Warren Buffett is known as a legendary investor. He is the greatest investor of all time. He earned consistent returns from his investment, which seems unrealistic, but true. Every investor wants to know, how did he do this. Warren himself explained that sticking to a few key principles over long term is key to successful investing. These rules can be implemented in everyday life. Here are seven rules of Warren Buffett, revealed by him during a lecture, which can make us better investors.

Intelligence, Initiative, and Integrity

Warren says – “We look for intelligence, initiative or energy, and integrity when hiring people. If somebody does not have integrity, then the first two will kill you. Because if you hire someone without integrity, you want them dumb and lazy. You don’t want them smart and energetic.”

Thus an investor must look to invest at those companies, that are run by people of integrity. Obviously, the first two are important, but integrity is a non-negotiable principle.

Always look at facts, not emotions

Warren says – “Investors behave in very human ways, which is they get very excited during bull markets and they look in the rearview mirror and they say, I made money last year, I want to make more money this year. So this time I will borrow. So when In view in the rearview mirror, a lot of money has been made in the last few years. They plow in and they just push and push up prices and when they look in the rearview mirror, and they see no money having been made, they just say, “ This is a lousy place to be”, So they don’t care what is going on in the underlying business. It is astounding but that makes for a huge opportunity.”

Typical investors get influenced by the bull run or bear phase. The correct ways to focus on the underlying business, irrespective of market sentiments.

Buy Wonderful Businesses at fair prices, not Cigar Butts

Warren says – “I have been taught by Ben Graham to buy things on a quantitative basis. Look around for things that are cheap. That was taught in 1940s or 1950s. It made a big impression on me. So I went around looking for what I call “Used Cigar Butt” of stocks. The Cigar Butt approach of buying stock is that you walk down the street and you are looking around for cigar butts and you find that on the street this terrible looking soggy, ugly looking cigar, one puff left in it. But you pick it up and you get one puff and throw it away. Disgusting, but it is free. I mean it is cheap. And then you look around for another soggy one puff cigarette. That’s what I did for years. But it is a mistake. Although you make money doing it but you can’t make it with big money. It is so much easier to buy wonderful businesses. So now I would rather buy a wonderful business at affair price than a fair business at wonderful price.”

Crappy businesses are unpredictable. There is a very low probability of making money by investing in such businesses. It is always better to invest in wonderful companies at a fair valuation.

Buy only those stocks, that you understand

Warren says – “I have an old-fashioned belief that I can only expect to make money on things that I understand and when I say understand, I do not mean to understand, what the product does or anything like that. I mean, I understand what the economics of the business look like 10 years from now or 20 years from now. I know in general what the economics will say, Wrigley’s chewing gum will look like 10 years from now. The internet is not going to change the the way, people chew gum. It is not going to change, which gum they chew. If you own the chewing gum market in a big way and if you have got Doublemint, Spearmint and Juicyfruit, those brand would be there 10 years from now on. I can’t pin point exactly, what the numbers going to be look like, but will not be way off, if I try to look forward on something like that. Evaluating that company is within what I call “ my circle of competence”. I understand what they do, I understand the economics of it, I understand the competitive aspects of business.”

Finding your circle of competence and investing around it will increase the probability of success in investing. One can understand the economics behind such businesses and can see 20 years from now in such businesses.

Avoid missing the opportunities

Warren says – “The biggest mistake we have made by far of mistakes of omission, not commission. It means, things, I knew enough to do. They were within my circle of competence. Still, I passed up the opportunity. I probably cost Berkshire at least USD 5 billion. For example 20 years ago, when Fannie Mae was having some troubles and we could have bought the whole company for practically nothing. I don’t worry about that if it is Microsoft, because Microsoft isn’t my circle of competence. But I did know enough to understand Fannie Mae and I blew it. Those were the big mistakes and I have got plenty of them. Big opportunities in life have to be seized. We do not do so many things, but when we get a chance to do something, that is right and big, we’ve got to do it. And even doing it a small scale is almost not doing it at all. You really got to grab them, when they come. Because you are not going to get 500 great opportunities. You would be better off, when you got out of school and you got a punch card with 20 punches on it and every big financial decision you made, you used up a punch, you’d get very rich because you’d think through very hard in making each decision. If you go to a cocktail party and someone talking about a company, he made money on that last week, you would not buy it, if you had only 20 punches on the card.”

Always think very hard before making an investing decision. Always look out for good investing opportunities.

When to sell?

Warren says – “We are not going to sell our wholly owned business, no matter how much somebody offers us. If somebody offers 3 times, what somebody is worth, we are not going to sell it. I may be wrong in having that approach. But selling one would be like selling one of my children, because somebody waived a big cheque. If we are short of funds and some opportunity comes, we might have a somewhat different approach. But our inclination is not to sell things unless we get really discouraged perhaps with management or we think that the economic characteristics of the business change in a big way. And that happens. So we are not going to sell simply because it looks too high, in all likelihood.”

Stay invested for long term. Sell only when business economics changes and does not support your long-term views.

How does Warren finds intrinsic value in a company…

Warren says – “Intrinsic value is the number that if you were all knowing about the future and could predict all the cash that a business would give you between now and the judgment day, discounted at a proper discount rate, that number is what the intrinsic value of a business is. In other words the only reason for making an investment and laying out money now is to get more money later on, right? That’s what investing is all about. Now when you look at a stock, when you look at a bond, assuming it is a United States Government Bond, It is very easy to tell, what you are gonna get back. It says when you get the interest payments, it says when you get the principal. So it is very easy to figure out the value of a bond. It can change tomorrow if interest rates change. The cash flows are printed on the bond. But cash flows are not printed on stock certificate. That is the job of analyst to print out change that stock certificate , which represents an interest in the business and change that into a bond and say, this is what I think, it’s going to payout in future. If you buy Coca Cola today, the company is selling at $110-115 billion in the market. If you had $110-115 billion, the question is “ would you lay it out today, to get what the Coca Cola company is going to deliver to you over the next 200-300 years. The discount rate does make much difference after, as you get further out. And that is a question, how much cash they are going to give you. It is true if you are buying a farm or an apartment or oil in the ground, any financial asset. You are laying out cash now to get more cash back later on. And the question is how much you are going to get? When are you going to get it? And How sure are you? When I calculate intrinsic value of a business, whether we are buying all of a business or a little piece of a business, I always think, we are buying the whole business, because that’s may approach to it. I look at it and say, what will come out of this business and when? What you really like of course is then to be able to use the money, they earn and earn higher return on it, as you go along. I mean Berkshire has never distributed anything to its shareholders, but its ability to distribute goes up, as the value of business we own increases. We can compound it internally. So if you can’t answer this question, you can’t buy the stock.”

Intrinsic value is the present value of future cash flow, discounted at an appropriate discount rate. It is not very complex to estimate long-term cash flows of a simple and predictable business.