business is compared to a castle, then a moat is necessary for protection.
The Economic Moat
The economic moat can be described as a business that’s able to defend – or even define – its market position. This tactic requires market and pricing power. For example, Berkshire Hathaway insurance businesses have a float created by the insurance premiums that are then paid out in claims. This float costs only 2.2%, which is below the average T-bill rate.
Buffett also believes in investing in enduring companies, or those that aren’t industry-prone to rapid and constant change. As he said in his 2007 shareholder letter, “A moat that must be continuously rebuilt will eventually be no moat at all.”
Creating a Blue Ocean
Buffett also endorses a strategy to build an economic moat that emphasizes tapping into new market spaces. This creates a “blue ocean” without competition. For example, Alexion Pharmaceuticals created Soliris, a drug that treats an orphan disease known as atypical hemolytic uremic syndrome (aHUS). After receiving regulatory approval, the company was able to sell the drug at a premium price, even though the number of patients using the drug wasn’t high. The reason? A lack of competition. Since 2007, the company’s shares have increased by roughly 1,605%.
Better than Everyone Else
Another way to build a moat is by offering a product of service that’s more effective than rivals’ products. For instance, MySpace was more popular than Google and Yahoo Mail in 2006. Within 15 months of being acquired by Google, MySpace revenues had jumped from $1 million per month to $50 million per month. By June 2009, Facebook surpassed MySpace with its number of American users. In this case, MySpace was an early mover in social networking, but Facebook had the second-mover advantage and perfected the concept.
Buy Quality when it is Marked Down
Buffett’s advice when looking at a quality company is to buy the entire business, or 80 percent of it if management is a partner. A purchase decision, however, is also based on a lucrative price tag. A famous quote buy Buffett reads, “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.” Buffett’s mentor, Ben Graham, said when businesses sell below market value, it’s a signal for investors to buy.
There are several reasons why stocks can become undervalued, from market crashes and cyclical fluctuations to a failure to achieve short-term goals and dirty corporate. Whatever the reason, there are several things to look for when searching for undervalued stocks, such as P/E ratio, earnings yield, positive earnings, and dividend yield. Purchases of a stock by a company’s managers or directors could be another sign that the company is headed toward a bright financial future.
Invest in What You Understand
Buffett believes it’s important for him to invest in businesses he understands. Since he doesn’t understand technology, tech stocks are mostly absent from Berkshire’s portfolio. When approached by Google prior to its IPO, for instance, Buffett passed because he didn’t understand how the company would stay profitable and maintain a competitive edge. While he missed out on a highly rewarding stock, the bigger picture highlights his decision to avoid rolling the dice on an unfamiliar industry.
The Dangers of Chasing Novelties
Though investing in a developing technology or industry can appear lucrative, investors should be mindful and recognize the risk of chasing opportunities they don’t fully understand. A recent example of this is the rush to invest in blockchain technology. At its peak, Bitcoin (BTC) was valued at $19,783. However, its value dropped below $7,000 in March 2018.
Skeptics of blockchain tech have claimed if an asset can’t be valued, then the investor can’t be rational. They also assert that believing in the tech doesn’t equate to a wise investment decision. Furthermore, they state that owning Bitcoin doesn’t impart individual ownership of blockchain tech, and that the drive to buy Bitcoin is fueled by FOMO (fear of missing out). Despite these concerns, many early investors rushed in and suffered a huge loss.
Buffett’s take on blockchain tech furthers his philosophy of investing in only what is understood. “In terms of cryptocurrencies, generally, I can say with almost certainty that they will come to a bad ending…when it happens or how or anything else. I don’t know. I get into enough trouble with things I think I know something about…Why in the world should I take a long or short position in something I don’t know anything about?”
For entrepreneurs, Buffett’s investment principles can be applied to their startups in the three ways. Firstly, they shouldn’t go into business just for the money – passion should be the driving force. Secondly, they need to recognize the importance of team and culture, because a startup’s success hinges on individuals working together. Finally, entrepreneurs should embrace failure instead of being afraid to fail.
The secret to successful investing is that not every investment will be successful. Also, not all startups succeed. Investing – and entrepreneurship – should be driven by an idea and passion. By applying the aforementioned investment principles, investors and entrepreneurs can become better at recognizing red flags and avoiding negative outcomes.