Jul

8

The Investing Philosophy of Warren Buffett: Part 6

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This is my sixth post in a series about Warren Buffett’s investing philosophy. If you haven’t read the first five parts yet, you might want to do so now. I am going to build on the concepts that I talked about previously.
Part 1
Part 2
Part 3
Part 4
Part 5

Stick to your circle of competence.

Your chances of investment success will be greatly increased if you focus your energies on analyzing companies within your “circle of competence” or area of expertise. Your circle of competence could be related to your career, your hobbies, your interests, your background, or whatever has given you insights into the particular industry you are looking at. Once you have found an area where you think you could develop some expertise, sharpen your focus by analyzing the industry more deeply. Is the market growing or shrinking? Do the market conditions change quickly or slowly? How predictable is the industry? Are there a few large competitors or many smaller competitors? Is the industry heavily unionized? Is it capital-intensive, labor-intensive, or both? Are there specialized accounting rules for the industry? How heavily is the industry regulated? What are the key metrics for the industry?

If you are really interested in improving your investment results, you need to become an expert in the area you are investing in. In yesterday’s post, I suggested that you should approach a stock purchase as if you were acquiring a private company. If you were buying a private company, you would do it very carefully and deliberately. Buying a publicly traded stock should be no different. Let’s say that you were considering buying Microsoft stock. Would you be able to have an intelligent conversation with Steve Ballmer – Microsoft’s CEO – about the product markets that Microsoft competes in? Or would you lack the confidence that you know what you are talking about? If you would lack confidence, then you need to do more homework, shift your focus to another area, or give up stock picking entirely and invest in index funds instead.

Incidentally, it’s not important to have a huge circle of competence. It’s more important to know what areas are solidly in your circle of competence, as Buffett talked about.

“Should you choose, however, to construct your own portfolio, there are a few thoughts worth remembering. Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.”
1996 Letter to Berkshire Hathaway shareholders

“The most important thing in terms of your circle of competence is not how large the area of it is, but how well you’ve defined the perimeter. If you know where the edges are, you’re way better off than somebody that’s got one that’s five times as large but they get very fuzzy about the edges.”
“Warren Buffett Talks Business,” The University of North Carolina, Center for Public Television, Chapel Hill, 1995

Let’s say that you have decided that you have some insights into the software industry and that you would like to increase your knowledge in this area. Where should you start? A good place to start is by reading as many 10-K’s (annual reports filed with the SEC) as you can stand. You might want to begin by reading an industry leader’s 10-K from start to finish. Then continue onto a competitor’s 10-K and read that from start to finish. Then read another competitor’s 10-K. And another. Keep going. If you still aren’t even familiar with the basic layout and structure of the 10-K, then you know you haven’t come close to reading enough 10-K’s. Once you are familiar with a particular company and industry, you will no longer have to read the entire 10-K. You will learn how to scan the 10-K for changes and important items.

In the software industry, Microsoft is clearly an industry leader. You can find Microsoft’s 10-K on the Yahoo! Finance website by entering Microsoft’s ticker symbol (MSFT) and then by clicking on the SEC Filings link. Or you can search the Edgar database on the SEC website. One cool feature about the Yahoo! Finance website is that you can quickly find some of the major competitors by clicking on the Competitors link.

What if you don’t want to do so much reading? In my opinion, you would be better off investing in index funds. Intelligent investing isn’t glamorous, and it isn’t always particularly exciting, although it can be interesting and challenging. It helps to have a burning curiosity to continuously learn more. If you don’t have the desire to really make a strong effort at picking your own investments, then don’t do it. Beating the market consistently is very difficult, which is why most investors (even most professionals) are unable to do it. There is no shame in investing in index funds. In fact, you just might find that you can Beat the Pros by Being a “Know-Nothing Investor”.

To be continued…

Jul

7

The Investing Philosophy of Warren Buffett: Part 5

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This is my fifth post in a series about Warren Buffett’s investing philosophy. If you haven’t read the first four parts yet, you might want to do so now. I am going to build on the concepts that I talked about previously.
Part 1
Part 2
Part 3
Part 4

In my last post, I discussed the idea that using volatility as a measure of risk makes little sense. Today I am going to expand on my discussion of volatility. With the stock market’s recent gyrations, the topic is a timely one.

Volatility can reduce your risk and increase your returns.

Conventional wisdom teaches us that volatility is risky, but Warren Buffett explained to us why volatility doesn’t increase our risk. In fact, volatility is actually desirable to the value investor.

“In fact, the true investor welcomes volatility.  Ben Graham explained why in Chapter 8 of The Intelligent Investor.  There he introduced “Mr. Market,” an obliging fellow who shows up every day to either buy from you or sell to you, whichever you wish.  The more manic-depressive this chap is, the greater the opportunities available to the investor.  That’s true because a wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses.  It is impossible to see how the availability of such prices can be thought of as increasing the hazards for an investor who is totally free to either ignore the market or exploit its folly.”
1993 Letter to Berkshire Hathaway shareholders

Volatility creates opportunities to buy stocks that are significantly undervalued – i.e. that have a large margin of safety. This margin of safety reduces your risk and increases your potential for high returns. It all comes back to being able to estimate the intrinsic value of the stock and then patiently waiting for opportunities to buy stocks at prices that are well below their intrinsic values. The intrinsic value will act like a magnet, and the stock price will move towards the intrinsic value. It might not happen immediately. It may even take a few years, but it will happen.

It is not always easy to maintain our confidence when markets become volatile. Conventional wisdom teaches us that volatility is risky, but why should it be? Intuitively, we seem to understand that the result that we most want to avoid is a negative rate of return during our holding period, but we are constantly receiving programming from a variety of sources that volatility is something to be avoided. Google’s stock price started at $85 back in August 2004, increased by 779% to $747, and declined by 28% to its closing price as of last Thursday of $537. How it went from $85 to $537 doesn’t matter. If the price had instead followed a straight trajectory to $537 instead of increasing to $747 before declining to $537, the end result would be the same – a rate of return of 532%. It is the end result that matters. We can’t always know the precise end result ahead of time, but we can sometimes make a reasonable estimate of intrinsic value and estimate how it will change over time, and that’s good enough.

Risk comes from not knowing what you’re doing.

Buffett once said, “Risk comes from not knowing what you’re doing.” He’s absolutely right. The real risk isn’t that the price will be volatile. The real risk in investing comes from buying stocks when you can’t determine their intrinsic values. There is no one alive who can reasonably estimate the value of every single stock out there, but it doesn’t matter. The secret is to understand where you have the ability to estimate intrinsic value and where you don’t. You also have to have the discipline to not be impulsive. When in doubt, don’t buy. Stay in cash.

Approach a stock purchase with the same level of deliberation that you would use if you were acquiring the whole company in a private transaction. If you were going to acquire a private company, you would have the advantage of not worrying about the volatility of the stock price, because there would be no quoted stock price to worry you. You would instead focus on the underlying fundamentals so that you could determine what the company is worth. You would think carefully about the future prospects of the product market, competitive position, and any number of factors. Before you make a stock purchase, always ask yourself if you would be comfortable determining the purchase price if you had no access to the historical stock market prices.

Side Note: When Google announced the initial public offering (IPO) price of $85, I thought it was overvalued. Oops. I still don’t know how to value Google, but it doesn’t bother me. I stick with what I know, and I have been very happy with the results.

To be continued…

Jun

23

The Investing Philosophy of Warren Buffett: Part 4

Filed Under Investing, Warren Buffett | 1 Comment


This is my fourth post in a series about Warren Buffett’s investing philosophy. If you haven’t read the first three parts yet, you might want to do so now. I am going to build on the concepts that I talked about previously.
Part 1
Part 2
Part 3

Understand risk.

Most investment thinking today is still dominated by a view of risk that makes very little sense – the idea that volatility is risky. Stocks go up and down, and we fret about it because we are bombarded with the idea that this makes stocks risky. This idea has been thoroughly developed by academic researchers over many decades, but it is helpful to understand why they use volatility as a measure of risk. The reason is simple: academicians use volatility (usually measured by the variance or standard deviation of returns) as a measure of risk because it is easy to measure precisely and therefore makes it easier for them to use to test their hypotheses. This measure of risk became so common among financial researchers that it soon was rarely challenged anymore. Once academicians became brainwashed with this idea of the equivalence of volatility and risk, it wasn’t long before they trained college graduates to believe it too. The research done by the academicians had an air of scientific precision, so it wasn’t difficult to convince students to ignore their own common sense. If “experts” think that volatility is a good measure of risk, who are we to disagree with them? Right? Wrong.

This is one area where the old view of investing is far superior to the current view. Investors used to think in terms of the dictionary definition of risk – “possibility of loss or injury” – which makes far more sense. As Warren Buffett wrote:

“In our opinion, the real risk that an investor must assess is whether his aggregate after-tax receipts from an investment (including those he receives on sale) will, over his prospective holding period, give him at least as much purchasing power as he had to begin with, plus a modest rate of interest on that initial stake.  Though this risk cannot be calculated with engineering precision, it can in some cases be judged with a degree of accuracy that is useful.”
1993 Letter to Berkshire Hathaway shareholders

What does Buffett mean? In simpler terms, he means that we should assess the probability that an investment won’t leave us with more money in the future (after adjusting for inflation) than we have now.

If you instead use volatility as a measure of risk, you could reach some absurd conclusions. For example, if you look at the annual volatility of the stock market (say the S&P 500 Index), you will notice that it is much higher than the annual volatility of money market funds.  From this, you could easily come to the erroneous conclusion that the stock market is much riskier than money market funds. This is a foolish conclusion because it ignores your prospective holding period. If you bought shares in an S&P 500 Index fund and held it for 30 years, this would be far less risky than investing in money market funds and holding it for 30 years. The reason for this is because you are virtually guaranteed to lose money on the money market fund after adjusting for taxes and inflation, whereas the S&P 500 Index fund would virtually guarantee that you would earn positive inflation-adjusted after-tax returns. What seems riskier to you? The money market fund that will virtually guarantee a loss, or the S&P 500 Index fund that will virtually guarantee a gain? The answer is obvious and should clarify why volatility is a poor measure of risk.

Another absurd conclusion that results from using volatility as a measure of risk is the idea that an investment that has suddenly dropped in price is now riskier than it was previously because it is now more volatile. Suppose you were considering buying the stock of ABC Company. Would buying at $25 be just as risky as buying it at $50? Using volatility as a measure of risk, the two prices would have identical risk, but this is a ludicrous view of risk. We aren’t concerned with volatility, per se. We are concerned with the possibility of losing money (or not achieving a satisfactory return). The problem is that volatility doesn’t tell us the extent to which we are in danger of losing money. It just tells us how much the investment’s returns have moved up and down in the past.

To be continued…


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