8 investing keys from Buffett's latest letter

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I follow a pretty straightforward investment strategy. My belief is that you don't need to reinvent the wheel to be successful in the stock market.

Fortunately for me (and you), a few legendary investors have shared their wisdom and their stock-picking principles through books, academic papers and articles. When one of these stock market gurus speaks up, I listen.

So when Warren Buffett, CEO of Berkshire Hathaway (BRK.A, news, msgs) and arguably the most successful investor of all time, recently released his annual letter to shareholders in Berkshire's 2007 report, I took notice. (I encourage you to read the letter using the link above.)

In an astute, witty and yet humble way, Buffett outlines many insightful ideas. Everyone who reads the first 20 or so pages will walk away with something different, but I wanted to share with you what I gleaned from this year's letter.

Buffett's 'enduring moat' indicator

Unlike many of the gurus I follow, Buffett has never fully disclosed, criteria by criteria, his investment methodology. (I based my Buffett strategy on the book "Buffettology," which was written by his ex-daughter-in-law Mary Buffett.) Throughout the years, however, he has given many hints in interviews, articles and his annual letters, and this year is no different.

On Page 6 of the report, Buffett talks about the type of companies he looks for, and while his methods, in general, are nothing new to those who are intimate with his investment approach, I think this deserves some attention.

Buffett writes, "Charlie (Munger, Berkshire's vice chairman) and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag."

Buffett goes on to say that he wants to see a high return on capital and an "enduring moat" that protects this profitability from competitors. An enduring moat could be a strong brand name or the ability to produce a quality product at a lower cost than rivals. Both of these are long-term competitive advantages that can lead to sustained success.

Coca-Cola (KO, news, msgs), one of Buffett's big holdings, has, for example, a brand name that is known throughout the world and ingrained in our everyday life. We sometimes refer to colas as "Coke" when they're made by a different company. That kind of name recognition is hard for new competitors to overcome -- no matter how much money they have to spend promoting their product.

There are, however, situations in which a "moat" isn't enough. In Berkshire's letter this year, Buffett explains a few reasons why, even if a company has an "enduring moat," he might not consider it for an investment.

One reason would be if the firm is in an industry that is rapidly changing and evolving (think high-technology businesses), because that constant change can quickly lead to the erosion of a company's moat. As Buffett says, "A moat that must be continuously rebuilt will eventually be no moat at all." In addition, he also shuns businesses that are dependent on a superstar CEO to produce results. Buffett wants to invest in companies that have strong management and bench strength, and ones that wouldn't be hurt by a departing executive.

4 more key principles

Turning back to the four investment principles -- "a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag" -- all of these are ways to reduce risk and variability. Buffett wants to understand the company, how it makes money, what its competitive position is, whether it has a unusual advantage that leads to high returns on capital, whether the management is strong and displays good principles, and, lastly, whether the stock is trading at a value that gives a good chance for a reasonable return.

Also inherent in this four-pronged approach is disciplined investment strategy and framework that he has consistently followed for years. Buffett never gets caught up in the hype around a hot stock, and he's never dissuaded from investing in a company simply because others think little of it. He focuses on numbers -- the real value of the firm, and the price for which he can get its stock. In part, it's this approach that has enabled Buffett to increase Berkshire's book value by an astonishing 400,863% since 1965 (see Page 2 of the report for the annual and total gains in the per-share book value of the firm). By following this discipline Buffett is able to override emotions and stick with an approach that has been successful.

Continued: Learn from your mistakes

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