How to Invest like Warren Buffett

Warren Buffett made his millions following the rules of value investing. Find undervalued stocks with good-looking balance sheets for the chance to emulate his success

Emma Wall 25 November, 2013 | 7:00AM
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Emma Wall: Hello, and welcome to the Morningstar series, Why Should I Invest with You? I'm Emma Wall and here with me today is Nick Kirrage, Manager of the Schroder Recovery Fund.

Hello, Nick.

Nick Kirrage: Good morning, Emma.

Wall: So the Recovery Fund follow the values of value investing. What exactly is value investing?

Kirrage: Value investing is the art of buying stuff for less than its intrinsic value. I suppose all fund managers say that buy stocks that are worth more than they pay for them. That's the whole point of fund management. But with value investing, we have a more kind of disciplined way of identifying those companies, of finding businesses that trade explicitly low valuations, low P/Es, low cyclically adjusted P/Es, valuation metrics, and we fish in particular ponds of cheap stocks. Businesses often are cheap for a reason, but is that a good reason? 

As value investors, we frequently find it's not. By investing in those businesses, when they're very out of favor, you can make significant returns for clients.

Wall: Most famous value investor, of course, is Warren Buffett. He strayed somewhat from strict value investing. With strict value investing, macro has no bearing on it and the market cycle has no bearing on it. Is that correct?

Kirrage: I suppose value investing, as many different styles are, is a broad church and there are different ends. I think, Warren Buffett started in the mold of his mentor, Benjamin Graham, who was around in the 1930s, Forties and Fifties and is considered the father of value investing. His belief is that you focus explicitly on cheap valuations and you don't concern yourself overly with the macro economy. The macro economy, of course, is very important. Macroeconomics and the business cycle have a big impact on companies. It's just very, very hard to know how the cycle will unfold and what the direct impact will actually be on the companies, and of course, on their share prices, because the stock market is a discounting mechanism.

So, no, we don't take an explicit macro view, but we always have in the back of our mind that economics is a very cyclical phenomenon. It's very mean reverting over time. So, where we are investing where the assumptions are the things are good and will remain good, that's potentially quite dangerous and where we are investing where things are bad and the assumption is it will never improve, that potentially approaches right side of the averages.

Wall: Looking then at the risks, 2011 was quite a difficult year for you. The nature of value investing is, of course, sometimes stocks will be cheap just because they are rubbish.

Kirrage: Well, there is that, and I suppose we’re constantly asking ourselves. People often say things have changed, that's why the stock is cheap, because what it has done in the past is not a guide for the future. And sometimes things have changed. Things changed dramatically for HMV. It looked like a very cheap stock for long period of time. It wasn't. Things had changed. But what we frequently find is that more often than not, things have not changed. The expression, it’s different this time, we believe four of the most dangerous words in investment, because actually frequently it is not that different. And companies are dynamic, remember. They evolve, they change. If things have changed in their marketplace, they evolve to try and take advantage the way in which they've changed.

So, what we find is businesses that are out of favor, frequently come back into favor. You're right though. There are risks to the style of investment. The one we're more focused on is balance sheet risk, because we don't know the time period it will take for companies to improve, to see that recovery.

So, we wanted some security that we won't permanently lose money. We can't control volatility. We can't control whether the stock market will like or dislike these businesses in the short term. But we can make sure that the businesses have better balance sheets, and where they don't have a stronger balance sheet, we're very compensated for that with large amount of upside. That's what our recovery fund does.

Wall: And I suppose just accepting that now and again, stocks will go wrong?

Kirrage: It's very humbling, being a fund manager. I mean, I suppose nobody likes to look silly. But it's actually quite liberating once you accept the fact that you're going to look silly. And by potentially looking silly by accepting that that might happen that you might invest in something that would go wrong, you can kind of free yourself of the constraints of investing in a very small part of the market, and you can look across a very wide opportunity set, and you can make fabulous returns for clients.

And our recovery fund is a great example of that. We have had three or four failures over the last seven years, and yet the returns have been very, very, very strong. So, you've to kind of accept that as an occupational hazard of what we do.

Wall: Nick, thank you very much.

Kirrage: Thank you.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Emma Wall  is former Senior International Editor for Morningstar