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Lessons from Warren Buffett - XXVII - Views on News from Equitymaster
 
 
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  • Jan 24, 2008

    Lessons from Warren Buffett - XXVII

    Few months ago, we at Equitymaster decided to bring out a series on what we think is one of the most valuable and most importantly freely available investment advice. Infact, call it a series of investment advice. Regular readers of this website must have guessed that we are indeed referring to the 30 odd letters or masterpieces if you will, written by Warren Buffett, one of the most successful and foremost proponents of value investing. However, little did we know that the series would coincide with one of the darkest days in the Indian stock market history. While we do feel sorry for the investors who have lost a significant portion of their net worth in the recent melee, for the fortunate others, no better time than this to imbibe the lessons being imparted by the master in value investing, a discipline or a form of investing that we think is one of the safest around.

    One of the key mistakes the investors who suffered the most in the recent decline made was they never tried to fathom the relationship between the stock and the underlying business. Instead, they bought what was popular and hoping that there will still be a greater fool out there who would in turn buy from them. We believe that no matter how good the underlying business is, there is always an intrinsic value attached to it and one should not pay even a dime more for the same. Alas, this was not to be the case in the Indian stock markets in recent times. Infact, even those companies that did not have a single paisa of earnings to show for, were trading at egregious valuations. No effort was being made to evaluate the business model and the sustainability or longevity of the business.

    In his 1993 letter to shareholders, the master has a very important point to say on why it is important to know the company or the industry that one invests in. This is what he has to offer on the topic.

    "In many industries, of course, Charlie and I can't determine whether we are dealing with a "pet rock" or a "Barbie." We couldn't solve this problem, moreover, even if we were to spend years intensely studying those industries. Sometimes our own intellectual shortcomings would stand in the way of understanding, and in other cases the nature of the industry would be the roadblock. For example, a business that must deal with fast-moving technology is not going to lend itself to reliable evaluations of its long-term economics. Did we foresee thirty years ago what would transpire in the television-manufacturing or computer industries? Of course not. (Nor did most of the investors and corporate managers who enthusiastically entered those industries.) Why, then, should Charlie and I now think we can predict the future of other rapidly evolving businesses? We'll stick instead with the easy cases. Why search for a needle buried in a haystack when one is sitting in plain sight?"

    As is evident from the above paragraph, an investor does himself no good in the long-run if he keeps on investing without understanding the economics of the underlying business. Infact, even when one is close to cracking the industry economics, some industries are best left alone because they are so dynamic that rapid technological changes might put their very existence at risk. Instead, one should stick with the ones that can be easily understood and not subject to frequent changes.

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