Active portfolio management or index investing tend to be the most used types of investing. Index investing is a buy and hold broad variety of index stocks. Active portfolio managers base their value on their skills to pick the stocks to beat the market. Neither consistently provide excessive returns, but both see diversification, as more is better. Buffett believes that the know-nothing investor can use the index investing method to receive average returns, not doing better or worse than the index.
Buffett is a value investor. Benjamin Graham and David Dodd, finance professors at Columbia University, laid out the framework for value investing. Value investors pay very close attention to the price-to-earnings ratio (P/E ratio). A low P/E ratio indicates that the company is inexpensive. Value investors will also conduct some fundamental analysis with various other ratios, etc. to determine best buy. They will then wait for those stocks to trade at bargain prices.
He uses an approach to value investing with what is known to be called Focus Investing that he fine-tuned from reading William Grahams book The Intelligent Investor. Depth, substance and solid thinking are said to be the determination of focus investing. The concepts of focus investing seem to be quite opposite from other types of investing taught. Buffett’s method uses business economics, psychology and probability as a foundation to determine whether an investment is worth it. An investor is to look at investments as if they were purchasing the company rather than just an under priced stock.
They are to only invest in what you are fully confident that you have knowledge about the market business that you are investing in. The more an investor understands about the company the more likely he/she is to have a sound investment portfolio. Shares represent part-ownership of a business and when thinking of an investment, think like an owner. Focus on the overall business, and its future stability, etc. , not the stock. Limit stocks to a few and keep turnover rate low, diversifying risks, and focus on high-quality business with a variety of economic positions.
Harry Markwitz’s journal submission discussing the relationship of risk and return using economics, measures of risk using variance and standard deviation from the normal (average risk) was a break through for investment management. Bill Sharpe later expanded on this idea replacing complex formulas of covariance and used the gross national product (GNP), stock market or other indices as the basis for comparison of stock instead of the covariance of each stock compared in a portfolio. He is also credited with developing the Beta factor, and Capital Asset Pricing Model (CAPM).
Finally, Eugene Fama contributed with his concept of the efficient market theory encompassing the weak, semi-strong and strong forms all together, their concepts are defined as modern portfolio theory, which is taught in our investment class today. With respect to the concepts of risk, diversification, and the efficient market theory Warren Buffett looks at something called intrinsic value risk of a business, not simply stock behavior which is accentuated by Harry Markwitz’s theory on risk. Diversification is built into valuing the right business picks.
The efficient market theory that stresses investors cannot consistently receive excess return, essentially beat the market, due to the efficiency of the market in setting the prices. Warren Buffett has proven that theory completely false with his investment history. The modern portfolio management and focus investing are opposing belief systems on the market and what it is made up of. Buffett does, however, use the net present values and calculations for future cash flows of the business, and discounting these back to a present-day value by applying the rate of return you could otherwise get, with no risk.
He values the actual business through financial statements, etc. instead of with the stocks and dividends, etc. He uses something called the top-down fundamental analysis which three tier evaluation of a possible investment. The first tier is an economic analysis which would consist of looking at business cycles, monetary-fiscal policy, economic indicators, government policy, world, events and foreign trading public attitudes of optimism or pessimism, domestic legislation, inflation, GDP growth, unemployment, productivity, capacity utilization, and more.
The second tier is an industry analysis, which consists of looking at industry structure, competition, supply-demand relationship, product quality, cost elements, government regulation, business cycle exposure, financial norms and standards. Finally, the third tier is company analysis which consists of forecasts of earnings, dividends, and discount rates, balance sheet-income statement analysis, flow-of-funds analysis, analysis of accounting policy and footnotes, management, research, and return risk. Geoffrey Hirt also represents this information in Chapter 5 of Fundamentals of Investment Management.