Jul

7

The Investing Philosophy of Warren Buffett: Part 5

Filed Under Investing, Warren Buffett |


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…


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