The self-made billionaire Warren Buffett is widely considered the most successful living investor. And via his Berkshire Hathaway investment firm, he’s greatly enriched a lot of other people along the way.
How did he get to be so good, from whom did he learn his craft, and what are his key lessons?
A piece of a business
An early turning point came when the young Buffett read Benjamin Graham’s book The Intelligent Investor in 1949, and then went on to study under him at Columbia Business School.
Buffett credits Graham as setting the ground for his own investing style and a key early lesson was about what a share in a company’s stock really is.
To many people, it’s a number on a chart that you hope will go up. It’s a gamble that you hope will pay off, or it’s a scary, hard-to-understand thing that you should avoid at all cost. But what if I say it’s the same as owning a corner shop, maybe in partnership with your family?
That’s exactly what a share is. It’s part ownership of a company and Buffett has famously said he selects “investments on a long-term basis, weighing the same factors as would be involved in the purchase of 100% of an operating business.” If you wouldn’t be happy owning the whole business, don’t even buy one share of it.
Buy the best, forever
Do you spend any time looking for the next big thing out there, the overlooked newcomer that’s set to fly any day now? How about stocks you think you can get into and out of rapidly and pocket a short-term profit?
One problem with that approach is that while you’re searching for these short-term bargains in an attempt to make some quick cash, you’re likely to be overlooking the truly great generators of long-term wealth.
Buffett says: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.“
The best throughout history bring in steady profits year on year and can easily turn their shareholders into millionaires. But those looking from a short-term “today’s biggest bargain” view never buy them — and they miss out on serious potential riches.
And, as Buffett says, “only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”
That, for me, greatly narrows the selection of stocks I’d choose from.
Value, not price
To many, the price of a share is what counts, and the main interest lies in where it’s going on a daily basis. That couldn’t be further from Buffett’s approach, and it shouldn’t come anywhere near yours either.
No, it’s the intrinsic value of the underlying business that’s important — according to one of Buffet’s famous quotes: “Price is what you pay, value is what you get.” How can a share price be wrong with respect to the underlying value of the stock?
That’s covered by an oft-quoted opinion of Graham, that “in the short run, the market is a voting machine, but in the long run it is a weighing machine.” But what does that mean?
In the short run, setting the market price of a stock is a popularity contest. Stocks go up and down simply because people are buying and selling them, and people often buy and sell for the most irrational reasons.
But in the long run, all those short-term ups and downs eventually fall back to reflecting the underlying value of the company. So ignore fad and fashion and buy on valuation, not on price.
Margin of safety
To explain his desire for a margin of safety in his investments, Buffett suggested you shouldn’t “try and drive a 9,800-pound truck over a bridge that says, capacity: 10,000 pounds. But go down the road a little bit and find one that says, capacity: 15,000 pounds.”
It’s a key lesson from Graham, to look for a stock where the price you have to pay is sufficiently lower than your appraisal of the company’s intrinsic value. It doesn’t have to be screamingly cheap, just with that safety margin.
Do we see top companies with these margins of safety? Sure we do. Whenever we see market bearishness, that’s usually a sure sign that there are great companies being sold too cheaply.
Even whole sectors can remain undervalued for surprisingly long periods. Right now, for example, I see the insurance sector as providing an attractive margin of safety.
Conventional wisdom suggests we should diversify our investments to provide safety. But how does that square with Buffett’s claim that “diversification is protection against ignorance. It makes little sense if you know what you are doing“?
I like diversification within reason, but I certainly think it’s possible to over-diversify and to diversify for the wrong reasons.
If you’re confident with your shortlist of good candidates for your next investment, then I’d say it does make sense to consider your existing holdings. If I were choosing between, say, a bank and a miner and I liked both, if I already held a bank then that might well sway me towards the miner.
What Buffett is surely railing against is choosing stocks simply for the purpose of diversification. If I thought I didn’t understand a sector well enough and there were no companies in it that I considered solid long-term value, no way would I invest in it just for diversification.
If you start from the position that you need a company from, say, the FTSE’s Construction & Materials sector next… well, that’s surely not the way to identify the very best companies out there.
Can you do it?
I’ve often heard people saying that you can’t do as well as Buffett — and I know I can’t. But I don’t need to. To justify learning the same lessons he has (and the lessons he’s taught) I only need to do better than I would do otherwise.
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Alan Oscroft has no position in any of the shares mentioned. The Motley Fool UK owns shares of and has recommended Berkshire Hathaway (B shares). Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.