Archives for posts with tag: warren buffett

Some weeks back, my younger brother wanted to learn about investing. I thought about it long and hard for quite a few weeks and eventually, I told him to go and buy this book – The Intelligent Investor by Benjamin Graham, the version with annotations by Jason Zweig.

intelligent-investor-benjamin-graham

Don’t call yourself an investor if you haven’t even read this

Who is Ben Graham?

Benjamin Graham is more famously known as Warren Buffett’s professor and former boss. Graham, together with Dodd, wrote the classic textbook, Security Analysis. Essentially, Graham is the godfather of Value Investing.

Graham biggest contribution was to popularise the idea that buying stocks should be a function of what you get relative to what you pay for. What you pay for is the price but what you get is a share of the profits and assets of the business. In essence, Graham popularised the use of the P/E (price-to-earnings) ratio and, together with Dodd, suggested normalising earnings before comparing with price, which is basically what Shiller’s Cyclically Adjusted Price to Earnings (CAPE) ratio is.

Anyway, I told my brother to buy the book for two reasons and this post is essentially for him.

 

Reason 1: It’s the right way to think about Investing

I don’t mean to offend anyone from what I’ve seen, too many people approach business and investing the wrong way. They learn wrong ideas and end up doing stupid things until they either realise it too late or never at all.

Many people think that investing is all about buying low and selling high and they fail to understand what it really means to buy a stock. From ‘The Intelligent Investor’, there are three important lessons to learn.

#1: Price is what you pay, Value is what you get

Buying a stock means buying a share of the business which is why stocks are also known as ‘equities’ which basically translates into ownership. The essence of Graham, which is at the core of what Buffett and other Value Investors believe, is that an owner of the business cares about the assets of the business and what earnings or cashflows those assets can bring the owner.

Now, the majority of “investors” in Singapore only care about price. They know how much they bought a share of Singtel for. And they know how much they can sell one share of Singtel in the market right now. Why? Because the price is the simplest piece of information to find.

Better investors can cite the earnings, cashflows or dividends that the business can bring in each year. But imagine you’re a business owner. Will those metrics be enough? You’d probably want to know other things: How your competitors are doing? What do customers think of the product? What are the largest components of the cost of production?

The first important lesson from Graham is that being a stockholder means being an owner of the business. If you only buy the stock based on its price and the hope that the price will go higher than the price that you paid for it, that’s speculation. And Graham made it quite clear in the book that therein lies the difference between investing and speculation.

The trick is knowing which activity you’re engaging in.

#2: Price and Value can, and will diverge

The second important idea from Graham is that the stock market is driven by emotion, short-termism, and irrational behaviour. He personified the market as a fellow called Mr. Market who quotes you prices on the stocks each business day.

As Buffett understood, the advantage investors have is that an investor can afford to ignore Mr. Market and take advantage of his over-pessimism or over-optimism. On days where Mr. Market believes that the world is going to end, he ends up quoting prices that are so low that it’s benefit to buy. On days where he thinks markets will keep going up forever, he’ll quote prices that are so high that the business will never be able to provide a decent rate of return for investors*.

#3: Price and Value will converge (eventually)

Of course, for Value Investing to work out, prices and value must converge. In other words, buying at prices that are low relative to value lead to good returns because the market will eventually recognise that the company is worth much more than the current price and therefore bid prices back up to what the company is actually worth.

The problem with this is that this recognition can take time. For example, prices of financial stocks remained fairly depressed following the Global Financial Crisis of ’08-09 and it was only until last year (2017) that bank stocks finally started to gain some favour again.

This is why the great economist, John Maynard Keynes, who was a pretty successful investor as well, said that the markets can remain irrational longer than you can remain solvent. This is why many investors caution against the use of excess leverage. For the majority of retail investors, leverage is something to be VERY careful of. If you choose to proceed, do so with caution.

On the other hand, prices tend to come down fast. So if you’ve bought at a very high price relative to value, don’t expect to hang on to your gains for long. Once again, taking on leverage by shorting the market is also not for the faint-hearted. There are many Value Investors who short Growth and have paid a high price for it. When you short, being early is (almost) the same as being wrong.**

I wanted to do this in one post but it’s gone on for a little too long. In the second part, I’ll show you the parallel between buying “The Intelligent Investor” and investing.

Notes:

*The classic example of knowing how ridiculous the market was when a dot-com CEO told his shareholders that given the company’s share price at the time, he would need to return them 10 years worth of revenues in order for them to just break even. I thought it was Cisco but I can’t seem to find a source for this. Cisco’s price to sales went as high as 37 though.

**For those interested in finance, go watch ‘The Big Short’. It’s accessible and the heroes in the show almost lost everything by being early.

Following the post about the new Warren Buffett documentary, I thought I’d share some thoughts on the most useful things I’ve learned over the years reading about Warren Buffett. Most people would think that this is a list about his investing acumen but this goes beyond that. This is more like a First Principles list and if you never deviate from these first principles, then you will most likely arrive at the same methods that he does.

1 . Be rational

Ok, it’s no secret that Buffett has an extremely quick mind when it comes to numbers and that’s helpful when doing calculations to weigh odds. But it wouldn’t help if he was counting the wrong things.

That’s where his hyper-rational mind comes in. In Becoming Warren Buffett, there was a part where Buffett describes why he switched to a Democrat. And the reason he gave was that it didn’t make sense to him that the country was essentially not giving the same kind of rights to Blacks or Women as that essentially stifled the growth of the economy by shutting out the human capital that was left in these two demographics.

While also unconventional, Buffett and his first wife, Susan Buffett, lived apart for a fair bit of their lives because he knew that she wasn’t happy living in a town like Omaha. Warren Buffett also famously said that he wasn’t going to leave a lot of money behind for his descendants because of the dangers of raising ‘trust-fund kids’.

Buffett is not cutting his children out of his fortune because they are wastrels or wantons or refuse to go into the family business — the traditional reasons rich parents withhold money. Says he: ”My kids are going , to carve out their own place in this world, and they know I’m for them whatever they want to do.” But he believes that setting up his heirs with ”a lifetime supply of food stamps just because they came out of the right womb” can be ”harmful” for them and is ”an antisocial act.” To him the perfect amount to leave children is ”enough money so that they would feel they could do anything, but not so much that they could do nothing.” For a college graduate, Buffett reckons ”a few hundred thousand dollars” sounds about right.

Fortune Magazine, September 1986

But the biggest testament to his rationality is the fact that he still refuses to pay a dividend to shareholders because he knows that he can still compound money at a faster rate than if he were to pay a dividend and this would ultimately be more beneficial to shareholders.

2 . Simple ideas are more effective

Early in the documentary, Buffett shows a framed picture of the front page news from Black Friday, 1987. He also detailed his rule for deciding how much to spend on McDonald’s breakfast each day. If you read his annual letters to shareholders, you’ll find many more simple aphorisms and anecdotes that convey exactly the idea he wants to bring across.

My favourite one has to be the one on how to decide if you should do something that may be damaging to one’s reputation.

We can’t be perfect but we can try to be. As I’ve said in these memos for more than 25 years: “We can afford to lose money — even a lot of money. But we can’t afford to lose reputation — even a shred of reputation.”

We must continue to measure every act against not only what is legal but also what we would be happy to have written about on the front page of a national newspaper in an article written by an unfriendly but intelligent reporter.

– 2010 Berkshire Hathaway Annual Letter

Aside from his thoughts on business, Buffett lives very simply too. Him living in the same house that he bought all those decades ago and subsisting on a diet of cherry coke and burgers is the stuff of legends. How many people do you know behave differently once they come into wealth?

3. Be willing to face up to your weaknesses and work on them

Buffett’s performance hasn’t been without its downs. Berkshire bought into Salomon Brothers right before the bond trading scandal almost brought the whole place down. In fact, if not for Buffett, it may well have. More recently in 2011, Buffett had a star hire, David Sokol embroiled in an insider trading scandal. Buffett has been quick to admit his mistakes where they happen.

What I find more amazing is that even when Buffett was younger, he was quick to recognise that he needed to fix some weaknesses. This resulted in him enrolling in a Dale Carnegie course on public speaking where he has described it as ‘not learning how to speak without his knees shaking but rather to learn how to speak while his knees are shaking’.

Now, I’m not saying that Warren Buffett has had the best life and that I would like to emulate every single aspect of his life but by and large, I think whatever he’s done and continues to do, is going to be worth keeping track of and learning from.

In case you haven’t heard, there’s a new documentary on Warren Buffett. If you don’t even know who Warren Buffet is…well, it’s time for you to find out.

HBO’s documentary on Buffett is a fantastic introduction to the living legend of a man. Why’s Warren Buffett a legend? Well, he’s not just one of the richest men on the planet but he’s pledged and has already started giving, a substantial portion of his wealth away.

For me, there isn’t much that I haven’t already heard before (the part on him buying breakfast from McDonald’s was interesting) but it’s always refreshing to see it on a screen rather than from the pages of a book. For a more detailed account of his life, check out his authorised biography, The Snowball by Alice Schroeder.

Why Warren Buffett is such an inspiration to me is a more personal tale. It started sometime in 2006 when I was still studying at the National University of Singapore. The NUS Investing Society (or Finance Society), which probably stems from the Business School, was organising a book sharing by Robert Miles, author of Warren Buffett Wealth, and I guess they wanted a wider audience and so they were putting up all these advertisements around the Faculty of Arts and Social Sciences where I was.

Prior to the talk, all I knew about Warren Buffett was that he was one of the richest guys on the planet but other than that, I knew nothing about him. I knew nothing about the stock market. Heck, I didn’t even know what I wanted to do after university. That talk changed everything.

After that talk, I started reading up on Buffett, Graham, Value Investing, the stock market, financial statement analysis, stock valuation and so on. And there’s something new to learn about the markets every single day. I’m now approaching the tenth year that I’ve begun investing for myself and it’s all thanks to that talk back in 2006. Probably the most useful thing that came out of my university education. Watching Becoming Warren Buffett just might do for you what attending that talk did for me.

PS: I’m not sharing a link to the documentary because I’m pretty sure that goes against copyrights but I’m sure whoever’s reading this will know where to find it.

The fallacy of composition is perhaps the most common one made by many investors. I have a post on this over on my economics blog detailing how Warren Buffett avoided that by shutting down Berkshire Hathaway’s textile operations as well as how this plays out during bubbles in asset classes.

An acquaintance of mine posted this (along with a picture of the book ‘Reminiscence of a stock operator’*) on his facebook wall the other day:

“Retail investors quote Warren Buffett. Fund managers quote Jesse Livermore.
Who would you rather trust?”

I’m not sure why these two financial market personalities were even mentioned in the same breath but given this particular acquaintance’s recently found interest in trading I think the point he was trying to make is that if you want to make serious money, go down the path of the fund manager and not the retail investor.

There are a couple of ideas implied in that sentence that I find terribly misinformed.

First off, not all fund managers are going to have short holding periods (and therefore, should be classified as ‘traders’). Most do but that doesn’t change the fact that different fund managers have different styles and mandates.

Second, studies (championed by financial market luminaries such as Jack Bogle) have shown that fund turnover correlates strongly with worse returns.

Next, I like to present to you Jack Macdonald.

Jack who? Well, Jack MacDonald was a retired attorney from a Washington State who left close to US$200 million in his trust to three charities. That’s right. You didn’t read that wrongly, he left almost US$200 million. How did Jack do it? He didn’t do it by running an extremely profitable legal practice. Nor did he trade his way to those riches. He just stuck to good old fashioned investing and playing really strong (financial) defence. So strong, in fact, that no one in his retirement community even figured he was a millionaire, much less a hectomillionaire. The beauty of what he’s left behind is that his trust will probably be able to generate millions of dollars to disburse year after year to his charities in perpetuity. This is the kind of legacy you can build through proper investing. (you can read more about him here. h/tip: Joshua Kennon)

Trading might be a way to get you to riches but ultimately, to leave behind a legacy that lasts, one will have to adopt proper investing.

Lastly, I thought I’d mention that Jesse Livermore died penniless and of a self inflicted gun wound while Warren Buffett looks likely to eventually pass on a wealthy and happy man.

I think I’ll continue to listen to the retail investor in me.

*This book, of course, is the biography of Jesse Livermore.

From the recently published pages of Warren Buffett’s letter to Katherine Graham, whose family is in the news recently for selling the Washington Post to Jeff Bezos, some 38 years ago:

I am virtually certain that above-average performance cannot be maintained with large sums of managed money. It is nice to think that $20 billion managed under one roof will produce financial resources which can hire some of the world’s most effective investment talent.

Why the lack of optimism regarding such huge sums of money? Buffett offers this logic:

Down the street there is another $20 billion getting the same input. Each such organization has its own group of bridge experts cooperating on identical hands and they all have read the same book and consulted the same computers. Furthermore, you just don’t move $20 billion or any significant fraction around easily or inexpensively—particularly not when all eyes tend to be focused on the same current investment problems and opportunities. An increase in funds managed dramatically reduces the number of investment opportunities, since only companies of very large size can be of any real use in filling portfolios. More money means fewer choices—and the restriction of those choices to exactly the same bill of fare offered to others with ravenous financial appetites.

Buffett was advising Katherine Graham on the Washington Post’s pension fund and this letter was what saved it. Of course, the same case could be made for sovereign wealth funds of which, ahem, we have two.

PS: Actually, the headline is a little misleading. GIC’s 20 year real annual return is only 4% which seems to give truth to Buffet’s theory.

Source QuartzWarren Buffett, age 44, explains the futility of playing the market. (h/t: The Big Picture)

This is classic Warren Buffett. Anyone who wants to know how and investor thinks should read this.

Snippets:

At Berkshire Hathaway (BRKA) we take a more demanding approach, defining investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power — after taxes have been paid on nominal gains — in the future. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.

The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability — the reasoned probability — of that investment causing its owner a loss of purchasing power over his contemplated holding period.

Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce — gold’s price as I write this — its value would be about $9.6 trillion. Call this cube pile A.

Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?

My own preference — and you knew this was coming — is our third category: investment in productive assets, whether businesses, farms, or real estate. Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment. Farms, real estate, and many businesses such as Coca-Cola (KO), IBM (IBM), and our own See’s Candy meet that double-barreled test. Certain other companies — think of our regulated utilities, for example — fail it because inflation places heavy capital requirements on them. To earn more, their owners must invest more. Even so, these investments will remain superior to nonproductive or currency-based assets.