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Lessons from Warren Buffett - LXIII
Apr 25, 2016

In the last article based on Warren Buffett's 2011 letter to shareholders, we explained the folly of stock markets and how one must deal with it.

With that wisdom in mind, we now move on to the 2012 letter. Here Buffett explains why bargain stocks do not always translate into wonderful investments. To drive home his point, he emphasises the importance of moats.

To those who blindly look for cheap stocks to invest in, he writes:

  • More than 50 years ago, Charlie told me that it was far better to buy a wonderful business at a fair price than to buy a fair business at a wonderful price. Despite the compelling logic of his position, I have sometimes reverted to my old habit of bargain-hunting, with results ranging from tolerable to terrible. Fortunately, my mistakes have usually occurred when I made smaller purchases.

Market participants always talk of buying stocks trading at cheap prices. But they overlook that these stocks do not always translate into greater returns and could actually turn out to be value traps.

Many factors can lead to subpar returns. Maybe the underlying business is bad, the management is negligent, or future prospects are weak. In short, the stock is cheap because it deserves to be.

And then there's the other side... Buffett writes:

  • Of course, a business with terrific economics can be a bad investment if the price paid is excessive.

Even you have identified a great company with a sound business model and good management, it does not necessarily mean you should invest immediately in the stock. It all depends on the valuations. If a good business is available at an expensive price, stay away. The possibility of good returns diminishes if the purchase price is too high. A profitable investment is a stock with good management quality bought at attractive prices.

As a value investor, your ultimate goal should be to find the right company at the right price. And while doing so, you must also keep in mind the concept of margin of safety. Indeed, Graham says that the first objective in investing has to be to protect your investment. And to do so, you must identify investment opportunities that provide sufficient margin of safety. This increases your chances of maximising returns.

Before you buy, you must arrive at the intrinsic value of the business that you like. And then only buy if it is trading at a sufficient discount to its intrinsic value.

Why a safety margin? As Graham says, 'It is available for absorbing the effect of miscalculations or worse than average luck.'

If you can wrap your head around this idea, you will look upon volatility in the stock markets as an opportunity to profit.

Rahul Shah

Rahul Shah (Research Analyst), Managing Editor, Microcap Millionaires has led the team from the front in developing some of our most stringent and rewarding research processes. As per his own admission, the turning point in Rahul's life as a financial analyst came a few years back when he got introduced to the works of Warren Buffett and Charlie Munger. From Buffett, he understood the value of investing in good quality business with powerful moats and strong management teams. Charlie Munger on the other hand inspired him to be a lifelong learner and use mental models in order to arrive at the crux of matters across most disciplines. Rahul firmly believes that in order to be successful at investing, you have to do the big things right and possess a great temperament and a contrarian streak.

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