Warren Buffett: Lessons from a legendary investor

Here are Warren Buffett's central principles of his investment strategy from Berkshire Hathaway's 1977 annual report.

Video Transcript

- Warren Buffett is widely regarded as the world's most successful investor. In his company's 1977 annual report, Buffett described the central principles of his investment strategy. First, Buffett determines the attractiveness of a company's price by comparing it with his estimate of the company's value. To determine value, he estimates the company's future cash flows and discounts them at an appropriate rate.

Second, Buffett focuses on companies with durable, competitive advantages that fall within his circle of competence. If he can't understand a company's business, then it lies beyond his circle of competence and he won't try to value it. Third, even if a business is easy to understand, Warren Buffett won't attempt to value it if its future cash flows are unpredictable.

Fourth, Buffett seeks businesses with talented, likable managers. He has written that good managers are unlikely to triumph over a bad business, but given a business with decent economic characteristics, good managers make a significant difference. Buffett largely ignores the judgment of the daily market price, except to take advantage of the market's mistakes.

And he builds in substantial room for error when estimating the company's fair value. So if a stock's estimated value is $80 per share, then a purchase at $60 allows an investor to be wrong by 25% but still get a satisfactory result. That $20 difference is called the margin of safety, a principle of Buffett's investment success.

Last, Buffett's investment portfolio has often been concentrated in relatively few companies that meet his requirements, a practice at odds with diversification. But he'd rather add more money to his top investment choices than invest in his 20th favorite holding. Stay financially fit, friends.