In the 2013 Berkshire Hathaway Chairman’s letter to shareholders, Warren Buffett writes about “certain fundamentals of investing.” These fundamentals form the nucleus of the Rule One investing philosophy.
Because of this, I’ve included selections from his letter regarding these key points, along with my own comments. I hope my thoughts help to amplify the point he’s making.
If you follow what we’re saying here, you can be a very successful investor.
You Don’t Have to be an Expert
“You don’t need to be an expert in order to achieve satisfactory investment returns. But if you aren’t, you must recognize your limitations and follow of course certain to work reasonably well. Keep things simple and don’t swing for the fences. When promised quick profits, respond with a quick ‘no’”.
Buffett’s point of view is that investing isn’t something that only experts can do. However, but if you don’t intend to stay focused on the things you are an expert in or become an expert in, you are much better off buying an index and leaving stock investing alone.
Focus on the Future
“Focus on the future productivity of the asset you are considering. If you don’t feel comfortable making a rough estimate of the asset’s future earnings, just forget it and move on. No one has the ability to evaluate every investment possibility. But omniscience isn’t necessary; you only need to understand the actions you take.”
Looking at the history of the business is only part of the due diligence process. It provides clues to the future, or at least eliminates unpredictable companies from our consideration as “too hard”.
The key to being right is to understand the business well enough to be comfortable predicting the future cash growth out at least five years. Beyond that, a high degree of comfort that similar results will follow for decades.
Do Not Speculate Price Changes
“If you instead focus on the prospective price change of a contemplated purchase, you are speculating. There is nothing improper about that. I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so. Half of all coin-flippers will win their first toss; none of those winners has an expectation of profit if he continues to play the game. And the fact that a given asset has appreciated in the recent past is never a reason to buy it.”
Don’t be concerned about the stock price going up. Stock prices will follow intrinsic value.
If you know the intrinsic value is going to improve over time, and you know you’re getting a margin of safety on today’s intrinsic value, you’re good to go. Don’t become a momentum investor.
Understand Your Business
“With my two small investments, I thought only of what the properties would produce and cared not at all about their daily valuations. Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at the stock prices, give it a try on weekdays.”
Focus your time on understanding businesses and what kind of cash flow results they will sustain over time.
Market prices are there us for only two purposes: if we want to sell or if we want to buy.
Since we don’t want to sell, our main concern about prices is to take advantage of low prices to buy. Otherwise, prices aren’t worth watching.
Do Not Form Opinions Based on Market Predictions
“Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important. (When I hear TV commentators glibly opine on what the market will do next, I am reminded of Mickey Mantle’s scathing comment: ‘You don’t know how easy this game is until you get into that broadcasting booth.’)”
I’ve been guilty as sin about bailing out of the market at certain times and I’ve been quite lucky in those exits (and in the entrances that followed).
But, it’s a big risk to try to time the exit and a much safer policy to just ignore it.
Stay Inside Your Circle of Competence
“When Charlie and I buy stocks – which we think of as small portions of businesses – our analysis is very similar to that which we use in buying entire businesses. We first have to decide whether we can sensibly estimate an earnings range for five years out or more. If the answer is ‘yes,’ we will buy the stock (or business) if it sells at a reasonable price in relation to the bottom boundary of our estimate. If, however, we lack the ability to estimate future earnings – which is usually the case – we simply move on to other prospects. In the 54 years we have worked together, we have never foregone an attractive purchase because of the macro or political environment, or the views of other people. In fact, these subjects never come up when we make decisions.”
“It’s vital, however, that we recognize the perimeter of our ‘circle of competence’ and stay well inside of it. Even then, we will make some mistakes, both with stocks and businesses. But they will not be the disasters that occur, for example, when a long-rising market induces purchases that are based on anticipated price behavior and a desire to be where the action is.”
We look to buy companies we understand at prices that are below the value regardless of the market at the time. And again, don’t buy because something is going up. Buy when you get a deal on something you understand.
Wait for the Good Deals
“Most investors, of course, have not made the study of business prospects a priority in their lives. If wise, they will conclude that they do not know enough about specific businesses to predict their future earning power.”
Again, if studying your circle of competence isn’t a priority, you’ve no business trying to be an investor.
Either admit you’re a gambler and go take your best shot, or get out of the game altogether by buying index stocks.
You can invest the way Buffett, Munger and I do, but it requires studying the market and patience to wait for the good deals. Mainly, it requires discipline to not be affected by rising or falling markets and mass emotions.
This isn’t for everyone but it could be for you if you are willing to learn. Fortunately for you and your family, you are. Your finances will thank you for that.
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Featured Image: By USA White House [Public domain], via Wikimedia Commons
Phil Town is an investment advisor, hedge fund manager, 3x NY Times Best-Selling Author, ex-Grand Canyon river guide, and former Lieutenant in the US Army Special Forces. He and his wife, Melissa, share a passion for horses, polo, and eventing. Phil’s goal is to help you learn how to invest and achieve financial independence.