Mr. Market and Common Stocks
Mr. Market is a character who lives on Wall Street. He is your hypothetical business partner. Mr. Market is moody, prone to manic swings from joy to despair. The poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.
Mr. Market has another endearing characteristic: He doesn’t mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transaction is strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren’t certain that you understand and can value business far better than Mr. Market you don’t belong in the game.
Sometimes Mr. Market offers prices way higher than value; sometimes he offers prices way lower than value. The more manic-depressive he is, the greater the spread between price and value, and therefore the greater the investment opportunities he offers.
If you are an investor, defined as one who buys and holds a business, then the actions of management are critical to the long net worth of the business and thus the future price of the stock. What matters is people who are able, honest, and hardworking. They work because they love what they do and relish the thrill of outstanding performance. They unfailingly think like owners and find all aspects of their business absorbing. Once a company’s reputation for honesty, rationality, and fairness become evident, the stock market will ultimately reward these good deeds.
Investors should focus on fundamentals, be patient, and exercise good judgment based on common sense. Great financial success can be created by investing in business with excellent economic characteristic and run by outstanding managers. Stay away from businesses without favorable and durable economic and competitive characteristics.
People who buy for non-value reasons are likely to sell for non-value reasons. Their presence on Wall Street will accentuate erratic price swings unrelated to underlying business development. Short-term investors mistaken mindset price with value. Stock splits attract shareholders with short-term, market-oriented views who unduly focus on stock market prices; and, as a result of both of those effects, they lead to prices that depart materially from intrinsic business value.
We should measure success in investment by the long-term progress of the companies rather than by the month-to-month movements of their stocks. If we have long-term expectations, short-term price changes are meaningless for us except to the extent they offer us an opportunity to increase our ownership at an attractive price. So when the market plummets – as it will from time to time – neither panic nor mourn. It’s good news!
From Wall Street to Main Street, many professional still believe that stock market prices always accurately reflect fundamental values, that the only risk that matters is the volatility of prices, and that the best way to manage that risk is to invest in a diversified group of stocks.
In reality most markets are not purely efficient and equating volatility with risk is a gross distortion.
Assessing investment risk requires thinking about company’s management, products, competitors, and debt levels. The primary relevant factors are the long-term economic characteristics of a business, the quality and integrity of its management, and future levels of taxation and inflation. Therefore before we invest it is important to make research on the economic characteristic of business and the quality of management, and to face difficult judgments that are always necessary, but not always correct. In judging the debt level the inquiry is whether after-tax returns on an investment are at least equal to the purchasing power of the initial investment plus a fair rate of return.
Long-term investment success not depends on studying betas and maintaining a diversified portfolio, but on recognizing that as investor, one is the owner of a business. A pile of stockpicking software isn’t worth a damn if you haven’t done your basic homework on the companies. Reconfiguring a portfolio by buying and selling stocks to accommodate the desired beta-risk profile defeats long-term investment success. Such “flitting from flower to flower” imposes huge transaction costs in the form of fees and commissions, not to mention taxes. I do not think people can achieve long-term investment success by flitting from flower to flower.
One should not make an investment in a stock unless there is sufficient basis for believing that price being paid is substantially lower than the value being delivered. If the stock is grossly overpriced, even if everything else goes right, you won’t make any money. All true investing must be based on an assessment of the relationship between price and value. Strategies that do not employ this comparison of price and value do not mount to investing at all. You must have the conviction that price being paid is lower than the value being obtained.
Many investors buy into a great many deals – perhaps 20 or more per year. With that many irons in the fire, they must spend most of their time monitoring both the progress of businesses and the market movements of the related stocks. That is not how I wish to spend my life.
Investors who do not understand the economics of specific businesses require wide diversification. If you are a know-something investor, able to understand business economics and to find several sensibly priced companies whose posses important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort chooses to put money into a business that in his 20th favorite rather than simply adding that money to his top choices – the business he understands best and that’s the least risk, along with the greatest profit potential. Too much of a good thing can be wonderful.
I believe that Mark Twain hit it on the head when he said, “Put all of your eggs in one basket and watch the basket!” I put nearly eighty percent of my eggs in the company I know the best. I stick with the easy cases. Why search for a needle buried in a haystack when one is sitting in plain sight?
My goal is to find an outstanding company at an attractive price, not a mediocre company at a bargain price. I try to invest not only in good company, but ones run by high-grade and likeable managers.
I select my stocks in much the way I would evaluate a company for acquisition in its entirety. I want the business to be:
1. that I can understand,
2. with favorable long-term prospects,
3. operated by honest and competent people, and
4. available at a very attractive price.
Invest only in businesses you are capable of understanding with a modicum effort. It is this commitment you need to stick with that will enable you to avoid mistakes other investors repeatedly make.
Growth is always a component in the calculation of value. What is investing if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value – in hope that it can soon be sold for a still-higher price – should be labeled speculation. By speculating instead of investing, you lower your own odds of building wealth. You must treat speculation as gamblers take their trips to the casino. You must never delude yourself into thinking that you’re investing when you’re speculating. Make sure you will never fool yourself into confusing speculation with investment. Speculating becomes mortally dangerous the moment you begin to take it seriously.
An ancient saying “A bird in the hand is worth two in the bush.” Valuation is counting cash, not hopes or dreams, a lesson many should have learned amid the late 1990s high tech rush bubble that burst when everyone finally realized there were few birds in the bushes. You see, how unrealistic market prices can be as an index of real value.
Very few large businesses have a chance of compounding intrinsic value at 15% per annum over an extended period of time. Investors making purchases in an overheated market need to recognize that it may often take an extended period for the value of even an outstanding company to catch up with the price they paid.
There is a powerful unseen force that allows people to act irrationally. This unseen force is a mindless, lemminglike imitation of others, no matter how irrational their actions may be. We seem to assume that if a lot of people are doing the same thing, they must know something we don’t. Especially when we are uncertain, we are willing to place an enormous amount of trust in the collective knowledge of the crowd. Quite frequently the crowd is mistaken because they are not acting on the basis of superior information but are reacting themselves to the principle of social proof. A snowballing effect occurs.
A lemming-like willingness to follow the crowd endures. Entailing the destruction of both leadership and independent thought, that weakness is the intellectual foe in the struggle wage for intelligence and focus investing.
Growth benefits investors only when the company in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates a dollar market value. In the case of a low-return business requiring incremental funds, growth hurts the investors.
The best company to own is one that over an extended period of time can employ large amounts of incremental capital at very high rates of return. The worst company to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amount of capital at very low rates of return. Unfortunately, the first type of company is very hard to find: Most high-return companies need relatively little capital.
An intelligent investor would continually search for business with understandable, enduring, and mouth-watering economics that are run by able and shareholder-oriented managements and buy at an attractive price. This investment approach – searching for superstars – offers us our only chance for real success.
In searching for superstars, first we should try to assess the long-term economic characteristics of each business; second, asses the quality of the people in charge of running it; and, third, try to buy a piece of the best operations at an attractive price. As times goes on, I get more and more convinced that the right method in investment is to put fairly large sums of money into enterprises which one thinks one knows something about and in the management of which one thoroughly believes.
It is a mistake to think that we limit our risks by spreading too much between enterprises about which we know little and have no reason for special confidence. Our knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which we personally feel ourselves entitled to put full confidence.
It only takes you a handful of winner to make a lifetime of investing worthwhile. Here’s the math: if you start out with $10,000 and manage to triple it five times, you’ve got $2.4 million, and if you triple it ten times, you’ve got $590 million, and 13 times, you are a billionaire.
Take the advantage of concentration. Concentrate on a few good companies. By owning too many stocks, you will lose this advantage of concentration. I believe that a policy of concentration may well decreased risk. I define risk using dictionary terms as, “the possibility of loss or injury.”
The experts, the academics, and short-term investors, however, define risk differently, everything that is the relative volatility of a stock market or portfolio of stocks – that is risky, their volatility as compared to that of a large universe of stocks. Employing databases and statistical skills, these academics compute precision of “beta” of a stock – its relative volatility in the past – and then build arcane investment and capital-allocation theories around however, they forgot the fundamental principle: It is better to approximately right than precisely wrong.
The experts’ and the academics’ definition of risk is far off mark, so much as that it produces absurdities. For example, under beta-based theory, a stock that has dropped very sharply compared to the market – as had the Coca-Cola Co., Gillette, and Motorola they purchased in the short crash in 1987 became “riskier” at the fast reduced price than it was at the higher price. Would that description have then made any sense to someone who was offered the entire company at vastly reduced price? The less these companies are being valued at, says this approach, the more vigorously they sold. As a “logical” corollary, the approach commands the institutions to repurchase these companies once their prices have rebounded significantly. Considering that huge sums of money are controlled by fund managers following such “Alice-in-Wonderland” practices, is it any surprise that markets sometimes behave in aberrational fashion?
During 1987 the stock market was an area of much excitement but little net movement: The Dow advanced 2.3 percent for the year. You are aware, of course, of the roller coaster ride that produced this minor change. Mr. Market was on a manic rampage until October and then experienced a sudden, massive seizure. Instead of focusing on what business will do in the years ahead, many prestigious money managers focus on what they expect other money managers to do in the days ahead. For them, stocks are merely tokens in a game, like the thimble and flatiron in Monopoly. If you’ve thought that investment advisors were hired to invest, you may be bewildered by their technique.
They are fond of saying that the small investor has no chance in a market now dominated by the erratic behavior of the big boys. This conclusion is dead wrong: Such markets are ideal for any investor – small or large – so long he sticks to his investment strategy. Volatility caused by money managers who speculate irrationally with huge sums of money will offer the true investor more chances to make intelligent investment moves. He can be hurt by such volatility only if he is forced, by either financial or psychological pressures, to sell at untoward times.
In fact, true investors welcome volatility. The more manic-depressive the market is, the greater the opportunity available to investors. That’s true because a wildly fluctuating market means that irrationally low prices periodically attached to solid business. Intelligence investors will happily forgo knowing the price history and instead will seek whatever information will further his or her understanding of the company’s business.
Though risk cannot be calculated with engineering precision, it can in some cases be judged with a degree of accuracy. The primary factors bearing this evaluation are:
1) The certainty with which the long-term economic characteristics of the business can be evaluated.
2) The certainty with which the management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flows.
3) The certainty with which the management can be counted on to channel the reward from the business to the shareholders rather than itself.
4) The price being paid is substantially lower than the value being delivered.
These factors will probably strike many analysts as unbearably fuzzy since they cannot be extracted from database of any kind. People who have been trained to rigidly quantify everything have a big disadvantage.
“I know it when I see it,” is a useful way – “see” the risks inherent in certain investments without reference to complex equations or price histories. It’s obvious that studying business & economics, psychology, and philosophy was much better preparation for the stock market than, say, studying statistics or mathematics. By confining himself to a relatively few, easy-to-understand cases, a reasonably intelligent, informed and diligent person can judge investment risks with a useful degree of accuracy.
I do not have, never have had, and never will have an opinion about where the stock market, interest rates, or business activities will be a year from now. I dismiss all such forecast but I concentrate on what’s actually happening to the companies in which I have invested.
To invest successfully, you do not need to understand beta, efficient markets, modern portfolio theory, option pricing, or emerging markets. You may, in fact, be better off knowing nothing of these. In my view, we as investment students need only two well-taught courses: how to value a business and how to think about market prices.
Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards – so when you see one that qualities, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guideline: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Time is the friend of the wonderful business, but the enemy of the mediocre.
An investor obtains superior profits from stocks only by carefully evaluating the facts and continuously exercising discipline. The disciplines that investors need the most are:
1. You should not make an investment in a stock unless there is sufficient basis for believing that price being paid is substantially lower than the value being delivered.
2. Invest only in businesses you are capable of understanding with a modicum effort. It is this commitment you need to stick with that will enable you to avoid mistakes other people repeatedly make.
3. Concentrate on a few good companies. By owning too many stocks, you will lose this advantage of concentration.
Useful financial statements must enable a user to answer three basic questions about a business:
1) approximately how much a company is worth,
2) its likely ability to meet its future obligations,
3) how good a job its managers are doing in operating the business.
Business with more economic goodwill relative to tangible assets is hurt far less by inflation than businesses with less of that.
If (a) operating earning, (b) depreciation expense and other non-cash charges, and (c) required reinvestment in the business. It is common companies using calculation of cash flows equals to (a) + (b). But the real cash flows or “owner earnings” are results of (a) + (b) –(c).
For most companies (c) usually exceeds (b), so cash flow analysis usually overstates economic reality.
Despite of enormous managerial leeway in reporting earnings and potential abuse, financial information can be of great use to investors. You may make judgment to determine look-through earnings, owner earnings, and intrinsic value, and to show the real costs of stock options or other obligations that are not required to be recorded on the financial statements.
Though simple to state, calculating intrinsic value is neither easy nor objective. It depends on estimation of both future cash flows and interest movements. But it is what ultimately matters about a business. Book value is easy to calculate, but of limited use. Differences between intrinsic value and book value and market price may hard to pin down.
The key to successful investing is the purchase of shares in good companies when market prices were at large discount from underlying business values. A depressed stock market is likely to present us with significant advantages. We look at the economic prospects of the business, the people in charge of running it, and the price we must pay. We are willing to hold a stock indefinitely so long as we expect the business to increase in intrinsic value at a satisfactory rate. When investing, we should view ourselves as business analysts – not as market analysts. Eventually, our economic fate will be determined by the economic fate of the business we own.
The stock price is the least useful information you can track. The stock price is a dangerous delusion. What Mr. Market pays for a stock today or next week doesn’t tell you which company has the best chance to succeed. Invest in companies, not in the stock price. Ignore short-term fluctuations. Predicting the short-term direction of the stock market is futile.
In my opinion, investment success will not be produced by arcane formula, computer programs or signals flashed by the price behavior of stocks and markets, rather an investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace. In my own efforts to stay insulated, I have found it highly useful to keep Mr. Market’s concept firmly in mind.
The market may ignore business success for a while, but eventually will confirm it. In the short run, the market is a voting machine but in the long run it is a weighing machine.
Sometimes it takes years for the stock price to catch up to a company’s value, and the down periods last so long that investors begin to doubt that will ever happen. But value always wins out. The speed at which a business’s success is recognized, furthermore, is not that important, is not that important as long as the company’s intrinsic value is increasing at a satisfactory rate. In fact, delayed recognition can be an advantage: It may give us the chance to buy more of a good thing at a bargain price.
Sometimes, of course, the market may judge a business to be more valuable than the underlying facts would indicate it is. In such case, I will sell my stocks. Sometimes, also, I will sell a security that is fairly valued or even undervalued because I require funds for a still more undervalued investment or one I believe I understand better. I am quite content to hold any stocks indefinitely, so long as the prospective return on equity capital of the underlying business is satisfactory, management is competent and honest, and the market does not overvalue the business.
When I own stocks of outstanding business with outstanding managements, my favorite holding is forever. I continue to think that it is usually foolish to part with an interest in business that is both understandable and durably wonderful. Business interests of that kind are simply too hard to replace. For example, by investing $40 in the Coca-Cola Co. in 1919 in one share turned into $3,277 by the end of 1938, and grew to $25,000 by year-end 1993.
Interestingly, many investors have no trouble understanding that point when they are focusing on business: A parent company that owns a subsidiary with superb long-term economics is not likely to sell that entity regardless of price. “Why,” the CEO would ask, “should we part with our crown jewel?” Yet the same CEO, when it comes to running his personal investment portfolio, will offhandedly – and even impetuously – move from business to business when presented with no more than superficial arguments by his broker for doing so. The worst of these arguments is perhaps, “You can’t go broke taking a profit.” Can you imagine a CEO using this line to urge his board to sell a star subsidiary? I my views what makes sense in business also make sense in stocks: An investor should ordinarily hold a small piece of an outstanding company with the same tenacity that an owner would exhibit if he owned all of that company.
Prospective purchasers should much prefer sinking prices. They should therefore rejoice when markets decline and allow them deploy funds more advantageously. So smile when you read a headline that says, “Investors lose as market fall.” Edit it in your mind to, “Disinvestors lose as market falls – but investors gain. It’s only dangerous if you sell. A crash is a unique opportunity to buy stocks cheap. Buy shares in solid companies with earning power and don’t let go of them without a good reason. Markets that then were hostile to investment transients were friendly to those taking up permanent resident. True investors gained enormously from the low prices on many equities and business in the 1970s, 1980s and 2000s.
Many times stocks swing between levels of severe under-valuation and over-valuation. Many times exists wide discrepancy between price and value. Occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics will be unpredictable. And the market aberrations produced by them will be equally unpredictable, both as to duration and degree. Therefore, we should never try to anticipate the arrival or departure of either disease. My personal investment strategy is rather modest: I simply attempt to be fearful when the crowds are greedy and to be greedy only when the crowds are fearful.
If investors are prone to make irrational or emotion-based decisions, some pretty silly stock prices are going to appear periodically. Manic-depressive personalities produce manic-depressive valuations. Such aberrations may help us in buying when Mr. Market is manic-depressive and selling the stocks when Mr. Market is too optimistic.
In the late 1990s little fear is visible in Wall Street. Instead, euphoria prevails – and why not? What could be more exhilarating than to participate in a bull market in which the rewards to owners of businesses become gloriously uncoupled from the plodding performance of the businesses themselves? Unfortunately, however, stocks can’t outperform businesses indefinitely. Bull markets can obscure mathematical laws, but they cannot repeal them.
What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know. An investor needs to do very few things right as long as he or she avoids big mistakes. The worst thing you can do is to invest in companies you know nothing about. Invest only in businesses you are capable of understanding with a modicum effort.
Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected business. You don’t have to be an expert on every business, or even many. You only have to be able to evaluate businesses within your circle of competence. The size of the circle is not very important; knowing its boundaries, however, is vital.
If there is a choice between a questionable business at a comfortable price or a comfortable business at a questionable price, I much prefer the latter. What really gets out my attention, however, is a comfortable business at a comfortable price.
Insist on a margin of safety in your purchase price. If I calculate the value of common stock to be only slightly higher than its price, I’m not interested in buying. I believe this margin-of-safety principle so strongly to be the cornerstone of investment success. The stock market, which is periodically ruled by mass folly, is constantly setting a “clearing” price. No matter how foolish that price may be, it’s what counts for the holder of the stocks, who needs or wishes to sell, of whom there are always going to be a few at any moment. In many instances, shares worth X in business value have been sold in the market for ½ X or less.
Mr. Market has another endearing characteristic: He doesn’t mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transaction is strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren’t certain that you understand and can value business far better than Mr. Market you don’t belong in the game.
Sometimes Mr. Market offers prices way higher than value; sometimes he offers prices way lower than value. The more manic-depressive he is, the greater the spread between price and value, and therefore the greater the investment opportunities he offers.
If you are an investor, defined as one who buys and holds a business, then the actions of management are critical to the long net worth of the business and thus the future price of the stock. What matters is people who are able, honest, and hardworking. They work because they love what they do and relish the thrill of outstanding performance. They unfailingly think like owners and find all aspects of their business absorbing. Once a company’s reputation for honesty, rationality, and fairness become evident, the stock market will ultimately reward these good deeds.
Investors should focus on fundamentals, be patient, and exercise good judgment based on common sense. Great financial success can be created by investing in business with excellent economic characteristic and run by outstanding managers. Stay away from businesses without favorable and durable economic and competitive characteristics.
People who buy for non-value reasons are likely to sell for non-value reasons. Their presence on Wall Street will accentuate erratic price swings unrelated to underlying business development. Short-term investors mistaken mindset price with value. Stock splits attract shareholders with short-term, market-oriented views who unduly focus on stock market prices; and, as a result of both of those effects, they lead to prices that depart materially from intrinsic business value.
We should measure success in investment by the long-term progress of the companies rather than by the month-to-month movements of their stocks. If we have long-term expectations, short-term price changes are meaningless for us except to the extent they offer us an opportunity to increase our ownership at an attractive price. So when the market plummets – as it will from time to time – neither panic nor mourn. It’s good news!
From Wall Street to Main Street, many professional still believe that stock market prices always accurately reflect fundamental values, that the only risk that matters is the volatility of prices, and that the best way to manage that risk is to invest in a diversified group of stocks.
In reality most markets are not purely efficient and equating volatility with risk is a gross distortion.
Assessing investment risk requires thinking about company’s management, products, competitors, and debt levels. The primary relevant factors are the long-term economic characteristics of a business, the quality and integrity of its management, and future levels of taxation and inflation. Therefore before we invest it is important to make research on the economic characteristic of business and the quality of management, and to face difficult judgments that are always necessary, but not always correct. In judging the debt level the inquiry is whether after-tax returns on an investment are at least equal to the purchasing power of the initial investment plus a fair rate of return.
Long-term investment success not depends on studying betas and maintaining a diversified portfolio, but on recognizing that as investor, one is the owner of a business. A pile of stockpicking software isn’t worth a damn if you haven’t done your basic homework on the companies. Reconfiguring a portfolio by buying and selling stocks to accommodate the desired beta-risk profile defeats long-term investment success. Such “flitting from flower to flower” imposes huge transaction costs in the form of fees and commissions, not to mention taxes. I do not think people can achieve long-term investment success by flitting from flower to flower.
One should not make an investment in a stock unless there is sufficient basis for believing that price being paid is substantially lower than the value being delivered. If the stock is grossly overpriced, even if everything else goes right, you won’t make any money. All true investing must be based on an assessment of the relationship between price and value. Strategies that do not employ this comparison of price and value do not mount to investing at all. You must have the conviction that price being paid is lower than the value being obtained.
Many investors buy into a great many deals – perhaps 20 or more per year. With that many irons in the fire, they must spend most of their time monitoring both the progress of businesses and the market movements of the related stocks. That is not how I wish to spend my life.
Investors who do not understand the economics of specific businesses require wide diversification. If you are a know-something investor, able to understand business economics and to find several sensibly priced companies whose posses important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort chooses to put money into a business that in his 20th favorite rather than simply adding that money to his top choices – the business he understands best and that’s the least risk, along with the greatest profit potential. Too much of a good thing can be wonderful.
I believe that Mark Twain hit it on the head when he said, “Put all of your eggs in one basket and watch the basket!” I put nearly eighty percent of my eggs in the company I know the best. I stick with the easy cases. Why search for a needle buried in a haystack when one is sitting in plain sight?
My goal is to find an outstanding company at an attractive price, not a mediocre company at a bargain price. I try to invest not only in good company, but ones run by high-grade and likeable managers.
I select my stocks in much the way I would evaluate a company for acquisition in its entirety. I want the business to be:
1. that I can understand,
2. with favorable long-term prospects,
3. operated by honest and competent people, and
4. available at a very attractive price.
Invest only in businesses you are capable of understanding with a modicum effort. It is this commitment you need to stick with that will enable you to avoid mistakes other investors repeatedly make.
Growth is always a component in the calculation of value. What is investing if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value – in hope that it can soon be sold for a still-higher price – should be labeled speculation. By speculating instead of investing, you lower your own odds of building wealth. You must treat speculation as gamblers take their trips to the casino. You must never delude yourself into thinking that you’re investing when you’re speculating. Make sure you will never fool yourself into confusing speculation with investment. Speculating becomes mortally dangerous the moment you begin to take it seriously.
An ancient saying “A bird in the hand is worth two in the bush.” Valuation is counting cash, not hopes or dreams, a lesson many should have learned amid the late 1990s high tech rush bubble that burst when everyone finally realized there were few birds in the bushes. You see, how unrealistic market prices can be as an index of real value.
Very few large businesses have a chance of compounding intrinsic value at 15% per annum over an extended period of time. Investors making purchases in an overheated market need to recognize that it may often take an extended period for the value of even an outstanding company to catch up with the price they paid.
There is a powerful unseen force that allows people to act irrationally. This unseen force is a mindless, lemminglike imitation of others, no matter how irrational their actions may be. We seem to assume that if a lot of people are doing the same thing, they must know something we don’t. Especially when we are uncertain, we are willing to place an enormous amount of trust in the collective knowledge of the crowd. Quite frequently the crowd is mistaken because they are not acting on the basis of superior information but are reacting themselves to the principle of social proof. A snowballing effect occurs.
A lemming-like willingness to follow the crowd endures. Entailing the destruction of both leadership and independent thought, that weakness is the intellectual foe in the struggle wage for intelligence and focus investing.
Growth benefits investors only when the company in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates a dollar market value. In the case of a low-return business requiring incremental funds, growth hurts the investors.
The best company to own is one that over an extended period of time can employ large amounts of incremental capital at very high rates of return. The worst company to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amount of capital at very low rates of return. Unfortunately, the first type of company is very hard to find: Most high-return companies need relatively little capital.
An intelligent investor would continually search for business with understandable, enduring, and mouth-watering economics that are run by able and shareholder-oriented managements and buy at an attractive price. This investment approach – searching for superstars – offers us our only chance for real success.
In searching for superstars, first we should try to assess the long-term economic characteristics of each business; second, asses the quality of the people in charge of running it; and, third, try to buy a piece of the best operations at an attractive price. As times goes on, I get more and more convinced that the right method in investment is to put fairly large sums of money into enterprises which one thinks one knows something about and in the management of which one thoroughly believes.
It is a mistake to think that we limit our risks by spreading too much between enterprises about which we know little and have no reason for special confidence. Our knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which we personally feel ourselves entitled to put full confidence.
It only takes you a handful of winner to make a lifetime of investing worthwhile. Here’s the math: if you start out with $10,000 and manage to triple it five times, you’ve got $2.4 million, and if you triple it ten times, you’ve got $590 million, and 13 times, you are a billionaire.
Take the advantage of concentration. Concentrate on a few good companies. By owning too many stocks, you will lose this advantage of concentration. I believe that a policy of concentration may well decreased risk. I define risk using dictionary terms as, “the possibility of loss or injury.”
The experts, the academics, and short-term investors, however, define risk differently, everything that is the relative volatility of a stock market or portfolio of stocks – that is risky, their volatility as compared to that of a large universe of stocks. Employing databases and statistical skills, these academics compute precision of “beta” of a stock – its relative volatility in the past – and then build arcane investment and capital-allocation theories around however, they forgot the fundamental principle: It is better to approximately right than precisely wrong.
The experts’ and the academics’ definition of risk is far off mark, so much as that it produces absurdities. For example, under beta-based theory, a stock that has dropped very sharply compared to the market – as had the Coca-Cola Co., Gillette, and Motorola they purchased in the short crash in 1987 became “riskier” at the fast reduced price than it was at the higher price. Would that description have then made any sense to someone who was offered the entire company at vastly reduced price? The less these companies are being valued at, says this approach, the more vigorously they sold. As a “logical” corollary, the approach commands the institutions to repurchase these companies once their prices have rebounded significantly. Considering that huge sums of money are controlled by fund managers following such “Alice-in-Wonderland” practices, is it any surprise that markets sometimes behave in aberrational fashion?
During 1987 the stock market was an area of much excitement but little net movement: The Dow advanced 2.3 percent for the year. You are aware, of course, of the roller coaster ride that produced this minor change. Mr. Market was on a manic rampage until October and then experienced a sudden, massive seizure. Instead of focusing on what business will do in the years ahead, many prestigious money managers focus on what they expect other money managers to do in the days ahead. For them, stocks are merely tokens in a game, like the thimble and flatiron in Monopoly. If you’ve thought that investment advisors were hired to invest, you may be bewildered by their technique.
They are fond of saying that the small investor has no chance in a market now dominated by the erratic behavior of the big boys. This conclusion is dead wrong: Such markets are ideal for any investor – small or large – so long he sticks to his investment strategy. Volatility caused by money managers who speculate irrationally with huge sums of money will offer the true investor more chances to make intelligent investment moves. He can be hurt by such volatility only if he is forced, by either financial or psychological pressures, to sell at untoward times.
In fact, true investors welcome volatility. The more manic-depressive the market is, the greater the opportunity available to investors. That’s true because a wildly fluctuating market means that irrationally low prices periodically attached to solid business. Intelligence investors will happily forgo knowing the price history and instead will seek whatever information will further his or her understanding of the company’s business.
Though risk cannot be calculated with engineering precision, it can in some cases be judged with a degree of accuracy. The primary factors bearing this evaluation are:
1) The certainty with which the long-term economic characteristics of the business can be evaluated.
2) The certainty with which the management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flows.
3) The certainty with which the management can be counted on to channel the reward from the business to the shareholders rather than itself.
4) The price being paid is substantially lower than the value being delivered.
These factors will probably strike many analysts as unbearably fuzzy since they cannot be extracted from database of any kind. People who have been trained to rigidly quantify everything have a big disadvantage.
“I know it when I see it,” is a useful way – “see” the risks inherent in certain investments without reference to complex equations or price histories. It’s obvious that studying business & economics, psychology, and philosophy was much better preparation for the stock market than, say, studying statistics or mathematics. By confining himself to a relatively few, easy-to-understand cases, a reasonably intelligent, informed and diligent person can judge investment risks with a useful degree of accuracy.
I do not have, never have had, and never will have an opinion about where the stock market, interest rates, or business activities will be a year from now. I dismiss all such forecast but I concentrate on what’s actually happening to the companies in which I have invested.
To invest successfully, you do not need to understand beta, efficient markets, modern portfolio theory, option pricing, or emerging markets. You may, in fact, be better off knowing nothing of these. In my view, we as investment students need only two well-taught courses: how to value a business and how to think about market prices.
Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards – so when you see one that qualities, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guideline: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Time is the friend of the wonderful business, but the enemy of the mediocre.
An investor obtains superior profits from stocks only by carefully evaluating the facts and continuously exercising discipline. The disciplines that investors need the most are:
1. You should not make an investment in a stock unless there is sufficient basis for believing that price being paid is substantially lower than the value being delivered.
2. Invest only in businesses you are capable of understanding with a modicum effort. It is this commitment you need to stick with that will enable you to avoid mistakes other people repeatedly make.
3. Concentrate on a few good companies. By owning too many stocks, you will lose this advantage of concentration.
Useful financial statements must enable a user to answer three basic questions about a business:
1) approximately how much a company is worth,
2) its likely ability to meet its future obligations,
3) how good a job its managers are doing in operating the business.
Business with more economic goodwill relative to tangible assets is hurt far less by inflation than businesses with less of that.
If (a) operating earning, (b) depreciation expense and other non-cash charges, and (c) required reinvestment in the business. It is common companies using calculation of cash flows equals to (a) + (b). But the real cash flows or “owner earnings” are results of (a) + (b) –(c).
For most companies (c) usually exceeds (b), so cash flow analysis usually overstates economic reality.
Despite of enormous managerial leeway in reporting earnings and potential abuse, financial information can be of great use to investors. You may make judgment to determine look-through earnings, owner earnings, and intrinsic value, and to show the real costs of stock options or other obligations that are not required to be recorded on the financial statements.
Though simple to state, calculating intrinsic value is neither easy nor objective. It depends on estimation of both future cash flows and interest movements. But it is what ultimately matters about a business. Book value is easy to calculate, but of limited use. Differences between intrinsic value and book value and market price may hard to pin down.
The key to successful investing is the purchase of shares in good companies when market prices were at large discount from underlying business values. A depressed stock market is likely to present us with significant advantages. We look at the economic prospects of the business, the people in charge of running it, and the price we must pay. We are willing to hold a stock indefinitely so long as we expect the business to increase in intrinsic value at a satisfactory rate. When investing, we should view ourselves as business analysts – not as market analysts. Eventually, our economic fate will be determined by the economic fate of the business we own.
The stock price is the least useful information you can track. The stock price is a dangerous delusion. What Mr. Market pays for a stock today or next week doesn’t tell you which company has the best chance to succeed. Invest in companies, not in the stock price. Ignore short-term fluctuations. Predicting the short-term direction of the stock market is futile.
In my opinion, investment success will not be produced by arcane formula, computer programs or signals flashed by the price behavior of stocks and markets, rather an investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace. In my own efforts to stay insulated, I have found it highly useful to keep Mr. Market’s concept firmly in mind.
The market may ignore business success for a while, but eventually will confirm it. In the short run, the market is a voting machine but in the long run it is a weighing machine.
Sometimes it takes years for the stock price to catch up to a company’s value, and the down periods last so long that investors begin to doubt that will ever happen. But value always wins out. The speed at which a business’s success is recognized, furthermore, is not that important, is not that important as long as the company’s intrinsic value is increasing at a satisfactory rate. In fact, delayed recognition can be an advantage: It may give us the chance to buy more of a good thing at a bargain price.
Sometimes, of course, the market may judge a business to be more valuable than the underlying facts would indicate it is. In such case, I will sell my stocks. Sometimes, also, I will sell a security that is fairly valued or even undervalued because I require funds for a still more undervalued investment or one I believe I understand better. I am quite content to hold any stocks indefinitely, so long as the prospective return on equity capital of the underlying business is satisfactory, management is competent and honest, and the market does not overvalue the business.
When I own stocks of outstanding business with outstanding managements, my favorite holding is forever. I continue to think that it is usually foolish to part with an interest in business that is both understandable and durably wonderful. Business interests of that kind are simply too hard to replace. For example, by investing $40 in the Coca-Cola Co. in 1919 in one share turned into $3,277 by the end of 1938, and grew to $25,000 by year-end 1993.
Interestingly, many investors have no trouble understanding that point when they are focusing on business: A parent company that owns a subsidiary with superb long-term economics is not likely to sell that entity regardless of price. “Why,” the CEO would ask, “should we part with our crown jewel?” Yet the same CEO, when it comes to running his personal investment portfolio, will offhandedly – and even impetuously – move from business to business when presented with no more than superficial arguments by his broker for doing so. The worst of these arguments is perhaps, “You can’t go broke taking a profit.” Can you imagine a CEO using this line to urge his board to sell a star subsidiary? I my views what makes sense in business also make sense in stocks: An investor should ordinarily hold a small piece of an outstanding company with the same tenacity that an owner would exhibit if he owned all of that company.
Prospective purchasers should much prefer sinking prices. They should therefore rejoice when markets decline and allow them deploy funds more advantageously. So smile when you read a headline that says, “Investors lose as market fall.” Edit it in your mind to, “Disinvestors lose as market falls – but investors gain. It’s only dangerous if you sell. A crash is a unique opportunity to buy stocks cheap. Buy shares in solid companies with earning power and don’t let go of them without a good reason. Markets that then were hostile to investment transients were friendly to those taking up permanent resident. True investors gained enormously from the low prices on many equities and business in the 1970s, 1980s and 2000s.
Many times stocks swing between levels of severe under-valuation and over-valuation. Many times exists wide discrepancy between price and value. Occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics will be unpredictable. And the market aberrations produced by them will be equally unpredictable, both as to duration and degree. Therefore, we should never try to anticipate the arrival or departure of either disease. My personal investment strategy is rather modest: I simply attempt to be fearful when the crowds are greedy and to be greedy only when the crowds are fearful.
If investors are prone to make irrational or emotion-based decisions, some pretty silly stock prices are going to appear periodically. Manic-depressive personalities produce manic-depressive valuations. Such aberrations may help us in buying when Mr. Market is manic-depressive and selling the stocks when Mr. Market is too optimistic.
In the late 1990s little fear is visible in Wall Street. Instead, euphoria prevails – and why not? What could be more exhilarating than to participate in a bull market in which the rewards to owners of businesses become gloriously uncoupled from the plodding performance of the businesses themselves? Unfortunately, however, stocks can’t outperform businesses indefinitely. Bull markets can obscure mathematical laws, but they cannot repeal them.
What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know. An investor needs to do very few things right as long as he or she avoids big mistakes. The worst thing you can do is to invest in companies you know nothing about. Invest only in businesses you are capable of understanding with a modicum effort.
Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected business. You don’t have to be an expert on every business, or even many. You only have to be able to evaluate businesses within your circle of competence. The size of the circle is not very important; knowing its boundaries, however, is vital.
If there is a choice between a questionable business at a comfortable price or a comfortable business at a questionable price, I much prefer the latter. What really gets out my attention, however, is a comfortable business at a comfortable price.
Insist on a margin of safety in your purchase price. If I calculate the value of common stock to be only slightly higher than its price, I’m not interested in buying. I believe this margin-of-safety principle so strongly to be the cornerstone of investment success. The stock market, which is periodically ruled by mass folly, is constantly setting a “clearing” price. No matter how foolish that price may be, it’s what counts for the holder of the stocks, who needs or wishes to sell, of whom there are always going to be a few at any moment. In many instances, shares worth X in business value have been sold in the market for ½ X or less.
posted by Inspirational Articles at 6:46 AM
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