Investing Lessons of Warren Buffett: Part 1

Invest 29

Warren Buffett is arguably the greatest investor of all time. But more importantly, he’s also one of the best teachers of investing. In his annual reports and countless interviews, he freely offers priceless wisdom that helped him become a billionaire, and that you can use to invest better and reach your financial goals sooner. Here are some of the lessons I’ve learned from him that have helped me achieve more success in investing, business, and life. 1) Stockpicking isn’t a hobby Everyone should be an investor. But not everyone should choose their own investments. To be a successful investor requires thousands of hours of deliberate effortful study to master the necessary skills, and then thousands more (or in Buffett’s case, tens of thousands) to use those skills to find worthwhile investments. Buffett read every investing book in his local library, many of them multiple times… by the time he was eleven years old. If you aren’t willing to put in the time and effort that stockpicking requires, the person on the other side of your trades is likely to know more than you, which is a recipe for underperformance. In that case, you’re better off simply buying a low-fee index fund which passively tracks the market, like VFINX, which tries to match the S&P 500. All of the lessons below are relevant for active investing, but many of them also apply to passive investing, so I encourage you to read on regardless of whether you decide to pick stocks yourself or just buy the entire market. 2) Invest Unemotionally It’s human nature to be emotional, and life is richer for it. But it reduces investment returns. Many people make systematic errors in their investment thinking, due to their emotions, egos and innate cognitive biases. They suffer from confirmation bias, tending to seek out and find evidence to support their position rather than evidence that might refute it. They think about risk more when things are already going badly and less when prices are already up. They resist admitting mistakes and hold their losers too long. They think about how they’ll spend the money they’re expecting to make from investing, and this can cloud their judgment and encourage excessive risk-taking. They’re overly optimistic and overly confident about their investment abilities, which is dangerous. By contrast, Buffett is a paragon of rationality. His investment decisions are insulated from such emotionality. He has said he’d never give up a good night’s sleep for a chance at a slightly better return. He thinks long term and so he doesn’t panic when the market falls; instead, he sees drops as buying opportunities. To invest better, become a student of human psychology. Learn how emotions lead to cognitive errors, so that you can avoid those errors and benefit when others make them. 3) Ignore modern financial theory Buffett says modern financial theory is fundamentally flawed. His consistent long term success is evidence that the efficient market hypothesis is wrong. He says beta is a silly way to measure risk. He thinks diversification is counterproductive for anyone skilled at investment selection. He says financial models oversimplify things, underestimating the frequency of black swans and assuming that what hasn’t happen can’t happen. Markets are more dependent on behavioral science than physical science, but the models don’t adequately factor in human behavior. Investing is part art and part science, and the models don’t capture the artistic side of the process. Buffett says you’re better off ignoring most of modern financial theory. 4) Invest in what you understand Buffett stresses the importance of having a circle of competence, a clearly defined industry, business model, asset class, investment style, or other area that you are an expert at, and investing only within that circle. You should continue to learn and thereby expand your circle of competence, but until you do, you shouldn’t invest where you aren’t yet skilled. Buffett has said that an investor needs to do very few things right as long as he or she avoids big mistakes, and staying within your circle of competence is one of them. This is closely related to Buffett’s suggestion of investing only in what you understand. He has three mailboxes on his desk, labelled “In”, “Out”, and “Too Hard”. Every business has factors which are knowable, unknowable, important, and unimportant; he recommends investing in businesses for which the important factors are knowable. He wants understandable businesses because he intends to hold long-term and wants to be able to predict roughly what the business will look like in five or ten years. He puts most technology companies in the too-hard pile. Tech changes so fast that there are only a handful of people in the world with the expertise to tell which will be spectacular successes and which will be spectacular failures. If you aren’t in that elite group, it’s best to look elsewhere. Buffett has said that investing isn’t like Olympic diving, where you get more points for a difficult dive than a simple one. Or to use another sports analogy, he doesn’t try to jump over seven-foot bars, he looks around for one-foot bars he can step over. 5) Stock ownership is business ownership When you buy a stock, don’t think of it as a line on a chart that you hope will move up. Think of it as partial ownership in the underlying business. Unlike collectibles or precious metals, stocks have intrinsic value because your ownership gives you a proportional claim on the company’s future earnings, in the form of dividends. If a business does well over time, the stock price eventually follows. Buffett sees himself not as a market analyst, or a macroeconomic analyst, or even a security analyst, but as a business analyst. He likes managers who think like owners, and especially ones who actually are owners. He has said that he’s a better businessman because he’s an investor, and a better investor because he’s a businessman. This leads directly into the next point… 6) Know what a good company looks like The list of essential characteristics Buffett looks for in an investment is surprisingly short. He wants a business that’s easy to understand, with a consistent operating history; good long term prospects, possibly due to some durable competitive advantages, or “moats”; a trustworthy, high-quality management team; and solid financials: high margins, high return on equity, and high free cash flow. He does like growth, but less so than investors who are focused on the short term, since it’s the nature of capitalism for growth not to last more than a few years as outsize profits attract fierce competition. When asked what metrics he uses in his investment decisions, his response is that if a computer could do valuation then everyone could do it, and if everyone could do it then the market would be efficient and there would be no bargains. Number geeks want math to provide easy answers, but it doesn’t. Buffett’s style of investing is at least as much art as science. [Extra for experts: To be precise, rather than free cash flow, Buffett uses what he calls “owner earnings”. This is defined as net income from operations, plus depreciation, depletion, and amortization, minus your best estimate of the average annual capitalized expenditures that the business requires to fully maintain its long-term competitive position and its unit volume. In other words, money the business is generating that doesn’t need to be spent just to avoid falling behind.] 7) Be cheap OK, now you know what a good company looks like. But you shouldn’t simply buy every good company you find, because good companies tend to be more expensive. The key to Buffett’s strategy is to find good companies at good prices. Price is what you pay; value is what you get. When value exceeds price, the difference is what Buffett’s mentor Ben Graham called a margin of safety. A large margin of safety enables you to be successful even if your valuation is slightly off or if things play out slightly differently than expected. Early in his career, Buffett preferred good companies at great prices. Later, perhaps because he had too much capital to deploy every year on finding new bargains and he began holding investments much longer, he shifted to preferring great companies at good prices. Both approaches are valid. 8) Be patient Above I mentioned the importance of not letting emotions impact your investment decisions. A closely related point is the value of patience. Buffett has said that investing differs from baseball in that there are no called strikes. You can stand at the plate all day and not swing if you don’t see any pitches you like. This can be difficult because the financial system encourages frequent trading, since its revenues grow as transaction volume grows. But great investment opportunities are rare; at most times and for most stocks, the market is pretty good at keeping price roughly in line with value. To resist the temptation to trade in and out of positions, Buffett suggests pretending you can only make twenty trades your whole life. Under this restriction, you’d be much more likely to do detailed research, and only move forward on a trade if you were very confident in it. This would force you to be patient both when buying and while holding. 

Another dimension of patience relates to time horizon. The right mentality is get rich slow, not get rich fast. Too many investors can’t wait to reach their financial goals, and focus on quarterly performance and keeping up with benchmarks. This encourages them to sell whatever has recently underperformed (at a loss) and buy more of whatever has recently outperformed (after it’s already risen), which usually doesn’t work. Even investment professionals feel short-term pressure, justifiably fearing that one bad quarter or year could cause their clients to pull their assets. It’s dangerous to try to outperform the market in the short term. You don’t need to, and you’re better off not trying. Others feel the need to, and you can use this to your advantage as well.

Overview of Procter & Gamble

Procter & Gamble ($PG) is a giant of the consumer goods sector. Here are some charts comparing P&G to its main competitors. If you have any questions, feel free to post it as a comment.

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To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What's needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.

Warren E. Buffett, in the preface to the fourth edition of The Intelligent Investor by Benjamin Graham