Warren Buffett's TOP5 Ground Rules

Key Takeaways

• Never try to predict the market 

• Investing in the "Deep Value"

• Approach investment with a long-term mindset

• Have something to compare against

• Pay attention to the compound interest

Jeremy C. Miller was a long-term shareholder of Berkshire Hathaway. He went through every one of Buffett's open letters from 1956 to now, thinking of them as an "investment textbook". Later, Miller wrote a book summarizing Buffett's insights shared in the open letters, which reveals the guru's investment philosophy.

The following five basic principles are Buffett's timeless investment secrets, summarized by the author.

Ground Rule 1: Never Predict the Market

Buffett has long declared that he is not in the business of predicting the general market.

Some partners once called Buffett, saying a stock would keep moving upward and thus should be bought. But Buffett declined their advice.

Buffett said: "If you knew in February that the Dow Jones Industrial Average Index was going to 865 in May, why didn't you let me know it then? And if you didn't know what was going to happen during the ensuing three months back in February, how do you know in May?"

We can see that apart from refusing to predict the market himself, Buffet also couldn't stand people obsessed with predictions, especially partners who offered belated advice. He believed they were "biased".

Buffett explained his opposition to the "bias" in his 2020 open letter to shareholders. Buffett said: "I never like to play the game of predicting interest rates because we don't know what the average interest rate will be in the next year, 10 years, or 30 years. Any changes in stock prices may occur: the market might even go down by 50% or more."

He also claimed that pundits who liked to predict markets actually revealed more about themselves than about the future.

Ground Rule 2: Investing in the "Deep Value"

As investors, what is valuable to us other than the market trends? "Deep Value" might be a good choice. This rule is also known as the "Value Investing Strategy".

"Deep value" refers to those companies that can produce excellent products and good management but are undervalued based on fundamentals. Once Buffet finds such a company, he would start comparing the company's assets to its market valuations, among other things. If the market valuation was low, Buffett would generally buy the company's stock without hesitation.

Buffett once instructed investors to buy and sell stocks based on the company's prospect, not the market's prospect.

For example, Buffett discovered a once-little-known company called Sanborn Maps, which mapped every city in the United States accurately to every building. Buffett believed that the company was highly undervalued, so he bought a lot of the company's shares and made a big profit.

In the 2020 open letter to shareholders, Buffett talked about what kind of companies are worth buying.

He proposed three criteria:

First, the business must earn a good return on its net tangible capital.

Second, the business must be run by able and honest managers.

Third, the business must be available at a sensible price.

In reality, large acquisition opportunities that meet these three requirements are rare. But Buffett believed meeting these criteria was crucial. He would rather wait for a good opportunity than live with a bad choice.

"The trick in investing is just to sit there and watch pitch after pitch go by and wait for the one right in your sweet spot," He noted.

Ground Rule 3: Approach Investments with a Long-Term Mindset

Looking closely at what Buffett said in the letter, we can see that when it comes to measuring company performance, Buffett didn't care much about short-term results. He believed that three years was the "shortest period" to measure a company's performance and suggested investors should pay attention to how a company performed over the past 5 years at least.

In the 2020 annual open letter to shareholders, Buffett once again explained the benefits of a "long-term mindset": the fallout from many of my errors has been reduced by a characteristic shared by most businesses that disappoint because as the years pass, the "poor" business tends to stagnate, thereupon entering a state in which its operations require an ever-smaller percentage of Berkshire's capital. Meanwhile, our "good" businesses often tend to grow and find opportunities for investing additional capital at attractive rates.

Buffett then gave an "extreme example". In early 1965, he took control of a textile company, which got into trouble shortly after. As a result, unprofitable textile assets were a huge drag on Berkshire's overall returns.

But by the early 1980s, they had acquired a spread of "good" businesses, such as the insurance industry, which Buffett called "superstars." This shift caused the dwindling textile operation to employ only a tiny portion of its capital.

In his letter, Buffett concluded that acquisitions were similar to a "marriage" – starting with a joyful wedding but gradually diverging from pre-nuptial expectations.

Ground Rule 4: Have Something to Compare Against.

Buffett valued relative performance. The benchmark used for comparison is the major US stock indexes that can be regarded as "bellwethers", such as the Dow Jones index and the S&P 500 index.

Buffett once set a goal to outperform the Dow. If the Dow Jones was down by 10% in a year and his investments fell by only 5%, he considered himself a winner; conversely, if the Dow Jones was up by 25% in a year and his investments only up by 20%, he would have felt a sense of failure.

This explains why Buffett's 2020 open letter to shareholders began with a comparison with the Standard & Poor's 500 index, another important gauge.

In 2019, Berkshire Hathaway's market capitalization per share increased by 11.0%, compared with the S&P 500's increase of 31.5% in the same year. In other words, in 2019, Buffett underperformed by 20.5 percentage points, indeed a bad year.

However, we do see that from 1965 to 2019, Berkshire Hathaway's per-share market capitalization had grown at a CAGR (compound annual growth rate) of 20.3%, more than double the growth rate of the S&P 500. From this perspective, Buffett was still a winner.

Ground Rule 5: Pay Attention to Compound Interest

When Buffett explained the basics of investing to his partners, he often talked about his favorite concept: compound interest. He drew a blueprint and told his partners how fast the money would grow:

Assuming there is an investment of $100,000 with an annual return of 4%, you'll have $148,024 after 10 years; at the same rate of return, after 30 years, that number will skyrocket to $324,337. If you want to change 8% or even 10%, 8% would be $1,006,265 in 30 years,10% would be $1,744,940.

But at the same time, Buffett warned partners of some other overlooked factors, too, such as fees and taxes, which could shrink wealth significantly.

So, it's worth noting that small variables can make a big difference in the long run.