Published June 8th, 2015
Individual investors benefit when investing greats share their wisdom. Warren Buffett, Seth Klarman, Peter Lynch, and Joel Greenblatt are all investing greats who have written books and/or shared their wisdom in annual reports. See their thoughts on investing applied to dividend stocks.
Warren Buffett’s $70+ billion fortune makes him one of the wealthiest men in the world. Warren Buffett’s quotes are concise and filled with investing wisdom.
Over the years Warren Buffett has evolved from a strict value investor to an investor that looks for shareholder friendly businesses with strong competitive advantages trading at fair or better prices. Warren Buffett’s portfolio is loaded with dividend growth stocks like Coca-Cola, Deere & Company, and Wal-Mart.
Warren Buffett’s approach to investing is to buy excellent businesses and let them compound wealth over time.
“Time is the friend of the wonderful company, the enemy of the mediocre”
Time is the friend of the wonderful company because over time wonderful companies will continue to gain market share, grow earnings, and reward shareholders. For a mediocre business, time is the enemy. The mediocre business will slowly succumb to the competitive forces of free markets.
“It’s far better to buy a wonderful business at a fair price than a fair business at a wonderful price”
Time + wonderful business = wealth. Time + fair business = mediocre results. When one buys a fair business at a wonderful price, they are relying on the stock market to generate their returns; hoping that the business’ valuation will rise. When one buys a wonderful business, they can sit back and let the business grow over time; increasing value on its own.
“Our approach is very much profiting from lack of change rather than from change”
Businesses that must undergo continuous change to stay relevant will eventually lose pace with the market. Businesses that rarely have to change their products have a much lower risk of product obsolescence.
What will the smart phone industry look like 20 years from now? I have no idea. Very few people (could anyone?) could have predicted the rise of Apple 20 years ago. On the other hand, think about the tissue industry. Kimberly-Clark manufactures Kleenex brand tissue. I find it very difficult to imagine that the tissue industry will be much different 20 years from now than it was 20 years ago.
Changing industries are exciting, but they reduce the durability of a businesses’ competitive advantage.
“I don’t look to jump over 7-foot bars; I look around for 1 foot bars that I can step over”
Warren Buffett’s strategy of buying excellent businesses reduces risk and complexity. It isn’t hard to see that Coca-Cola or American Express have strong competitive advantages. It is orders of magnitude more difficult to examine a biopharmaceutical start-ups expected value. There is no reason to take chances on overcomplicated analysis when you can buy easy-to-understand high quality businesses. There are no bonus points for difficulty in investing.
Warren Buffett’s investment strategy matches well with dividend growth investing. While Warren Buffett does not require the businesses in which he invests to pay dividends, most of them do. All of Warren Buffett’s top 5 holdings pay increasing dividends year-after-year – and 2 of his top 5 are Dividend Aristocrats. Warren Buffett’s 5 largest holdings are listed below:
- Wells Fargo (WFC) – 24% of portfolio
- Coca-Cola (KO) – 15% of portfolio (Dividend Aristocrat)
- IBM (IBM) – 12% of portfolio
- American Express (AXP) – 11% of portfolio
- Wal-Mart (WMT) – 5% of portfolio (Dividend Aristocrat)
Seth Klarman is the 58 year old founder of the Baupost Group hedge fund. Baupost Group has about $30 billion in assets under management. Seth Klarman is a risk-averse value investor. He wrote the preface for the 6th edition of Margin of Safety. Seth Klarman’s own book, Margin of Safety sells for over $1,000.
Like Warren Buffett, Seth Klarman prefers to invest for long periods of time. While he is not in the ‘hold forever’ camp, Seth Klarman does advocate a long-term mindset.
“The single greatest edge an investor can have is a long-term orientation”
The above Seth Klarman quote is incredibly powerful. It spells out in no uncertain terms how important investing for the long-run is. Having a long-term orientation prevents speculation by forcing investors to focus on business fundamentals rather than short-term price movement.
“The trick of successful investors is to sell when they want to, not when they have to”
To have a long-term orientation, one must not be forced to sell their stocks. Dividend stocks are unique in their ability to provide both current income while maintaining long-term growth prospects. The ultimate goal of building a dividend growth portfolio is to have dividend income fully cover all expenses. In this scenario, investors only have to sell when they want to, never because they have to.
“The avoidance of loss is the surest way to ensure a profitable outcome”
Taking unnecessary risk will lead to large losses. Loss avoidance is critical for investing success. When investors focus on minimizing downside risk, the upside tends to take care of itself. Investing in businesses with strong competitive advantages trading at fair or better prices is perhaps the best way to avoid long-term losses.
“Many investors insist on affixing exact values to their investments, seeking precision in an imprecise world, but business value cannot be precisely determined”
Investing would be extremely easy if there were a way to precisely determine the value of a business. Discounted cash flow analysis uses various inputs and estimates and produces an ‘exact business value’. Of course, this value is not ‘real’, it is only a projection based on the various inputs used in the formula. investors would be wise to avoid trying to label businesses with an exact value as such a task is impossible.
“If you don’t quickly comprehend what a company is doing, then management probably doesn’t either”
As discussed in the Warren Buffett section above, investors don’t get bonus points or extra return for degree of difficulty. If a business is exceptionally difficult to understand, then anyone’s analysis will likely miss important details. Further, it is more difficult to manage a complex business. Simple business models are easier to manage, measure, and improve.
Peter Lynch averaged an investment return of 29.2% between 1977 and 1990 when he ran the Magellan Fund. He has shared his investing wisdom in several books including One up on Wall Street and Beating the Street.
Peter Lynch’s investing philosophy focuses on buying fast-growing stocks (typically small-caps) for cheap. Peter Lynch pioneered the PEG ratio. The PEG stand for price-to-earnings-to-growth. It is the P/E ratio divided by the growth rate. A PEG ratio under 1 signals a ‘buy’ for Peter Lynch.
Like Warren Buffett and Seth Klarman, Peter Lynch likes simple stocks – maybe even more than the two previously mentioned investors. The two quotes below emphasize simplicity in investing.
“The simpler it is, the better I like it” and “If you’re prepared to invest in a company, then you ought to be able to explain why in simple language that a fifth grader could understand, and quickly enough so the fifth grader won’t get bored.”
The ‘5th grader’ test above is an excellent litmus test to see if you really understand what a business does. If a 5th grader can understand the business model, then the company is likely very focused on what it does best.
“Go for a business that any idiot can run – because sooner or later, any idiot is probably going to run it.”
In keeping with the simplicity narrative, Peter Lynch recommends investing in businesses that ‘any idiot can run’. This means businesses with strong competitive advantages that are very straightforward. It is an unfortunate truth that often times the CEO’s and top-level executives are the best at climbing the corporate ladder, and not necessarily the best at running a business (this, of course, is not always the case). A fantastic business has a much better chance at ‘weathering the storm’ of incompetent management versus a mediocre business.
“Stocks aren’t lottery tickets. There’s a company attached to every share.”
Many investors forget that stocks are fractional ownership of a business. They are not random ticker symbol lottery tickets that bounce up and down in value. Just because the stock market allows you to buy and sell every day does not mean it is advisable to do so. If you own your own business or are in a partnership, you would never consider selling every day. Why would it be any different in with fractional ownership of a larger business?
“Owning stocks is like having children — don’t get involved with more than you can handle.”
Peter Lynch (and Warren Buffett and Seth Klarman) advocates running a relatively concentrated portfolio. There is no point in buying 100’s of securities – it is impossible to track the business operations of all of them. Rather, investors should invest in businesses they know and understand well. Over diversifying leads to mistakes.
Joel Greenblatt is a 57 year old value investor and author. He managed the hedge fund Gotham Capital from 1985 to 2006 and generated absurd annual returns of 40% a year. Joel Greenblatt’s books include You can Be a Stock Market Genius and The Little Book that Beats the Market.
Joel Greenblatt now employs formula-based value investing. His strategy involves looking for businesses with high margins trading at a low price in relation to earnings. He currently has several mutual funds available (all with very high expense ratios).
Rule/formula based investing has a distinct advantage. It eliminates bias and emotion from the investing process. As a formula-based investor, Joel Greenblatt recognizes the advantages of this approach.
“Decisions to buy and sell stocks should be based solely on the investment merits.”
Joel Greenblatt, like all the investors discussed above, seeks to limit downside risk. His downside risk protection method is similar to that of Warren Buffett and Seth Klarman; Joel Greenblatt looks for a margin of safety. In value investing, a margin of safety refers to the difference between the estimate of what you think a business is worth and what it is trading for on the stock market. The larger the discount on the market, the more margin for error you have in your value calculation.
“One way to create an attractive risk/reward situation is to limit downside risk severely by investing in situations that have a large margin of safety.”
In addition to the margin of safety, Joel Greenblatt also recommends investing in situations where you are both knowledgeable and confident.
“It makes sense that if you limit your investments to those situations where you are knowledgeable and confident, and only those situations, your success rate will be very high.”
The underlying value of businesses does not bounce around much from day-to-day. Stock prices, however do.
“Prices fluctuate more than values—so therein lies opportunity.”
Rapidly fluctuating stock prices create opportunities when price falls below value. Patient investors must have the discipline to both buy and hold positions where price falls below value.
“Time is the currency of everyone’s life.”
Dividend growth investors prefer buying and holding high quality businesses for the long run. Businesses that reliably pay increasing dividends year-after-year provide rising income for dividend growth investors. When funds are invested in high quality businesses, little else must be done. This builds wealth while taking less time than other investment methods. Day trading, for example, requires constant attention on a daily basis. This reduces the time you have to pursue other, more rewarding non-investment activities.
All of the investors mentioned in this article have excellent investing records. The combined wisdom of these investors shows what works in investing. In summary, investors should look for easy to understand businesses with strong competitive advantages. These businesses should be held for the long-run, or until they no longer have competitive advantages.
Investors should look for undervalued businesses. An excellent business trading at the value of a mediocre business is undervalued. If you buy quality for a normal price, you get a bargain. The 8 Rules of Dividend Investing use many of the ideas of great investors to find high quality dividend stocks trading at fair or better prices suitable for long-term holding.