Sometimes, as we endeavour to protect the downside by searching for companies with cheap valuations, we can end up finding ourselves in the dreaded value trap. Such frustrating shares will not go up after weve bought them despite their cheap valuation. Sometimes they even dare to go down, and stay there.
If we sift through the dustbin of cheap valuations, the value trap is an ever-present danger. However, there is a way to keep ourselves out of them that comes in a simple three-point check delivered to the world by investing master Warren Buffett, as early as 1958.
Keep it simple
In the past, Ive struggled with great lists of buying criteria to help me make successful investments. It doesnt really work. As with most pursuits in life, the most satisfying results come when we keep it simple.
Of course, it helps if we can clarify our thoughts to pin down what really matters, and master investor Warren Buffett proved over a lifetime that he is good at doing just that. Read any Buffett pearl of wisdom and it seems deceptively simple, but the chances are strong that the more we think about it, the more sense it makes.
Luckily for me, I read through Warren Buffetts partnership notes a few years back and discovered a gem that has kept me on the straight and narrow ever since. With a brief example of an investment he made during 1958, Buffett outlined a three-point check he applied to that particular investment. I took it to heart, and make sure that every investment I enter can be justified in terms of Buffetts three criteria.
The more Ive cogitated over Buffetts criteria since first discovering them, the more certain I become that any investment whatsoever is best when it passes the test first, before any other considerations.
A three-point test
During 1958, Warren Buffett applied his test to a successful investment in a bank called Commonwealth Trust. Heres a warning: these three steps sound so simple and obvious that it is easy to skim read through them. Dont. Be thoughtful and internalise them, as they are the distillation of a lot of Buffett thought and wisdom.
The first point is that the investment must have strong defensive qualities. The second is that the investment should be building value, and the third is that there should be the presence of a potential catalyst to bring out the value.
When Buffett bought shares in Commonwealth Trust, he bought the shares for around $50 each when he believed the intrinsic value of the company worked out at about $125 per share, thus satisfying the first point regarding strong defensive qualities. Buffett saw that value was building thanks to the banks consistent yearly earnings of around $10 per share. He reckoned that over ten years, earnings could double the intrinsic value of the company, thus satisfying the second point that the investment should be building value. Buffetts analysis identified the desire of a larger bank for a merger. The other bank held around 25% of Commonwealths shares, but couldnt achieve a merger for personal reasons. Buffett believed that situation would change, and that satisfied the third point regarding the presence of a potential outer.
How did it work out for Buffett?
Buffetts investment in Commonwealth Trust was a rip-roaring success. He took 57% profit by selling his shares for $80 each, within a year. How lucky was that? I dont believe it was lucky at all. Buffett did everything he could to make sure that the odds of a successful investment outcome were stacked in his favour from the outset, by applying his three-point checklist.
Lets look at those points again:
- Strong defensive qualities;
- Building value;
- Presence of a potential outer.
Yet, how many times to we go into an investment without covering all three of those points? How often, for example, do we buy shares cheap, without considering whether value is building or how the value we think weve found is going to be released?
How often do we buy shares that are building value, perhaps by growing earnings, but forget to consider whether the shares are cheap enough to provide strong defensive qualities?
People often think of Warren Buffett as a value investor, which he is; he seeks good value in his investments and that approach drives his returns. However, the lesson I take here, from Buffetts methodology as long ago as 1958, is that good value means something completely different to cheap.
First and foremostly, we need a good company with a good business before we should even consider whether it is cheap enough on the stock market. To me, Buffetts form of value investing means buying quality firms at prices that make sense of an investment, and his three-point check, when rigorously applied before anything else, can help us to do just that.
Warren Buffett’s insights from almost sixty years ago, expressed in this simple three-step test, can help us avoid value traps and drive decent investment returns for 2015 and beyond. Why not start your investing campaign by reading this paper, which highlights seven steps to serious wealth, signposting compelling investment opportunities available now,ready for your immediate research.
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Kevin Godbold does not own shares in any companies mentioned.