May 12, 2008|
Investing framework: Preparation
In the previous article, we discussed the merits of a top down versus a bottom up approach for investing. In this article, we shall examine the importance of 'preparation' in building an investing framework.
Earlier articles in the series
"What should I buy now?"
The question that often pops up in conversations during happy times in stock market
(read, during a bull run) is: "What should I buy now?" Although it seems simple, it is actually a loaded question. It is worth examining the following aspects:
'I': The vital question of whether stocks are right for the person in the first place is often not examined. Old landladies who have no business pondering about the 'share bazaar' suddenly get interested. Pensioners, who have worked hard all their life in accumulating a nest egg, sadly get mesmerised by the easy returns on offer.
'Should': For an investor, investing means ownership of sound businesses that score well on the fundamental checks he runs. Unfortunately most people typically get interested in the stock market when it has had a sustained bull run and the media animatedly reports price movements. Hence, the question corrupts from "what should I buy?" (sensible investing), to "what could I buy?" (gamble for a quick buck).
'Now': Even if equities are right for someone and the businesses he chooses to invest in are also sound, the prices that prevail in buoyant markets are unsuitable. In fact, it likely to be the case except during truly depressed markets.
'Now' vs. 'Advance preparation'
If one first decides to buy some stocks, and then goes about choosing which stocks to buy, he leaves the door wide open for markets mood swing to sneak in. We believe that the best approach for serious investors (who pass the criteria of 'I' and 'should') is to study businesses without an immediate buy decision in sight i.e., preparing in advance. It is easier to keep emotions under control that way.
Regularly studying the annual reports, results and announcements and arriving at an intrinsic value for the business without a buy decision in sight helps rational stock selection.
Ben Graham was the first to explain how following the mood swings of Mr. Market is a great mistake. Warren Buffett, his star disciple, has used advance preparation throughout his investing career to nullify the effects of Mr. Market. His controlling stake in the auto insurer, GEICO came after years of study of the business (Buffett got interested in the company very early in his career because Ben Graham's firm had major stake it in it). He bought Anheuser-Busch (beer maker) in 2004 after regularly studying the annual reports for 25 years. That is advance preparation! His recent decision to buy Wrigley was also the logical end to years of admiring the company. For example the 1993 letter to shareholders of Berkshire Hathaway mentions, "Leaving aside chewing gum, in which
Wrigley is dominant, I know of no other significant businesses..."
Mr. Market and You
In all these instances, Buffett chose the companies he 'should' buy well in advance to the actual purchase. Then he waited patiently for the correct valuation to come by and only then executed the buy order. This process has produced his decisions, which are heralded as rational a few years later. Something the retail investor can adopt to great benefit.
We shall continue with our discussion on building an investing framework in the next article.
Reading is an excellent way to develop one's investment framework. We urge you to refer to investment classics (books, articles and speeches) in the original.
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