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

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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…

Jun

11

The Investing Philosophy of Warren Buffett: Part 1

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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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