Jun

23

The Investing Philosophy of Warren Buffett: Part 4

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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…

Jun

16

The Investing Philosophy of Warren Buffett: Part 3

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This is my third post in a series about Warren Buffett’s investing philosophy. If you haven’t read the first two 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

In my first two posts, I discussed the difference between price and value and how this difference occasionally arises in the marketplace. It is this difference between price and value that allows us to reduce our risk while achieving high returns.

Make sure that you have a margin of safety.

A margin of safety exists when the purchase price of an investment is lower than its intrinsic value. For example, let’s say a stock is currently trading at $75 per share. You do a thorough analysis and decide that the intrinsic value is about $110 per share. This would give you a nice little buffer of $35 per share ($110 - $75). This means that you could overestimate the value of the stock by roughly 32% and have little danger of taking a loss. A significant benefit to buying a stock that has a margin of safety is that it provides strong protection against downside risk. Not only that, but it also provides a good chance at earning high returns. Like I mentioned in my last post, intrinsic value exerts a “gravitational effect” on stock prices. When the price of a stock is below its intrinsic value, the price will increase until it approaches intrinsic value. The market eventually corrects its pricing mistakes.

“I would like to say one important thing about risk and reward. Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, “I have here a six-shooter and I have slipped one cartridge into it. Why don’t you just spin it and pull it once? If you survive, I will give you $1 million.” I would decline – perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice – now that would be a positive correlation between risk and reward!

The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it’s riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is.”
- Warren Buffett (The Superinvestors of Graham-and-Doddsville)

Buying a stock with a margin of safety is sometimes called buying “at a discount” (i.e. at a discount to intrinsic value). Buying at a discount is like waiting for something to go on sale before you buy it. Buffett describes it as “buying dollar bills for 50 cents.” Opportunities are out there if you have the motivation to do the research and the discipline and patience to only buy at a significant discount.

“We insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we’re not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.”
- Warren Buffett (1992 Letter to Berkshire Hathaway shareholders)

To be continued…

Jun

12

The Investing Philosophy of Warren Buffett: Part 2

Filed Under Investing, Warren Buffett | 1 Comment


In my last post, I started a discussion of Warren Buffett’s investing philosophy. If you haven’t read it yet, you might want to do so now. I am going to build on the concepts that I talked about previously.

In the short run, the market is a voting machine, but in the long run, it is a weighing machine.

According to Buffett’s mentor, Benjamin Graham, “In the short-run, the market is a voting machine – reflecting a voter-registration test that requires only money, not intelligence or emotional stability – but in the long-run, the market is a weighing machine.” This brings us back to the difference between price and value. In the short-run, price and value can be very different. Investors may get overexcited or overly concerned by a company’s prospects, and they may “vote” for a price that is either too high or too low. One of the reasons for this is because many investors aren’t even concerned about value. They are instead concerned with price trends on a chart or with market psychology or any number of things not related to value. Another reason for the difference between price and value is because investors often let their emotions get the best of them.

It was for these reasons that Yahoo’s stock price rose to a split-adjusted price of over $100 in 1999 compared to the current price almost nine years later of about $26. A good value investor – i.e. an investor who makes investing decisions by comparing price and value – should have been able to tell you that the prices in the late 1990s were insane, and a good value investor should have been able to easily avoid the ensuing market massacre. It didn’t take a rocket scientist to understand that many stocks, especially technology stocks, were overvalued. It just took a basic understanding of how to value a business.

In the short run, prices can differ widely from value, but in the long run, price and value tend to converge. This means that the market always comes to its senses at some point and eventually gets the price right. If the stock’s price is lower than its intrinsic value, investors will continue buying at higher prices until the stock price increases to intrinsic value. If the stock’s price is higher than its intrinsic value, investors will continue selling it at lower prices until the stock price declines to intrinsic value. In Yahoo’s case, investors finally figured out that the principles of economics were not suspended for technology companies after all, and they bid the stock down from over $100 to less than $5. Investors stopped “voting” for Yahoo and began to “weigh” its intrinsic value.

What does this mean for you as an investor? It means that you don’t need to concern yourself with market psychology, price charts, or anything else not related to the intrinsic value of the company whose stock you are interested in. If you can determine the intrinsic value per share, then you will know what is going to happen to the stock price, because intrinsic value exerts a “gravitational effect” on stock prices. The stock price might not move towards intrinsic value immediately, but it will do so eventually. As Warren Buffett wrote in his 1987 letter to shareholders:

“As Ben said: “In the short run, the market is a voting machine but in the long run it is a weighing machine.” The speed at which a business’s success is recognized, furthermore, is not that important as long as the company’s intrinsic value is increasing at a satisfactory rate. In fact, delayed recognition can be an advantage: It may give us the chance to buy more of a good thing at a bargain price.”

To be continued…

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