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Lessons from Warren Buffett - XLIII

Jun 25, 2008

In the previous article based on Warren Buffett's letter for the year 2000, we saw how the master reaffirmed his faith in the discounted cash flow approach to valuations by using one of Aesop's fables. Let us go further down the same letter and see what other things he has to say.Mother Nature's envy?
Mother Nature would be really envious of the stock markets. She has taken centuries to turn apes into rational human beings. But the same human beings and mind you, even the smartest of them turn irrational in no time when they dabble in stocks. What else could explain the dotcom boom where P/E ratios of 100 were a common sight?

In a lot of instances, the companies under consideration did not even earn a profit. Closer home, some of the power stocks and those in the infrastructure space were valued 2-3 times more than their FMCG counterparts. Now, how long does it take to realise that while FMCG companies can double their capacities in no more than 6-8 months and thus start producing cash flows immediately, power companies with even the best execution records will take no less than 3 to 5 years to come up with a new capacity, thus taking cash flows from this new capacity that many more years to fructify and hence, resulting in lower valuations. Warren Buffett has summed it up best when he has said that investors resorting to the above-mentioned investments were actually not investing but were engaging in speculation.

Speculation: Investor's enemy no. 1
As per the master, speculation as opposed to investment is not based on valuations and margin of safety but is dependent on making assumptions about what will the second investor pay for a stock that the first investor has bought a few days or a few months ago. It brings in good money as long as the game lasts but when one ends up being the last person to hold the stock with no one else willing to buy it, losses could be painful. It is indeed such an activity that the master advises investors to avoid at all costs and be rational in one's decision making. Indeed, attractive valuations and a good track record should be the foundation upon which an investment is based and not speculation.

Master's golden words
Buffett says, "The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball."

"They know that overstaying the festivities - that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future - will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There's a problem, though: They are dancing in a room in which the clocks have no hands."

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