The Three Basic Investing Idea that Warren Buffett Needed To Be Successful!
Wednesday, June 4, 2008
(Continuing on the wonderful compilation of Warren Buffett's sayings done by Bud Labitan called "The Warren Buffett Business Factors" but unfortunately the link I had recorded is broken.)
Three basic ideas of Intelligent Investing
1. That you should look at stocks as part Ownership of a business,
2. That you should look at market fluctuations in terms of his "Mr. Market" example and make them your friend rather than your enemy by essentially profiting from folly rather than participating in it, and finally,
3. The three most important words in investing are "Margin of safety" - which Ben talked about in his last chapter of "The Intelligent Investor" always building a 15,000 pound bridge if you're going to be driving 10,000 pound trucks across it.
I think those three ideas 100 years from now will still be regarded as the three cornerstones of sound investment. And that's what Ben was all about. He wasn't about brilliant investing. He wasn't about fads or fashion. He was about sound investing. And what's nice is that sound investing can make you very wealthy if you're not in too big a hurry. And it never makes you poor - which is even better. So I think that it comes down to those ideas - although they sound so simple and commonplace that it kind of seems like a waste to go to school and get a Ph.D. in Economics and have it all come back to that. It's a little like spending eight years in divinity school and having somebody tell you that the ten commandments were all that counted. There is a certain natural tendency to overlook anything that simple and important. But those are the important ideas. And they will still be the important ideas 100 years from now. And we will owe them to Ben.
In Berkshire's investments, Charlie and I have employed the principles taught by Dave Dodd and Ben Graham. I think the best book on investing ever written is "The Intelligent Investor" by Ben Graham. Ben wrote "Investment is most intelligent when it is most businesslike." I learned from Ben that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values. Ben identified this "margin of safety" in bargain purchasing as the cornerstone of intelligent investing. He wrote: "Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety." Years after reading that, I still think those are the right three words. And, the failure of investors to heed this simple message caused them staggering losses.
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Smart investing requires 3 basic ideas, the three basic ideas of Intelligent Investing.
Buffett makes it sound so easy and I do agree very much it is very easy but more often than not, it is us, the average investors, that makes investing so very difficult and complicated for ourselves!
1. Investing in the stock market requires one to use the part ownership perspective when one invests in a stock.
Ah, the Business Like Investing mentioned in Investing In What We Know and Business Like Investing.
Think about it again.
This is what's intelligent investing or perhaps I should call it as commonsense investing all about!
Think about it again.
Who would be insane to want to own a lousy business? For example, if you see a company's profit margin declining each single quarter, using commonsense thinking, doesn't this decline in profit margin suggests that perhaps intense competition could be eating into the company's profit? Or perhaps the management isn't capable to be delivering profits back to the shareholders? Remember as the minority shareholder or investor, your 'share' of profits is derived from how much the company declares its earnings per share. And worse still, the management is being paid by the company and not you. So if the profit or the profit margin is declining isn't it a sign of a lousy business? What else is there to argue?
So from a business perspective, would you want to own a struggling lousy business? Or would it make more sense to own an excellent business?
2. Mr.Market.
Ben Graham and Mr.Market :D For they abused this simple teaching and erroneously incorporate lower prices as the main reason to buy a stock. But if one takes the effort to re-read what Buffett is saying here, the lower prices is an opportunity to acquire even more of a good thing, if and only if the business experience continues to satisfy us. Meaning to say, the underlying business economics of the stock must still be good. Isn't there something wrong in the business that caused investors of the stock to dump the stock and head for the exit? Take the recent dramatic drop of Green Packet as an example. For sure, the share price has dropped so drastically. But is it really a buying opportunity because of this huge drop in share price? Now if the business does not improve and gets worse, and in Green Packet's case, what if the recent losses continue to snowball? Isn't it logical to say that there is a good possibility that the share price could even go down lower? Would one dare to discount such a risk? And if such a stock experiences a huge drastic drop in their share price, like they say, why be a hero in a hard place? Why ask for trouble? Isn't avoiding the share a smarter and more logical reasoning?
Ben Graham taught me that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values. The true investor welcomes volatility. Ben Graham explained this 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.
Ben Graham told a story 40 years ago that illustrates why investment professionals behave as they do: An oil prospector, moving to his heavenly reward, was met by St. Peter with bad news. “You’re qualified for residence”, said St. Peter, “but, as you can see, the compound reserved for oil men is packed. There’s no way to squeeze you in.” After thinking a moment, the prospector asked if he might say just four words to the present occupants. That seemed harmless to St. Peter, so the prospector cupped his hands and yelled, “Oil discovered in hell.” Immediately the gate to the compound opened and all of the oil men marched out to head for the nether regions. Impressed, St. Peter invited the prospector to move in and make himself comfortable. The prospector paused. “No,” he said, “I think I’ll go along with the rest of the boys. There might be some truth to that rumor after all.”
:D
This classical tale of Dr. Jekyll and Mr.Market was told mentioned in Ben Graham's investment classic book The Intelligent Investor. (Chapter 8).
But the one version that I liked is retold by Mary Buffett in her book The New Buffettology.
Benjamin Graham introduced Mr.Market to Warren. (see page 34)
Mr.Market had an interesting personality trait that some days allowed him to see only the wonderful things about the business. This, of course, made him wildly enthusiastic about the world and the business's prospects. On other days, he couldn't see past the negative aspects of the business, which, of course, made him overly pessimistic about the world and the immediate future of the businesses.
Mr.Market also had another quirk. Every morning he tried to sell you his interest in the business. On days he was wildly enthusiastic about the immediate future of the business, he asked for a high selling price. On doom-and-gloom days, when he was overly pessimistic about the immediate future of the business, he quoted you a low selling price hoping that you will be foolish enough to take the troubled business of his hands.
One other thing, Mr.Market doesn't mind if you don't pay any attention to him. He shows up to work every day - rain, sheet, or snow - ready and willing to sell you his half of the business, the price depending entirely on his mood. You are free to ignore him or take up on his offer. Regardless of what you do, he will be back tomorrow with a new quote.
If you think that the long-term prospects for the business are good and would like to own the entire business, when do you take Mr.Market on his offer?
When he is wildly enthusiastic and quoting you a really high price?
Or when he feels pessimistic and quotes you a very low price?
Obviously you buy when Mr.Market is feeling pessimistic about the immediate future of the business, because that's when you get the best price.
Graham added one more twist. He thought Warren that Mr.Market was there to benefit him, not to guide him.
You should be interested only in the price that Mr.Market is quoting you, not his thoughts on what the business is worth.
In fact, listening to his erratic thinking could be financially disastrous to you. Either you will become overly enthusiastic about the business and pay too much for it, or you become overly pessimistic and miss taking advantage of Mr.Market's insanely low selling price.
Warren says that, to this day, he still likes to imagine himself being in business with Mr.Market. To his delight he has found that Mr.Market still has his eye on the short term and is still manic-depressive about what businesses are worth.
Warren has discovered that to take advantage of the market's pessimistic shortsightedness, he must invest in companies whose economics will allow them to survive and prosper beyond the negative news that creates a great buying opportunity.
To do this Warren has to make sure that the company in which he is investing is not only intrinsically sound enterprise, but also has the economic ability to excel and earn fantastic profits. Warren isn't interested in the traditional contrarian investor approach of bottom picking.
Only by selectively picking the cream of the crop is he able to recover, but continue upward.
Mr. Market is there to benefit and not to guide!!
Ever think of the share market in this perspective?
These investment gurus are teaching us that that our investment decision should never be influenced by the current share market price (what Mr. Market is quoting you) and definitely not his thoughts on what the business is worth. Do not let your investment decisions be influenced by the drops in share prices and conversely do not be influenced by rises in share prices.
And this is where it does get complicated. No joke!
In Warren Buffett's Berkshire Hathaway's 1997 Annual Report * , Buffett remarked the following:
We ordinarily make no attempt to buy equities favourable short-term price behavior. In fact, if the business experience continues to satisfy us, we welcome lower prices as an opportunity to acquire even more of a good thing.
The very last part of what he said, "we welcome lower prices as an opportunity..".
And in my opinion, this is something, like the buy-hold thingy, which is usually badly misconstrued by the investing public.
Imagine what could go wrong if one uses falling prices as a buying opportunity.
Well... think about why stock prices fall drastically first.
Which is why investing is so complicated and so risky! And it is really difficult for the average investor to distinguish between a temporary setback in a company's business with a real deterioration of a business.
The winners are those that managed to pick out stocks with GOOD underlying business economics but due to some unforeseen circumstances faced temporary setbacks in their share price (like due to depressed market sentiments) will be rewarded with fame and glory.
The losers? The losers are those who purchased a stock solely because they ass-u-med that the stock is cheap due to their low share prices. They failed to realise that the stock is cheap because the business is simply failing! And with the market being very unforgiving to such stocks, their stock investment would be punished severely. Things like falling profit margins, diminishing market share of a company product, company burning up cash faster than it generates, rising loans, rising inventories, rising receivable issues are clear distinctive signs that there is something drastically wrong with the business. (Remember Megan?)
Forget this not... NOT all lower prices equates to buying opportunities! So do not be fooled by Mr.Market!
Yeah.. some would argue... no risk no gain dude... but do consider this... risking a lot to gain a little pales in comparison to risking a little to gain a lot!
One of the better comments I have read about this margin of safety was posted in the Wallstraits forum, which I had compiled it under this blog posting :Ze Compilation
The margin of safety must be sufficient.
I learnt the hard way that the margin of safety can only be sufficient when there are multiple criteria for investment.
An excellent profit margin, an efficient management, stupendous growth potential, a good dividend policy and a low price are individually insufficient to justify an investment decision.
They should all be present to some degree, but more importantly, strength in one area cannot offset weakness in another.
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This was posted under a posting thread themed Investment Mistakes. And I find it so educational (and of course very profitable) to learn from other people's mistakes.
The very key word for me is the second sentence, "individually insufficient" to justify an investment decision.
Take for example, if you see a company reporting some stellar net profit growth. That might trigger us to want to invest in it, right? However, upon our study of the company, what if we note that despite this stellar net profit growth is achieved by what they call the engineering of profits? The company borrows and borrows money to achieve an artificial turnover and net profit growth. Sacrificed in the company's bid to achieved more profits is the net profit margin. The company borrows and borrows to buy more and more machine to churn out more and more sales. However, in order to achieve this more sales, the company has to sell cheaper. Hence the lower margins. Now all this fine and dandy but what if trouble happens? For example, what if there is rise in production costs? Or perhaps would the lower sales induce an intense sales marketing war? Or what if the product runs out of favor? Or what if as they say "Not laku" anymore? How then? What about the millions spend or rather the millions borrowed to engineer this sales growth? And sadly in the end, the investor might be cursing that their margin of safety investment strategy was insufficient and because of this lack of margin of safety, it causes them staggering losses in their rather poor investment.
Let me remind myself this too:
The Margin of Safety must be sufficient and it simply cannot be compromised.
Or how about this? Say there is this fantastic company. Excellent profit margins, great profit growth, great balance sheet but the company's management/owners integrity and reputation is questionable. Now if this seemingly wonderful stock sells at a seemingly low price, do you reckon that it is wise to invest in it? Simply put, would you be willing to sacrifice the issue of trust for the sake of being a part owner in this seemingly wonderful business? How? Without trust, can one ever safely ass-u-me that one would be adequately and justly compensated for taking the risk to being a part owner in the business? Is it wise to do so? What if this owners cheats you? Not possible? Not possible that these owners embark on a corporate exercise that only enriches they, themselves and not you, the minority shareholder? How does one evaluate such risk? Or how do you evaluate a crooked company?
And the Margin Of Safety is never determined by the stock price!
So forget this not:
An excellent profit margin, an efficient management, stupendous growth potential, a good dividend policy and a low price are individually insufficient to justify an investment decision.
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