Warren Buffett’s Investment Philosophy

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The market tenants encompass two factors. First, the value of the business is assessed using the discounting of cash flows method. Therefore, the stream of cash flows and the discount rate are needed. Warren Buffett likes to compare this calculation to the valuation of a bond. Hence, the stream of cash flows, that analogically would be the coupon payments, need to be as stable and foreseeable as possible. Following this logic, the discount rate Warren Buffett uses is the long term US government bond rate because the investment is in the sense risk-free that he chose the investment based on minimizing the risk. Additionally, he strongly rejects the Capital Asset Pricing Model because it incorporates the price fluctuations that are irrelevant to Warren Buffett. Second, the business needs to be purchased at a significant discount. This follows Benjamin Graham’s approach of the margin of safety. Warren Buffett acknowledges that forecasting cast flows is highly speculative even though he already chooses based on stability. Hence, when he buys a company, the significant discount should serve as a safety for mistakes made when assessing the business prospects.

When a company passes the above-mentioned tenants, it is a highly attractive company that Warren Buffett likes to buy. However, those companies are rare and therefore, Warren Buffett always holds enough cash to be ready to buy when the time comes.

Portfolio strategy

Warren Buffett does not believe in diversification. According to him, diversification leads to average returns. In order to achieve above average return he prefers focus investing. He invests in companies he understands and companies that are better than the average in terms of generating return on equity. Generally speaking, this approach entails more risk, however as Warren Buffett picks the stocks based on risk criteria such as stability, consistency and long-term qualities, he argues that the companies he chose actually entail less risk than the average company. Historically speaking, this approach enabled him to achieve returns in far excess of market returns.