Buffett Says You Should Read This in a Turbulent Market
The most important and timely investing lessons from Warren Buffett’s favourite book
Disclaimer: None of this article should be considered investment advice. This is merely my attempt at summarising some investment lessons often discussed by Warren Buffett and originally written by his mentor, Benjamin Graham.
I think it would be best by starting with a note that this article is not designed for complete investing beginners. It’s not overly technical, but it does require some knowledge of investing principles.
If you are looking for an introduction to investing, I would recommend reading Why Stocks Go Up and Down.
The Intelligent Investor boasts the accolade of being called “by far the best book on investing ever written” by Warren Buffett.
It was written by Buffett’s mentor, and investing legend in his own right, Benjamin Graham and is generally considered one of, if not the most important book on value investing ever written.
There are two pieces of wisdom in the book that Warren Buffett thinks everyone should read and re-read when the market has been especially strong or weak:
- How to react to stock market fluctuations.
- Margin of safety as the cornerstone of investing.
We’re going to explore the two chapters that cover these points in this article to ensure we stay grounded in logic and not caught up in any overly bullish or bearish mania… What better time to help us as investors stay grounded in logic than in the crazy year that is 2020!
Stock Market Fluctuations: An Intelligent Investor’s Guide
Investing vs Speculating
The biggest difference between investors and speculators is their attitude towards stock price movements:
- Speculators hope to benefit from market movements by predicting the behaviour of other stock market participants.
- Investors hope to benefit from market movements by being able to acquire stocks at a discount to their true worth and sell stocks that are trading above their intrinsic value.
Intelligent investors consider market fluctuations only to the extent that they can make the price of good companies more attractive in times of a depressed market, or less attractive in a market that has seen major stock price appreciation.
An extension of this logic is that we should pay little attention to market forecasts. Given our daily exposure to forecasts by ‘experts’ on various financial news outlets, it can be easy to forget that virtually nobody can say with certainty whether the market is going up or down. If there was someone who could do this reliably, they’d be the richest person on the planet and we’d all know about them.
There is perhaps a single exception to the above statement on speculation and forecasting- Jim Simons and his band of mathematicians-turned-traders at Renaissance Technologies. However, that is a very different kind of forecasting and not one that the average investor could ever hope to replicate nor should they concern themselves with it during their day-to-day investing decisions.
The Buy Low, Sell High Approach to Speculation
It is worth explicitly calling out the adage of ‘buy low, sell high’. This is probably the most pervasive formula for speculation in all of investing. Given its simplicity and wide reach, it is also possibly the most dangerous form of speculation.
Buy low, sell high is the idea that in times of distress we should bet on the stock market as a whole to recover.
It’s easy to look at a historic price chart of the S&P 500 and highlight the points where you would have bought:
- January 2003
- February 2009
- March 2020
And where you would have sold:
- August 2000
- July 2007
- January 2020
But when you are physically living through that period, it’s almost impossible to know where the low or high points will be. Will December 2021 be the end of the longest bull market run in history, or will it continue for years to come? Not one person on the planet truly knows the answer to that question.
When we buy low with the plan of selling high, all too often we can find ourselves selling even lower because we got caught up in the panic and didn’t have a good foundation on which our investing philosophy was built, resulting in a lack of conviction.
Reality Check: Stocks are Incredibly Volatile
The stock market as a whole and the individual stocks that make it up are incredibly volatile, much more volatile than the mainstream financial theories allow for (check out The Black Swan or The Misbehaviour of Markets for more info).
If you own stocks for the next five years, it is the norm, not the exception, that they will increase by at least 50% from their lows, and decrease by 33% from their highs at various points over that time period.
This inherent volatility means we must have conviction in our investment strategy. If we don’t, we will have a very difficult time not following the crowd and selling good stocks out of fear in times of panic or purchasing mediocre stocks at a high price out of greed in a market boom.
Mr Market
When we purchase a stock, we are becoming a part-owner of the underlying business. We have expressed our belief that, for some reason, the company as a whole is worth more than the amount for which it was currently selling on the stock market.
Suppose we owned a private business alongside a business partner called Mr Market. Mr Market is incredibly persistent and every day he tells us exactly what he thinks our stake in the company is worth. He also offers us the chance to sell a portion of our interest to him at that price, or if we’d rather, buy some of his portion. This offer is available whenever we want it, but Mr Market always sets the price.
This dynamic can result in broadly three types of days:
- Some days, Mr Market’s view of the company’s prospects line up with our own and the price he offers is broadly in line with what we think the business is worth.
- Other times, he gets caught up in enthusiasm for the prospects of the company for some reason or another and offers a price much above what we consider the business to be worth.
- Other times still, he is fearful about the prospects and offers us a price well below our valuation.
We would be very foolish if we let our belief in the value of the company be completely decided by what Mr Market offers. A much more intelligent approach is for us to keep track of the material changes to the business, decide our own value, and trade with Mr Market when it is to our advantage.
None of this is to say that we shouldn’t listen to Mr Market at all; occasionally, if he suddenly offers us a much lower price it could be because we have not been paying close enough attention and the prospects of the business have drastically worsened. In this case, Mr Market’s price change will have alerted us to the need to change our own valuation in light of recent events. When we have reassessed our holdings, we can then once again decide whether or not to buy or sell more based on Mr Market’s panic.
The above section on Mr Market may sound a lot like the ‘buy low, sell high’ adage from earlier, but there is an important distinction.
We are not speculating on the future stock price movement by trying to time the market. We are buying shares of a company when our own valuation shows it to be selling at a discount to its intrinsic value, or selling shares when our valuation shows it to be selling well above its value.
Margin of Safety: The Core Principle of Investing
Margin of safety is the cornerstone of value investing.
When asked to distil investing into a single mantra, Graham chose ‘margin of safety’ to be the one phrase above all others that encapsulates what it means to be an intelligent investor, as opposed to a speculator.
What does ‘margin of safety’ really mean?
Simply put, it is the difference between what we calculate a business to be worth, and what it is selling for today.
Our formula for margin of safety is: (value — price)/value (this is the same as saying margin of safety is equal to the discount we get, divided by what we paid. We need to do the division to be able to compare the margin of safety across companies worth different amounts.)
Let’s use Apple as an example. In November 2020, Apple is selling for roughly $2 trillion.
Scenario A:
- We think Apple is worth $3 trillion after having made some projections about its future earnings.
- In this case, our margin of safety is ($3tn — $2tn)/$3tn = $1tn/3tn = 33%.
Scenario B:
- We think Apple is worth $1 trillion.
- Our margin of safety is ($1tn–$2tn)/$1tn = -100%.
- Our margin of safety has turned negative! We are overpaying by 100% for the company.
What can we take from these scenarios?
In Scenario A, if we purchase shares in Apple at $2 trillion, then even if we are too confident in our value of the company, we still haven’t overpaid for the company.
In Scenario B, even if the company turns out to be almost twice as valuable as we think it is, we have still overpaid for it.
So what’s the point of the margin of safety?
Margin of safety lets us be wrong and still make money! The greater our margin of safety, the more wrong we can be before we need to worry about losing money.
The risks of paying too much for high-quality companies such as Apple is real, but it’s not the main risk that the margin of safety will help us avoid. The more damaging risk is that we pay too much for mediocre companies.
- When a company happens to have had a couple of good years of growth, they can begin to receive very high valuations.
- If we pay the high valuation for a company and it continues to grow, the margin of safety won’t have mattered that much in the end because even if we overpaid today, it’ll be worth a lot more tomorrow and that will make up the difference.
- But if the company was actually a pretty mediocre business just happening to have a couple of good years, the valuation will plummet when reality catches up with the market, and we are unlikely to ever make our money back.
Making sure we purchase companies with a margin of safety might mean we miss out on some growth companies that could have made us a lot of money, but it massively reduces the risk that we go bankrupt.
As it’s harder to make money than it is to lose money (if we lose 50% of our money, we need to make a 100% return on what’s left to break even), our primary concern should not be with catching the winning growth stocks, it should be avoiding the bad ones.
Valuing Growth Stocks
As mentioned above, we should always err on the side of caution in investing. When valuing a growth company, this is even more important as companies experiencing high growth sell for much higher valuations.
Because the price we must be willing to pay for these shares is higher, we will be risking a lot more money when we are wrong. For that reason, we must have a system in place that helps us ensure the odds are in our favour when trying to identify companies which will continue to grow. It’s here that another Warren Buffett book recommendation may come in useful: Common Stocks and Uncommon Profits.
Valuing ‘Cigar Butt’ Stocks
Warren Buffett calls mediocre companies that are selling at a significant margin of safety ‘cigar butts’. It’s what Benjamin Graham did to build his fortune, and it’s what Buffett himself did early on in his career.
Because high growth stocks almost always look expensive on first glance, many investors who follow the margin of safety approach to investing find it more comfortable looking for downtrodden companies selling at a big discount.
The main question we should ask ourselves here is ‘can the company easily handle adverse developments?’. If we think the company is of low quality, it’s more likely to get hit by adverse developments (like a competitor coming out with a better product). If it couldn’t handle a series of negative developments and still leave you with a margin of safety, it might be what is commonly called a value trap instead of a cigar butt.
Value traps look cheap and appear to give a big margin of safety, but are actually very fragile companies that could risk going bankrupt and losing our entire investment (making them actually even riskier than a lot of the high-growth companies).
Circle of Competence and Margin of Safety
To avoid overpaying for mediocre companies that happen to have had a couple of lucky years, or mistaking a value trap for a cigar butt, we need to understand what we’re investing in.
If we know nothing about manufacturing semiconductors, we simply can’t expect to calculate a reasonable value for a chip manufacturer and know whether we have a margin of safety.
As Peter Lynch advocates in One Up on Wall Street, we need to buy what we know.
To Sum it Up
- Stick to what you know: you can’t value something you don’t understand.
- Build in a margin of safety: put the aim of not losing money higher in your priority list than trying to pick the next Amazon.
- Invest, don’t speculate: base your investment decisions on buying companies when they are selling at a discount to what they are worth and selling them at a premium to this figure. Don’t try to predict which way the stock market as a whole will go!
- Remember that stocks are volatile: it doesn’t mean you’ve made a good or a bad decision because a stock drops 25% after you bought it, stocks are incredibly volatile in the short-term and your success should be judged over a long time horizon.
Investments are never a sure-thing, but if we keep in mind the above points, we can at least make sure that when we’re making investment decisions, we’re doing so from a solid set of underlying principles, and not based on simply following the mood swings of, the ever-fickle, Mr Market.
