Berkshire Hathaway Chairman and CEO Warren Buffett is known as one of the most accomplished investors in the stock market. While some of the tenets of Buffett's success differ from The IBD Methodology, there are key similarities as well.
On this IBD Explains, IBD Market Research Director Justin Nielsen and Meredith Heyman discuss risk management lessons from Warren Buffett that active growth investors can learn from: keeping losses small, buying the right stocks at the right time and taking advantage of the power of compounding.
This interview has been edited for clarity and brevity.
IBD Methodology And Warren Buffett
IBD: When it comes to investing, how are the lessons from IBD and Warren Buffett the same?
Nielsen: A lot of the IBD tenets came from Bill O'Neil, the founder of Investor's Business Daily. I had the pleasure of working as his assistant for 15 years. So I know backwards and forwards Bill's thinking on things which again launched the IBD methodology. But for Warren Buffett, we have to go more from books, interviews and those Berkshire Hathaway stockholders meetings and great letters that he writes, which have been over years.
One of the things I think they both have in common is a big thing, and I find this across a lot of the best investors of all time — risk management. Risk management is such a key concept for both of them. For Bill O'Neil, he often said keeping losses small was rule number one. He had the 7%, 8% stop loss from the purchase price was a rule that he just never wanted to see broken.
Now, Warren Buffett has infamously said there are two rules to investing. Number one, don't lose money. Number two, don't forget rule number one. So you can see both guys had a very big belief in that. A huge part of investing is to not lose too much money. It's going to happen, but you want to be keeping your losses small whenever possible. And this is what allows you to keep on playing the game, because, as we'll discuss a little bit later, longevity matters.
The Various Parts Of Investing
There are a couple of parts to it, right? There is protecting capital. You don't want to put more money into things that aren't working. Bill O'Neil a lot of times said, look, I'm not going to average down because I don't want to be right in something, and in case I'm wrong, have an issue where I'm putting more money after bad money.
Now, Buffett really kind of looked, whereas O'Neil maybe looked a little bit more, at the stock chart to tell him that information. Buffett would look at the fundamentals of the company. He would be reading the story of how the company was doing the financial reports, specifically the footnotes.
And so his risk management style, although a little bit different, he was kind of coming up with this what he called the margin of safety. That's where he was making sure that the value that he was buying the company at — that stock price that he was buying the company at — was worth a little bit more than what he was paying. And that the company had extra assets or things that maybe weren't being valued properly. And so that margin let him have that risk management where he knew that he wasn't going to get too hurt on something because he really knew the fundamentals of the company very well.
Contrasting Strategies: Growth Vs. Value
IBD: How is what IBD teaches different from Warren Buffett's approach?
Nielsen: Well, that Buffett approach of really digging deep into the fundamentals — both O'Neil and Buffett believe in fundamentals. But O'Neil was more on the growth side, whereas Buffett was looking for those concepts of value he could find. O'Neil was looking for those companies that were growing, had these phenomenal earnings growth records and were doing something different and changing the way that we work, the way that we live and the way that we play. So he was looking for those things that would entice more people to buy into the company because of what it was doing and how it was growing.
Whereas Buffett might be very big on the dividend payers, he really liked those cash cows. And that's why he's got so many insurance companies. They just produce a lot of cash. Then he can use that cash to sometimes buy companies outright. O'Neil believed that a lot of times, with those growth companies, it was OK that they weren't paying a dividend because they were reinvesting in themselves for that expansion phase. Those expansion phases could be very lucrative, but also short-lived. Whereas, I would say O'Neil's longest holding was a Pic-'N'-Save investment he had in the '70s, over seven-and-a-half years. Buffett, on the other hand, has had some investments for decades.
Finding The Right Investing Approach
IBD: But there is some flexibility for investors to figure out what approach works best for them – different roads can lead to the kind of success that Buffett has had, right Justin?
Nielsen: Absolutely. Whether you do it through growth, whether you do it through value, there's a lot of different ways. If you read some of the best traders of all time, you find they have different ways of getting there. But I would say, be very cognizant of those similarities. The biggest one is the risk management factor, being very careful to protect yourself from taking big losses because longevity matters.
You have to think about the power of compounding. Buffett is over 90 now. IBD Founder Bill O'Neil lived to be 90. So they had, both of them, 70 years of investing, and compounding over that kind of period can make a big difference in building a fortune. Now the other lever for compounding is performance.
And both men had very good performance as well. So being able to do that over time is phenomenal. So those are the two levers you have to work for. Longevity is one of those things — we can control that a little bit better than our performance. And by longevity, I just mean you're controlling your risks to the point where you're not going to be out of the game because we've seen too many of these cases.
And you can go back through history where people blow up their accounts, they're out of the game, and then they can never come back from it. But if you can keep your losses small, keep your drawdowns small, then you always live to fight another day.
Warren Buffett's Biggest Wins
IBD: What are some examples of Buffett's big wins?
Nielsen: One of the things that makes Buffett a little bit different, not something everyone can do, is sometimes he's buying companies outright. That was the case of See's Candies. He bought that company outright, and that was a big winner for him. He's also had investments in things like Coca-Cola over the decades.
American Express, he got that at kind of a discount when there was a big scandal going on … and held on to that for a long time. And then, of course, there's Geico. He got a lesson from Benjamin Graham, the famed value investor, very early on in his career. And it really turned him on to insurance products.
Berkshire Hathaway itself, while the name is synonymous with Warren Buffett, the investment itself and Berkshire Hathaway wasn't a great one. It was a textile company. And the way I've heard the story, Buffett was going in for revenge because he got swindled by the CEO. So he took the company over to get that CEO out. But it ended up being one of those things that was very costly for him.
Now, of course, he eventually sold that textile business and kept the name, Berkshire Hathaway, as a holding company for all of these companies he's created or bought into over the years. So it's a mixed bag. You know, Berkshire Hathaway itself is a great stock story of success. But the company, the textile company, certainly didn't start that way.
Lessons For Active Growth Investors
IBD: What is the biggest lesson from Warren Buffett that active growth investors can use to become more successful in their trading?
Well, even though Warren Buffett's style is very different from what most active growth investors would use, I think one of the things you can learn from Warren Buffett is, again, not to sound like a broken record here, but paying attention to that risk management side of things — not letting small losses turn into big losses. This is something that is not singular to Warren Buffett. This is something I've seen across a lot of different traders, across a lot of different disciplines and styles, but this is part of what makes them great.
Also, I think it's having that discipline, a routine you go through and rules you follow so you're not just using emotions to make your investing decisions, but you're using cold, hard facts as much as possible to counter those emotions. Because let's face it, investing can be a very emotional game. Your hard-earned money is going up and down and fluctuating, so you have to have things to kind of counteract those emotions. Rules and discipline are the best things. I think Warren Buffett is a great example of someone who's applied rules and discipline throughout his life.
