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Lessons from Warren Buffett - XXXVIII - Views on News from Equitymaster
 
 
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  • May 16, 2008

    Lessons from Warren Buffett - XXXVIII

    In the previous article, we read Warren Buffett dish out (in his 1996 letter to shareholders) a few examples on why investing in market leading companies alone is no guarantee to success in stock markets. Let us move further down the same letter and see what other investment wisdom he has to offer.

    After spending quite a substantial portion of the letter on detailing his investment methods and the kind of businesses he buys into, Warren Buffett then turned his attention towards those investors who wish to construct their own portfolios and the techniques they must adopt in order to earn attractive returns year after year.

    The master's advice is a welcome relief especially for investors who find it extremely hard to understand some of the modern finance theories like CAPM, alpha, beta, option pricing etc. It will definitely not be a gross exaggeration to state that Warren Buffett's entire success story has been woven without any help from these concepts. Instead, he famously goes on to say that in investing, only two skills are of paramount importance, those of valuing a business and ways of thinking about market prices.

  • Towards an investing framework

    He further goes on to add that although investing is simple it is indeed not very easy because not all businesses can be evaluated with a great degree of certainty and hence investors should be aware of what businesses they are in a position to correctly evaluate. This in turn calls for knowing exactly what one's circle of competence is and correctly identifying the limits of the same. It is only when one acquires the patience and the discipline to do so, that one can think of achieving above normal returns in the market place otherwise one is more likely to be consigned to average returns.

    Let us now go back to the letter and understand the concept in the master's own words. This is what he has to say on the issue.

    "Should you choose, however, to construct your own portfolio, there are a few thoughts worth remembering. Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses. Note that word 'selected': You don't have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital."

    He further states, "To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these. That, of course, is not the prevailing view at most business schools, whose finance curriculum tends to be dominated by such subjects. In our view, though, investment students need only two well-taught courses - 'How to value a business?', and 'How to think about market prices'."

    "Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards - so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren't willing to own a stock for ten years, don't even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio's market value."

    Buffett goes on to say, "Though it's seldom recognized, this is the exact approach that has produced gains for Berkshire shareholders. Had those gains in earnings not materialized, there would have been little increase in Berkshire's value."

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