Young investors should focus on buying shares in undervalued companies, which Buffett calls Generals.
Once you’ve got the measuring part down, you can start developing your personal investing style. Remember, each investor is a unique snowflake. Your investing style should reflect your personality, goals, funds, and especially, your competence set. So, if you’re an alpaca rancher, you shouldn’t try to get rich off computer chips.
Here’s more good news. If you’re a new investor with less money, you actually have an advantage over investors managing huge funds. This is because you can invest in small companies not listed on the stock exchange, making big percentage gains. Once you’re managing more money, you need much bigger deals to move the needle on your overall results.
When Warren Buffett started his fund in 1956, he had just over $100,000 to play with. By 1960, his fund had ballooned to $1,900,000. He attributed this incredible rate of return to his focus on small, relatively unimpressive investments.
The key message here is: Young investors should focus on buying shares in undervalued companies, which Buffett calls Generals.
Along with his patient temperament, Buffett’s best asset as an investor is his skill at determining the value of a company. In the early years, he favored buying Generals, which he defined as “fair businesses at wonderful prices.” This means that the companies were of middling quality, but, for some reason, priced under market value. Once again, Buffett’s patience paid off. Most of the Generals he bought stayed in his portfolio for years.
Buffett also liked buying shares in companies that were worth more dead, that is in liquidation, than they were alive. That way, if the business started failing, he could liquidate it and not lose money. This type of business is called a net-net.
Ultra-cheap stocks and net-nets are not glamorous. In fact, Buffett referred to them as his “cigar butts.” But 12 years into his career as an investor, Buffett looked back and determined that this category of investment had done the best in terms of average returns.
As his success grew, Buffett’s definition of value changed. He began looking beyond cheap stock prices, toward the quality of a business and whether its earnings could be sustainable. As his experience as an investor grew, he transitioned from buying fair businesses at wonderful prices, to buying wonderful businesses at fair prices.
Once you have more experience as an investor, you might want to get involved in the management of one of your investments. Go right ahead, Buffett might say, but you’ll need some further guidelines. We’ll learn more in the next chapter.