We’re kicking off this occasional series with half a dozen lessons from one of the true greats of investing, Warren Buffett. These aren’t Buffett’s only words of wisdom, in fact far from it.
Anyone wanting to read The Sage of Omaha’s thoughts in depth should download the annual Berkshire Hathaway shareholder letters, which are available online. They contain a wealth of advice and information on how to be a successful long-term investor.
These lessons, however, are as a good a starting place as any. In the coming weeks we will follow up with lessons from Charlie Munger, Buffett’s business partner, and a host of US and other investing ‘greats’.
Lesson 1 – Timing versus pricing
First and foremost, don’t try to time the market. If you try to anticpate market moves, you are assuming you have an ‘edge’ over other investors. Your ‘edge’ should be your analysis and your assesssment of intrinsic or ‘fair’ value. The rest is guesswork.
Once you have done your research, and you have an idea of the intrinsic value of an investment, then you can decide what price to pay. Sometimes, in the case of a lower-quality company, you might be able to buy at a big discount. On the other hand, for a really good company you may decide to pay a ‘fair’ price because you understand its growth potential.
Lesson 2 – Ignore the market’s moods
One of Buffett’s mentors was Benjamin Graham, the author of the essential handbook ‘The Intelligent Investor’. In the book, Graham refers to ‘Mr Market’ to explain day-to-day movements in stock prices.
Some days, Mr Market is in a good mood and prices stocks higher, while on other days he’s in a bad mood and prices everything lower. As an ‘intelligent’ investor, your job is to avoid getting carried away by these moods.
You don’t have to buy or sell at any point, just because prices are going up or down. What you should do is use excessive weakness as a potential entry point and excessive strength as potential exit. Essentially, the market is there to serve you, not vice versa.
Lesson 3 – Margin of safety
Again, borrowed from Graham, the concept of using a ‘margin of safety’ refers to buying stocks below their intrinsic value. Simply put, if you overpay for an investment, you will end up with a bad return no matter how good the company. If on the other hand you buy with a margin of safety, you have a better chance of getting a good return.
When trying to work out intrinsic value, it is better to be roughly right than precisely wrong, to quote Keynes. If you are conservative in your assumptions, so much the better because it means if the stock still looks attractive you have built in a margin of safety. Moreover, if your calculation proves to be wrong, then at least your mistake shouldn’t cost you too much.
Lesson 4 – Don’t lose money
This may sound obvious, but the secret to increasing wealth is not to lose money along the way. Using a margin of safety should protect you to an extent from downside risk.
If you buy a stock and it loses 50%, you need it to double to get back your original investment. However, if you have lost 50%, it is likely the investment case has changed fundamentally. In that scenario, getting the stock to double back to your initial price is extremely unlikely.
Lesson 5 – Focus on what you know
There are several aspects to this lesson, starting with don’t invest outside your circle of competence. For example, unless you are a biotech expert, it’s unlikely you will have an advantage over more experienced investors in biotech.
The same could be said in truth about AI and technology stocks in general. If you want to invest in a specialist area, you’re usually better off buying a fund where the manager has a proven track record.
Secondly, base your investment decisions on known facts, not future expectations. Learn about the company’s products, its customer base, its earnings power and its financial situation.
If you know how fast a company grows, you can make a fair assumption about where its earnings will be in three, five or 10 years’ time. Without that information, simply investing on the basis of ‘forward PEs’, ie the consensus expectation of future profits, is a fool’s errand.
Lesson 6 – Think long term
Having said you should buy stocks based on what you currently know to be the facts, this might seem a contradiction. However, as people we have a tendency to favour action over doing nothing. To paraphrase Ben Graham, your worst enemy as an investor is likely to be you.
Just because prices move around from day to day, it doesn’t mean you have to act. Making quick gains is all well and good, but more often than not good investments take time to mature. You need to resist the temptation to give in to short-term thinking.
Moreover, for the power of compounding to work, you need to leave your investments alone for a considerable time. The ability to think long term and do nothing, while all around you are reacting to market moves, is one of the hardest skills to learn.
Final thoughts
Obviously, we can’t guarantee that by following Warren Buffett’s advice you will end up with a similar level of wealth. For what it’s worth, Buffett accumulated most of his current worth after the age of 60, which if anything goes to demonstrate how long-term you need to think when investing.
It’s also worth considering that market conditions now are very different to those when Buffett started out. Valuations, for one, are close to all-time highs in many markets. If anything, that makes his points about understanding intrinsic value and building in a margin of safety all the more important. To use one of Buffett’s most well-knowns quotes, price is what you pay, value is what you get.
