When I first started buying shares I didn’t really know what I was going. In fact, I didn’t have a clue. I’d buy on newspaper tips and gossip. I was particularly attracted to speculative ‘story’ stocks. And I’d soon sell — out of fear if the shares went down, out of eagerness to take a profit if they went up and out of boredom if they didn’t move.
I lost money.
So, I began reading the writings of the great investors. Warren Buffett probably had the biggest influence on changing my approach to share buying. Here are three key lessons I learnt from him that made me a better investor.
Down to business
Buffett once said: “Buy into a company because you want to own it, not because you want the stock to go up”.
The idea of looking at companies on the stock market in the same way as you might approach buying, say, a corner shop was a real eye-opener for me.
For one thing, it made me appreciate that the economic rewards of owning a business are only realised over a relatively long period of time. And that this is as true for a publicly listed company as it is for a corner shop. The daily wiggling around of share prices on the stock market signifies very little in the grand scheme of things.
Previously, I’d bought shares in all sorts of companies that I wouldn’t have gone anywhere near if I’d been considering buying the whole business. For example, companies whose businesses I didn’t understand, unprofitable companies and companies with high levels of debt.
Simply avoiding such companies, gave me more confidence to hold onto the stocks I did buy to benefit from the long-term economic returns the businesses delivered.
Wonderful businesses
Buffett credits his partner Charlie Munger with teaching him that: “It is far better to buy a wonderful business at a fair price than a fair business at a wonderful price”.
A wonderful business has consistently high margins and produces a consistently high return on equity with little or no debt. These traits show that there is a strong demand for the company’s products or services and that it has a competitive advantage which keeps it ahead of its rivals.
Buffett also stresses the importance of high-calibre management. When asked about the qualities he looks for, he once responded: “Integrity, intelligence and energy. And if you don’t have the first, the other two will kill you”.
I learnt from Buffett to avoid companies where the directors’ reports read like sales brochures, where managerial explanations are unintelligible, where the directors trumpet earnings before interest, tax, depreciation and amortisation, or anything else that suggests the directors “are trying to con you or they’re trying to con themselves”.
A fair price
Buffett has a cash flow formula he calls “owner earnings” which he considers the relevant basis for company valuation. Unfortunately, one item in the formula requires as much art as science, so no instant ‘Buffett valuation’ of a company is possible.
However, I reckon that by identifying wonderful businesses for your portfolio and regularly investing in them over many years, your average buy is likely to work out somewhere near a fair price.
As Buffett has said: “Investors should remember that their scorecard is not computed using Olympic-diving methods: Degree-of-difficulty doesn’t count”.
