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Lessons from Warren Buffett - XXXV

Apr 10, 2008

Last week, we read Warren Buffett discuss about the necessity of communicating to the minority shareholders, a true assessment of the intrinsic value of a business in his 1996 letter to shareholders. Let us go further down the same letter and see what other investment wisdom the master has to offer.

Blaise Pascal, the great French philosopher and mathematician had once said. "All men's miseries derive from not being able to sit in a quiet room alone." The quote probably rings truer in the field of equity investing than anywhere else. Blaming job related compulsions, most money managers will be frequently seen trading in securities at the outbreak of every market related news like rise in inflation, widening of trade deficit, discount rate cuts and so on. But is it necessary?

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The master thinks otherwise. And he puts forward a very simple argument. Had the same money managers been 100% owners of the businesses they so feverishly trade in, would they resort to the same tactics? The answer is most likely to be - No! And the reasons are not difficult to find. Since his inactivity could lead to people believing that he is not on top of his game, a fund manager has to make some moves to stay in news. Thus, unable to sit quietly in a room, he resorts to frequent trading in securities, which not only incur unnecessary frictional costs but might also result in him exchanging a good quality long-term investment for a mediocre business.

Warren Buffett though steers clear of such tactics and instead prefers long periods of inactivity to trading on every market related news. This is what he has to say on the issue.

"Inactivity strikes us as intelligent behavior. Neither we nor most business managers would dream of feverishly trading highly-profitable subsidiaries because a small move in the Federal Reserve's discount rate was predicted or because some Wall Street pundit had reversed his views on the market. Why, then, should we behave differently with our minority positions in wonderful businesses? The art of investing in public companies successfully is little different from the art of successfully acquiring subsidiaries. In each case, you simply want to acquire, at a sensible price, a business with excellent economics and able, honest management. Thereafter, you need only monitor whether these qualities are being preserved."

"When carried out capably, an investment strategy of that type will often result in its practitioner owning a few securities that will come to represent a very large portion of his portfolio. This investor would get a similar result if he followed a policy of purchasing an interest in, say, 20% of the future earnings of a number of outstanding college basketball stars. A handful of these would go on to achieve NBA stardom, and the investor's take from them would soon dominate his royalty stream. To suggest that this investor should sell off portions of his most successful investments simply because they have come to dominate his portfolio is akin to suggesting that the Bulls trade Michael Jordan because he has become so important to the team."

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