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Lessons from Warren Buffett - XXXIX

May 22, 2008

In the previous article, we rounded off our discussion on Warren Buffett's 1996 letter to shareholders by making readers know the master's advice to investors who want to build their own portfolios. Let us now proceed to the letter from the year 1997 and see what investing gems lie hidden in it.

A mathematician's wisdom true to investing
"All men's miseries derive from not being able to sit quiet in a room alone", said the noted mathematician Blaise Pascal. These words ring true in the world of investing if not anywhere else. As much as the fundamentals of the company are important while making investment decisions, key consideration has to be given to the price as well. For even the best of businesses bought at expensive valuations are not likely to lead to attractive returns.

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This is where discipline plays a key role. In an environment where prices are rising and each man and his aunt is making money, it is very difficult to remain sane especially with regards to valuations. As the master himself admits that although it is not possible to predict when prices will come down and to what extent, one can do a world of good to one's investment returns if good businesses are bought at decent prices. In fact, the master is believed to have waited as much as few decades for some of his investments to come down at valuations that he was comfortable with and the ones that he believed incorporated a sufficient margin of safety.

  • What's your margin of safety?

    So, what is the master preaching?
    In his 1997 letter to shareholders, Warren Buffett has compared this predicament to a game of baseball and this is what he has to say on the issue:

    Though we are delighted with what we own, we are not pleased with our prospects for committing incoming funds. Prices are high for both businesses and stocks. That does not mean that the prices of either will fall - we have absolutely no view on that matter - but it does mean that we get relatively little in prospective earnings when we commit fresh money."

    He further states, "Under these circumstances, we try to exert a Ted Williams kind of discipline. In his book 'The Science of Hitting', Ted explains that he carved the strike zone into 77 cells, each the size of a baseball. Swinging only at balls in his 'best' cell, he knew, would allow him to bat .400; reaching for balls in his 'worst' spot, the low outside corner of the strike zone, would reduce him to .230. In other words, waiting for the fat pitch would mean a trip to the Hall of Fame; swinging indiscriminately would mean a ticket to the minors."

  • Discipline in investing is the key

    Finally, he asserts, "If they are in the strike zone at all, the business 'pitches' we now see are just catching the lower outside corner. If we swing, we will be locked into low returns. But if we let all of today's balls go by, there can be no assurance that the next ones we see will be more to our liking. Perhaps the attractive prices of the past were the aberrations, not the full prices of today. Unlike Ted, we can't be called out if we resist three pitches that are barely in the strike zone; nevertheless, just standing there, day after day, with my bat on my shoulder is not my idea of fun."

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