Warren Buffett’s investing philosophy has evolved significantly over the last half-century. At the beginning of his career, he was more focused on finding really cheaply priced businesses which – for the most part – had serious structural problems that justified low valuations, but that also had a little potential upside left. As he grew older, he started focusing more on businesses that were fairly priced, but that he believed had excellent long-term prospects.
In both of these situations, the common theme is valuation. Whether you’re trying to pick up ultra-cheap companies, or looking for a fairly-valued firm with growth potential, the one thing that you cannot do is pay more than something is intrinsically worth. When you do this you step outside the arena of investing and into the realm of speculation. This holds true even if you are only paying a small premium to intrinsic value.
What is speculation, and why is it different to investing? Speculators buy expensive assets in the belief that someone else will pay even more for them. Unlike investors, they are not anchored to the concept of intrinsic value. Unsurprisingly, Buffett has historically taken a dim view of speculation as a strategy, believing it to be no better than gambling.
What is the investing climate today?
My colleague Peter Stephens recently noted some of the risks facing investors – the possibility of escalation in the US-China trade war, continuing Brexit uncertainty, and so on. These are all important factors that could end up undermining investors returns.
The outcomes of all of these things are notoriously difficult to predict. As investors, we shouldn’t be basing our buying and selling decisions on whether we think that the Conservatives will win a majority at the next general election, or whether we think that Trump and Xi Jingping will be able to sign a deal. However, what we can do is look at the accumulated risks in the system, and make a conscious decision to not purchase assets that are more expensive than their intrinsic value.
A simple measure of value is the price-to-earnings ratio, or P/E. The FTSE 100 currently has a P/E ratio of around 17.5 – this is slightly higher than its long-term historical average of 15. This doesn’t mean that there aren’t bargains hidden within the averages – but it does mean that investors must keep their eyes open for them.
How can investors apply Buffett’s wisdom? By looking for stocks that are priced below intrinsic value. This, as we have noted, is difficult in today’s slightly overpriced market. That said, if one of the aforementioned risks boils over into a full-blown crash in 2020, prudent investors with capital to spare should be well-positioned to take advantage, as many more attractive bargains will come up. Investing during downturns is difficult – which is why so few investors buy stocks when they are cheap – but it is the best way to secure good return on your savings.
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Neither Stepan nor The Motley Fool UK have a position in any of the shares mentioned. 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.