The Investing Philosophy of Warren Buffett: Part 1

Warren Buffett, currently the world’s richest person according to Forbes Magazine, is arguably the world’s greatest investor. As I mentioned in my review of his biography, Buffett: The Making of an American Capitalist, he has achieved extraordinary rates of return with minimal risk over an investing career of over 50 years. I’m always curious at how people who are at the top of their fields do what they do, so I’ve been studying Buffett for over 10 years. In my next few posts, I will be summarizing some of the most important components of his investment philosophy.

Rule #1: Never lose money. Rule #2: Never forget Rule #1.

The most important of Buffett’s principles is the idea that you should approach investing with the mindset that you should never lose money. While avoiding all losses might not be possible, you can at least limit your losses to very small amounts. One reason that this is so important is due to the difficulty in overcoming losses. For example, if you take a 25% loss on an investment, you need to earn a 33% return just to get back to your original starting point. I don’t know about you, but I personally don’t want to create that much extra work for myself! Consequently, I set a high standard for myself before I will part with my cash. If it doesn’t look like a particular investment opportunity is safe from capital loss, I am content with leaving my money in a money market fund while I wait for a better investment opportunity to arise.

Many people also have the mistaken notion that you need to take high risk in order to achieve high returns, but low risk is not inconsistent with high returns. In fact, the same principles that reduce your risk can also help increase your returns. This requires a very different mindset from the conventional wisdom that has come to be accepted in the investing industry. Investing is one of the few areas in life where “old school” thinking is far superior to currently accepted ways of thinking. Achieving high returns and low risk simultaneously requires throwing out the flawed thinking that dominates investing today and instead embracing principles that pre-date today’s conventional wisdom.

Understand the difference between price and value.

One critical concept to understand is the difference between price and value. These terms are quite often used interchangeably, but this betrays a lack of understanding of the difference between the two terms. As Buffett wrote to his investors in his investment partnership back in 1966: “Price is what you pay. Value is what you get.” The basic concept is that an asset has an underlying value or “intrinsic value” that is separate from its price. Even if it were impossible to sell an asset, it would still be inherently valuable. For example, if you own a house, it would be valuable to you whether you could sell it or not. Similarly, a business is valuable whether you intend to sell it or not because it generates cash flows. As Buffett wrote in the Berkshire Hathaway Owner’s Manual:

“Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”

A great example of the difference between price and value was clearly demonstrated in the “dotcom” bubble of the late 1990s and in early 2000. Rarely have stock prices been so divorced from reality as during this time period. Few people were buying Internet stocks for the long-term. Instead, people were buying these stocks in order to sell them quickly with the hope of instant riches. The underlying value of the stock wasn’t much of a consideration as long as the stock was in a hot sector. Many of these stocks simply had horrible economic prospects. Investors were not carefully weighing the expected future cash flows of each company. Even many of the entrepreneurs that were building these businesses were doing so in order to take advantage of the absurd prices by quickly selling the companies. Often they realized that the economic prospects were not nearly justified by the prices being offered in the market, so they were trying to unload the companies while “the iron was hot.”

Think like an owner.

In order to better understand the concept of intrinsic value, think of an owner of a private business. Private businesses are much more difficult to sell than businesses that are sold (or “traded”) on a stock exchange. With a private business, you don’t have thousands of people telling you how much they are willing to pay you to buy your business every second of the day. To understand what the business is worth, you have to understand the underlying cash flows. For example, suppose you have a business that currently generates about $100,000 in “free cash flow” that you can pull out of the business this year, and you expect that this cash flow will increase each year by about 5%. How much could an investor pay for such a business and earn an adequate rate of return on the investment? This is the “intrinsic value” of the business, and it has nothing to do with stock market psychology, looking at stock price charts, trying to guess what the Fed is going to do, or any number of things that stock market pundits like to talk about it.

Great investors like Warren Buffett are able to filter out the noise from the stock market and focus their attention on what’s most important – the fundamentals of the business. Focusing on the business instead of the market is the key to rational investing. Think of yourself as an old school capitalist looking to buy a business rather than looking to electronically trade some pieces of paper in the hope that someone will be willing to pay you more for it tomorrow.

To be continued…

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