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Five Simple Steps to Investing Like Buffett

Forget about momentum and charts and trading catalysts.

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It is amazing how simple Warren Buffett's investment strategy is, but how few successfully emulate it. The good news is that the skill-set required to invest like Buffett is quite widespread, and any nominally intelligent person can do it� with the proper focus and attitude.

Below, I've boiled down the wisdom that Buffett and his partner in crime Charlie Munger have given over the years into five simple steps. These are all things I try to do when managing the Tortoise and Hare model portfolios that are the centerpieces of Morningstar's StockInvestor newsletter service.

1. Buy businesses, not stocks
The financial media and many beginning investors often equate investing with trading. Nothing could be further from the truth. One of the most important things to remember when investing in stocks is that they are not just little pieces of paper to be traded. Rather, they represent ownership stakes in businesses.

I believe it is incredibly helpful to think like a business owner (and not just a "renter") when considering what to buy. This simple frame of mind will tremendously help both in stock selection and valuation.

2. Focus on companies with wide economic moats
Companies that have their cash flows structurally protected from competition should fare much better in an economic downturn, while also increasing in intrinsic value at above-average rates over long periods. In other words, time is on your side with these companies.

All the companies I've bought in the Tortoise and Hare model portfolios have economic moats. This means they either are low-cost producers (think  Wal-Mart (WMT) or  Vulcan Materials (VMC)), benefit from customer switching costs (think  Bank of America (BAC)), or have intangibles like patents and brands (think  Wrigley (WWY)). These companies should in aggregate continue to generate above-average levels of cash, given their solid positioning.

3. Let intrinsic value be your touchstone
The value of a business is the value of all the cash that business can generate for its owners in the future, discounted to today's terms. And since stocks represent ownership stakes in businesses, it makes perfect sense to value stocks via discounted cash-flow analyses. Forget about momentum and charts and trading catalysts; the intrinsic value of the businesses you are buying should be the utmost reference point. Valuing stocks any other way, as Charlie Munger would say, is just moronic.

This is why every single fair value estimate we publish at Morningstar is backed by a discounted cash-flow valuation model. We want our subscribers to get ahead of the game by grasping both the price and the value of their stocks.

4. Always require a margin of safety
Any intrinsic value estimate is based on projections of future cash flows. And since the future is inherently uncertain, it is highly beneficial to only buy at a discount to fair value to account for that uncertainty. Buying stocks without a margin of safety is like driving without a spare tire� you can do it for a while, but eventually something bad is going to happen.

5. Think independently, and be patient
We as humans are innately wired to receive comfort from going with the crowd. Meanwhile, we all want instant satisfaction. But these are harmful things when investing, and learning to avoid our own shortcomings is a surefire way to boost returns. To be greedy when others are fearful, and fearful when others are greedy, is some of the best advice Buffett has ever given.

This recipe has worked great, both for  Berkshire Hathaway (BRK.B) over the decades, and for us at Morningstar more recently. I have no doubt it will continue to work in the future. If you want to find some of the raw ingredients for this recipe--the companies with wide moats that are trading at discounts to intrinsic value--consider subscribing to StockInvestor.

A version of this article appeared in a special report that was handed out at the 2007 Berkshire Hathaway annual meeting in Omaha.

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Paul Larson has a position in the following securities mentioned above: BRK.B, VMC, WMT. Find out about Morningstar’s editorial policies.