Buffett's first rule is "never lose money," and the second rule is "never forget Rule No. 1
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Warren Buffett believes that investing in "wonderful companies" is the key to long-term investing success.
Characteristics of Wonderful Companies
1. Sustainable Competitive Advantages (Moats)
- Strong brand name and reputation
- Ability to raise prices without losing market share
- Exclusive control of a market (toll-bridge companies)
- High switching costs for customers
2. High and Consistent Profitability
- Above-average and consistent return on equity (ROE)
- Demonstrated consistent earning power
- Low capital expenditures that lead to high returns on invested capital (ROIC)
3. Honest and Competent Management
- Managers that are high-grade, talented and likable
- Management that acts with integrity and competence
4. Reasonable Debt Levels
- Low debt/equity ratio
- Debt that can be paid off quickly using free cash flow
5. Within Circle of Competence
- Investing in businesses you understand
- Focusing on companies that have "meaning" for you
Valuation
In addition to the above criteria, Buffett looks for wonderful companies trading at a fair price, with a sufficient margin of safety:
- Market price significantly below the estimated intrinsic value
- Buying at no more than 50% of the company's estimated fair value
By focusing on wonderful companies with strong competitive advantages, consistent profitability, competent management, and reasonable valuations, Buffett aims to generate market-beating returns over the long run. Time is the friend of the wonderful company, he says, while it is the enemy of the mediocre .