Hagstrom summarises Buffet's approach as being based on 4 key principles:
1) Analyse a stock as a business - Intelligent investing means having the priorities of a business owner (focused on long-term value) rather than a stock trader (focused on short-term gains and losses). In his view, an investor should only buy shares in a company which he would be willing to purchase outright if he had sufficient capital (i.e. a company with business operations that are understood, has favourable long-term prospects, is operated by honest and competent people and which is available at an attractive price).
2) Demand a margin of safety for each purchase - Following in the footsteps of Graham, Buffett has called "margin of safety" the three most important words in investing. Buffett targets large, successful businesses—those with expanding intrinsic values, which he seeks to buy at a price that makes economic sense based on the kind of business it is in, and based on the quality of the management running the company.
3) Manage a focused portfolio - Buffett's approach is to concentrate a few stocks that are likely to produce above-average returns over the long haul and have the fortitude to hold steady during any short-term market hiccups.
4) Protect yourself from the speculative and emotional excesses of the market - In essence, Buffett feels that the stock market exists simply to facilitate the buying and selling of shares. Anytime an investor tries to turn the market into a predictor of future prices, they run into problems. The only use for a regular glance at the market is to check whether anyone is foolish enough to sell a good business at a great price.
In terms of stock selection, Hagstrom identifies 12 basic principles that a company should possess to be considered for purchase.
A. Is the business simple and understandable from your perspective as an investor? Buffet emphasises the importance of understanding how the company generates sales, incurs expenses and produces profits. That means understanding revenues, expenses, cash flow, labour relations, pricing, flexibility and capital requirements.
B. Does the business have a consistent operating history? Buffett avoids companies that are either solving difficult business problems or fundamentally changing their direction because previous plans were unsuccessful. Turnarounds rarely succeed. Buffett feels that the best returns come from companies that have been producing the same product or service for years.
C. Does the business have favourable long-term prospects? Buffett feels that the economic world is divided into a small group of "franchise" companies and a large group of commodity businesses. Commodity companies compete solely on price, with no differentiation between suppliers, whereas companies which own the franchise have a product or service which is needed, has no close substitutes and have pricing power. Ideally, an investor will want to buy a franchise type of company but, the next best option is to buy the lowest cost supplier in a commodity market.
D. Is management rational? Buffett places a great deal of importance on management and one of the areas he focuses on is how excess cash is used. If the company can generate above average returns by reinvesting the cash in the business it should do so because this builds shareholder value. However, if not the management should return the cash to shareholders.
E. Is management candid with its shareholders? The ideal business manager reports financial performance openly and genuinely, with an ability to admit mistakes and report the progress of all aspects of the company. The tendency to include every piece of information that owners would deem valuable when judging the company’s economic performance is a characteristic of a strong management team
F. Focus on return on equity, not earnings per share. Companies are continually adding to their capital base by retained earnings in particular, so you'd expect EPS to increase year by year. A better measure of a company’s performance is return on equity, which measures the management’s ability to generate a return on the operations of the business given the capital employed.
G. Calculate "Owner Earnings". Buffett looks beyond earnings and even cash flow to measure company performance. Buffett judges performance using "owner earnings" who he argues reflects the true cash flow position of a company. This is defined as net income plus non-cash charges of depreciation and amortization less capital expenditures and any additional working capital that might be needed (effectively free cash flow).
H. Search for companies with high profit margins. Buffett seeks franchise companies selling goods or services in which there is no effective competitor, either due to a patent or brand name or similar intangible that makes the product unique.
I. For every dollar of retained earnings, has the company created at least one dollar’s extra market value? The market recognizes companies that use retained earnings unproductively through weak price performance. Buffett feels companies with good long-term prospects run by shareholder-oriented managers will gain market attention, which results in a higher market price.
J. What is the value of the business? Buffett calculates the value of a business as the net cash flows expected to occur over the life of the business discounted back to present value.
K. Can the business currently be purchased at a significant discount to its value? As with other value investors, Buffett is looking to purchase a business only when the current market price is at a significant discount to intrinsic value ("the margin of safety"). Buffet generally aims for a 25% discount as his margin of safety.