“That whole idea that you own a business, you know, is vital to the investment process.” Warren Buffett
Between the ages of 11 and 19, Warren Buffett was a failed investor. Hard to believe, right?
And it wasn’t for lack of trying. By the age of ten, Buffett had read every investment book on the shelves of the Omaha library. He’d gorged on stock quotes and technical analysis, and whilst his education in investing could be said to have improved, quite simply he wasn’t making any money.
But at the age of nineteen, Buffett picked up Ben Graham’s ‘Intelligent Investor‘ and everything changed for him. Within Chapter Eight of that book lay an alternative philosophy about investments. The author proposed that an investor was ‘analogous to that of a silent partner in a private business‘ whose results would be ‘entirely dependent on the profits of the enterprise’. Graham proffered that ‘as long as the earnings power of [the] holdings remain satisfactory, [an investor] can give as little attention as he pleases to the vagaries of the stock market‘.
It had been the ‘vagaries of the market‘, the unexpected and inexplicable changes in stock prices that had obstructed Buffett from investment success. With this learning, a light went on in Buffett’s mind. It was a seminal moment that would change his life.
“From 11 to 19, I was reading Garfield Drew, and Edwards and Magee, and all kinds of — I mean, I read every book — Gerald M. Loeb — I mean, I read every book there was on investments, and I didn’t do well at all. And I had no real investment philosophy. I had a lot of things I tried. I was having a lot of fun. I wasn’t making any money. And I read Ben’s book in 1949 when I was at University of Nebraska, and that actually just changed my whole view of investing. And it really did, basically, told me to think about a stock as a part of a business.” Warren Buffett
Like Buffett junior, most market participants think of stocks as pieces of paper to be traded, not an entitlement or claim to the underlying earnings of a business.
“To many on Wall Street, both companies and stocks are seen only as raw materials for trades.” Warren Buffett
These investors take their cues about a stock from the stock price movement rather than the performance and outlook of the underlying business. As such, a stock price decline must imply the outlook is deteriorating, and vice versa. But stock prices move for all sorts of reasons, and many of them are unrelated to business fundamentals. And humans are emotional, they often over-react; psychological biases mean they often do the wrong thing at the wrong time. Consequently, stock prices can have little semblance to what a company is worth, be it too high or too low. Basically, stock prices are frequently irrational.
“The beauty of stocks is that that do sell at silly prices from time to time. That’s how Charlie and I have gotten rich.” Warren Buffett
This is the beauty and the real opportunity in public markets. These markets are brimming with emotional participants who don’t know what they own, what their stocks are worth and who buy and sell at the wrong times. Emotions rather that facts drive their investment decisions. Sometimes it’s not even people, but two algorithms programmed to sell at market prices, come what may. No price is the wrong price for an algorithm.
“When the price of a stock can be influenced by a ‘herd’ on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact market prices are frequently nonsensical.” Warren Buffett
In contrast, private market transactions are ordinarily set by astute, informed, rational sellers.
“In a negotiated purchase of a business, you’re almost always dealing with someone that has the option of either selling or not selling, and can sort of pick the time when they decide to sell, and all of that sort of thing. In stock markets, it’s an auction market. Crazy things can happen. You can have, you know, some technological blip that will cause a flash crash or something. And the world really hasn’t changed at all, but all kinds of selling mechanisms are tripped off, and that sort of thing. So you will see opportunities in the stock market that you’ll never really get in the business market.” Warren Buffett
“The stock market will offer you opportunities for profit, percentage-wise, that you’ll never see, in terms of negotiated purchase of business.” Warren Buffett
By acknowledging that stock prices could be nonsensical, Buffett overcame the powerful emotional impact that can derail an investors’ decision making process. Buffett looked to the business as his guidepost, not a share price.
“We don’t consider ourselves richer or poorer based on what the stock does. We do feel richer or poorer based on what the business does. So we look at the business as to how much we’re worth. And we do not look at the stock price, because the stock price doesn’t mean a thing to us.” Warren Buffett
“You have to have an attitude that divorces you from being influenced by the market.” Warren Buffett
“I think it’s almost impossible if you’re to do well in equities over a period of time if you go to bed every night thinking about the price of them. I mean, Charlie and I, we think about the value of them.” Warren Buffett
Taking a step further, Buffett framed his purchases under the guise of buying the whole enterprise which provoked a different analytical lens than for share purchases.
“When we buy a stock, we always think in terms of buying the whole enterprise, because it enables us to think as businessmen, rather than as stock speculators.” Warren Buffett
Buffett even considered stock purchases in the hypothetical context of a stock market that was indefinitely closed.
“No matter what the stock was selling for — it just doesn’t make any difference — because we do look at the businesses. We really look at it as if there wasn’t any quote on the stock. Because we don’t know what the stock is going to do. If the business gets worth more at a reasonable rate, the stock will follow, over time. But it won’t necessarily follow week by week, or month by month, or year by year… So we really measure all the time by the business. We think of it as a private business, basically, for which there’s a quotation. And if it’s handy to use that quotation, either in buying more stock or something of the sort, we may do it. But it does not govern our ideas of value.” Warren Buffett
“We bought See’s Candy in 1972. We haven’t had a quote on it since. Does that make us wonder about how we’re doing with See’s Candy? No, we looked at the company results. So — there’s nothing wrong with focusing on company results. Focusing on the price of a stock is dynamite, because it really means that you think that the stock market knows more than you do. Now if the stock market may know more than you do, but then you shouldn’t be in stocks. I mean, you should have — the stock market is there to serve you and not to instruct you.” Warren Buffett
Buffett recognised that over the longer term a company’s share price must reflect the value of the future earnings of that company.
“Sooner or later, the amount of cash that a business can disgorge in the future governs the value it has — that the stock commands — in the market. But it can take a long time.” Warren Buffett
“Wild swings in market prices far above and below business value do not change the final gains for owners in aggregate; in the end, investor gains must equal business gains.” Warren Buffett
What a stock earns depends solely on the business that underlies that stock. It’s little wonder Buffett considers himself, first and foremost, a business analyst.
“When investing, we view ourselves as business analysts – not as market analysts, not as macroeconomic analysts, and not even as security analysts.” Warren Buffett
“The only way we know how to make money is to try and evaluate businesses.” Warren Buffett
And identifying good businesses that can grow their earnings is key.
“People have been successful because they’ve stuck with successful companies. Sooner or later the market mirrors the business.” Warren Buffett
Which means its important to think about what makes a good business. And focus on the ones you understand.
“I think most of the people in this room, if they just focused on what made a good business or didn’t make a good business and thought about it a little while, they could develop a set of filters that would let them, in five minutes, figure out pretty well what made sense or didn’t make sense.” Warren Buffett, Berkshire AGM 1997
“The way you learn about businesses is by absorbing information about them, thinking, deciding what counts and what doesn’t count, relating one thing to another. And, you know, that’s the job. And you can’t get that by looking at a bunch of little numbers on a chart bobbing up and down about a — or reading, you know, market commentary and periodicals or anything of the sort. That just won’t do it. You’ve got to understand the businesses. That’s where it all begins and ends.” Warren Buffett
“I would just read the Graham and the Phil Fisher books. And then read lots of annual reports, think about businesses, and try and think about which businesses you understand and which you don’t understand. And you don’t have to understand them all. Just forget about the ones that you don’t understand.” Warren Buffett
“I think you ought to learn everything you can about industries and businesses that — where you think you have the ability to get your mind around them if you work at them. And with that arsenal, you’ll do very well, and if you’ve got the temperament for the business.” Warren Buffett
Paying the right price for the future earnings is what value investing is all about.
“What you’re trying to do is look at all the cash a business will produce between now and judgment day, and discount it back at a rate that’s appropriate, and then buy it a lot cheaper than that.” Warren Buffett
Not overpaying is important. Although, paying too much for a great business is more likely to lead to waiting longer for results rather than the permanent loss of capital.
“Stocks are part of a business. If the business does well, they’re [the investors] going to do all right as long as they don’t pay way too much to join into that business… [If] you pay too much for them, [the] risk is usually a risk of time rather than loss of principal, unless you get into a really extravagant situation.” Warren Buffett
And if you get the business analysis right, the investment will be right.
“We figure if we’re right about the business, we’re going to make a lot of money. And if we’re wrong about the business, we don’t have any hopes — we don’t expect to make money.” Warren Buffett
“What costs us money is when we mis-assess the fundamental economic characteristics of the business.” Warren Buffett
It also means not having to worry about the macro or political issues.
“I can’t remember any discussions Charlie and I have had, ever, going back to 1959, that where we would’ve come to the conclusion at the end of them that we would’ve passed on a great business opportunity — a business to buy — because of external conditions. Nor did we ever buy anything that we thought was mediocre simply because we thought the world was going to be wonderful.” Warren Buffett
And it shouldn’t come as a surprise many of the Investment Masters think the same way as Buffett. While each Investment Master has their own style, a great majority consider themselves business owners rather than stockholders and consider stocks as ‘pieces of a business‘.
“Forget the noise. Investing is about owning businesses!” Francois Rochon
“The number one idea is to view stock as an ownership of the business and to judge the staying quality of the business in terms of its competitive advantage.” Charlie Munger
“You have to think of yourself as an owner of a business, rather than an owner of a piece of paper.” Li Lu
“Stock certificates are deeds of ownership in business enterprises and not betting slips.” J Paul Getty
“Stocks are ownership shares of businesses; they are not pieces of paper that bounce around on which you calculate Sharpe and Sortino ratios. They are ownership shares of businesses that we value, and either buy at a discount or short when they are overpriced.” Joel Greenblatt
I think one of the most important lessons from Buffett has to be this fundamental shift in his thinking. Prior to his discovery of Ben Graham’s book in 1949, he had been dabbling in the Stock Market and whilst having lots of fun, had not earned a cent. Once he had shifted his thinking towards Business Ownership as opposed to Stock Ownership, he began to make money.
And it’s a relatively simple lesson that is missed by the majority of the world’s investors. They live their lives based on what a stock price is doing rather than the future earnings potential of the businesses they own stock, and therefore often ‘create’ fluctuations in the prices of those stocks due to their emotions or thinking biases. Or even worse, the emotions and thinking biases of other people. AKA: the Herd.
So here’s a couple of easy things to remember from all this:
1) Think about the stock as part of a business
2) Apply Mental Tricks – consider you are buying the whole business and that the stock market will close indefinitely
3) Recognise that stock prices can be completely irrational
4) Identify good businesses with sustainable competitive advantages that are growing
4) Focus on the underlying performance of the business rather than its stock price
Sometimes the simple act of thinking about something in a different way can bring context to a situation. Buffett’s example is a case in point. It wasn’t until he read Ben Graham’s book and changed his frame of reference to consider stocks as ‘pieces of a business‘ that success came. And this approach has proven itself over time.
“I haven’t seen anything in the last 25 years, and I read — I glance through — most of the books. I’ve seen nothing to improve on Graham and Fisher in terms of the basic approach of going about investing, which is to think about stocks as businesses, and then think about what makes a good business.” Warren Buffett
‘Business Owner Mentally’ Investment Masters Class
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