Jun

16

The Investing Philosophy of Warren Buffett: Part 3

Filed Under Investing, Warren Buffett |


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…


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