This post is to acknowledge where my own investing principles have stemmed from (and continues to be shaped by) for the very short time that I've been investing. I'm very fortunate to have found my passion at a relatively young age and a set of philosophies that resonate with me. The notions that i outline below are implemented by me with my own funds and is dedicated to my hero with whom i have immense respect for.
There's no question as to why the world's greatest investor is exactly that. If you invested $10,000 in 1956 with Warren Edward Buffett when he commenced his investment partnership (Buffett Partnership, Ltd) you'd be worth over $500 million today. Contrastingly, that same $10,000 invested in the S&P would be $140,000. Ponder on that for a second.
Buffetts investment principles can be summed up as follows. I expand on them as to how i think they mean.
Rule number one: Don't lose capital.
Rule number two: Don't forget rule number one.
Capital preservation is the name of the game. When buying shares in a company you have to have at the forefront of your mind that you wish to not lose your money first rather than thinking along the lines of "how much money can i make". I think this is very important and it will make you rethink twice (or in my case 30 times) about whether what you're buying is really what you claim it to be.
1) Know what you own
When you buy a share you must understand what it is exactly that you're buying into. You must be 110% certain that you've made the right choice before going ahead and pressing that buy button. You must know the ins and outs of the business, as if you were the owner of that business. Buffett always says "Investment is most intelligent when it is most businesslike". Focus on buying businesses and let the market take care of itself.
2) Research before you buy
This rule i think is linked to number one. It is imperative that you do your research before you buy into a business. Don't buy businesses and then do the research, in my opinion you're setting yourself up for failure if you do this. After serious research is done, and by serious i mean you could talk about that business like the CEO would, you must stay on top of what's going on with that business.
3) Own a business, not a stock.
This is an extremely important foundation rule. When you buy a share, you're buying part ownership of that business. This is investing. On the other hand, buying stocks, i.e. pieces of paper that gyrate in prices by the second is speculating. This is akin to gambling. By following such a common tradition, you're punting on that the price will go up. With market updates "The Dow has hit an all time low today" or "It's red across the board" by the minute it's hard to sometimes step back and actually put that on the peripheral. Buffetts teacher, mentor and lifelong friend, Benjamin Graham introduces in chapter 8 of The Intelligent investor the concept of Mr.Market. A crazy, manic depressant who is there to serve you and not instruct you. If you own shares in lets say Flight Centre, and you notice that its lost 3% in market value today, do you sell because of this? Do you sell because the price has declined? Or do you research as to why it might have declined and to see if the underlying business value has changed? Stock prices change by the second, business value doesn't. Price and value are two completely different concepts. Buffett often reminds us that "Price is what you pay and value is what you get". If i was to ask you how much a typical ball point pen was worth, do you answer with something like "whatever it costs at Officeworks" or would you answer along the lines of "how much ink does it have". It's important to remember this distinction and don't buy into stocks because they are rising in price. This practice doesn't work in the long run.
4) Make a total of only 20 lifetime investments
Imagine
that you had a punch card (like a coffee card) and every time you buy a
stock you'd punch a hole. This is what this rule is referring to.
Now
i must admit i probably won't completely adhere to this. But the
underlying message here is important and that i do have this message
factored into my final decision of whether or not to buy a business. At
business school I've been taught that the market is efficient and that
you can't 'beat it'. Essentially, there's no point is trying to find
undervalued stocks because you're wasting your time. I believe that this
is rubbish. Beating an index can be done because the index is filled
with good companies but also bad companies which can drag its
performance (as the stock price in the long-run reflects the value of
the business. And I'm not talking about market value. I won't detail
this here as this is another post in itself). Therefore, to beat the
market i believe you need to be a better stock picker. Many people have
done this including Warren Buffett.
This leads me to talk about diversification (or diworsificaiton as
Mr Lynch coined). This is the process by which you spread your funds
over a variety of different companies and/or asset classes to reduce
risk (or so they say). Without getting too detailed here, i do believe a
little of diversification is necessary. By a bit i mean 8-16 stocks
(depending on your situation this may change, i.e. a mutual fund with
enormous funds under management, may have to do things differently due
to maybe legal obligations). Is over diversification necessary? Warren
Buffet doesn't seem to think so and neither do i. This is linked back
to know what you own among another things. If you own
50 different companies in your portfolio you can't tell me that you can
equally rank number 1 to 50. What i mean by this is that company number 1
and company number 50 is highly unlikely to be understood equally.
Further, if you're truly buying superior businesses with good economics
at a discount to business value its also unlikely that number 1 is just
as good as 50.
When Warren buys, he buys in a few
businesses (contrary to diversification) and he buys BIG. He also buys and
holds indefinitely (or until certain circumstances change). This indefinitely aspect reflects that he's 110%
certain that what he's bought is what he thinks it to be. Coca-Cola, GEICO Insurance, The Washington
Post, Gillette, American Express and more recently IBM are some examples of investments made by Buffett. Notice how these businesses are quite well known. Not just by him
but you too (with a few exceptions). Buffett likes to buy simple
business in which he can understand completely. In the lead up to the
dot-com crash, articles were posted about Warren saying that he has
"lost his touch" as ten-baggers (a phrase coined by Peter lynch meaning
that you've made 10 times your money. e.g. investing $1 turning into $10
would be an example of a ten-bagger) were popping up everywhere. These
notions about Warren were rubbish, Warren didn't invest in such business
because for one he didn't understand them, they had unstable earnings
(the ones that made any!) etc..., Essentially, he stayed within his circle of competence. To
become a successful investor i believe you must be extremely patient
and disciplined. Such qualities exude from Warren at levels that would
make most people cringe. I'm a firm believer that in order to become the
best you must learn from the best.
5) Margin of safety
A concept developed by Buffetts mentor Benjamin Graham and introduced in chapter 20 of The Intelligent Investor. It's crucial that before you buy shares you must buy them at a discount to their intrinsic value (intrinsic value means what the business is worth today). You need to find a suitable discrepancy between the price of the share and what the business is actually worth on a per-share basis. Suitability will differ for everyone and this is why i see investment as both an art and a science.This discrepancy is refereed to as the margin of safety and relates back to rule number 1 and capital preservation.
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