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Lessons from Warren Buffett - LX
Oct 7, 2015

Our last article was based on Buffett's 2008 letter to shareholders. It pointed out why you should learn from your investment mistakes. Further, we saw why fundamentals are vital. Keeping this in mind, we now move a step further. The 2009 letter shares some solid insights. Here, Warren Buffett submits what kind of businesses he avoids. He also explains the significance of liquidity.

On avoiding complex business, he admitted:

  • Charlie and I avoid businesses whose futures we can't evaluate, no matter how exciting their products may be. Just because Charlie and I can clearly see dramatic growth ahead for an industry does not mean we can judge what its profit margins and returns on capital will be as a host of competitors battle for supremacy. At Berkshire we will stick with businesses whose profit picture for decades to come seems reasonably predictable. Even then, we will make plenty of mistakes.

This can be a great hack for you. Knowing what not to do is as important as knowing what to do. It will save you a lot of trouble. And it's always a good idea to remember in a stock market bubble.

Some of this is accomplished by playing within your circle of competence. Pick out a few businesses that you can understand and are fundamentally strong. Look for their niche in the industry in which they operate. Factors like durable moats and prudent managements are important. Always buy them at fair prices. Then, all you have to do is hold on and see their prices skyrocket. As Buffett has said 'You only have to do a very few things right in your life so long as you don't do too many things wrong.'

To relate this, he quoted his partner Charlie Munger:

  • Long ago, Charlie laid out his strongest ambition: 'All I want to know is where I'm going to die, so I'll never go there.' That bit of wisdom was inspired by Jacobi, the great Prussian mathematician, who counseled 'invert, always invert' as an aid to solving difficult problems.

If understood properly, investors can learn much from this. Inversion in investing means calculating and analysing problems backwards as well as forwards. For example, amateur investors or speculators will always focus on making money. Investors who use the principles of inversion, however, also focus on how not to lose money.

This doesn't mean that investors who invert neglect returns. Their focus is on building wealth by all means. However, along with ways that can earn returns, they also focus on avoiding the ways that can decrease these returns. They ask 'where can I lose money?' along with the commonly asked 'where can I make money?' And that is how they gain from both the ends. You too can accomplish this. All you have to is invert all the common presumptions.

Let's take an example here by involving a behavioral pattern. Many amateur investors and speculators will be content to nail a growth expectation on a business and then calculate its valuation. On the other hand, investors who invert will start with the price observed in the market. With this, they will further analyse and question- does the implied growth that has determined this price makes sense?

Lastly, Buffett shared some of his views on the perks of liquidity:

  • We will never become dependent on the kindness of strangers. Instead, we will always arrange our affairs so that any requirements for cash we may conceivably have will be dwarfed by our own liquidity. Moreover, that liquidity will be constantly refreshed by a gusher of earnings from our many and diverse businesses. We pay a steep price to maintain our premier financial strength. The US$20 billion-plus of cash equivalent assets that we customarily hold is earning a pittance at present. But we sleep well.
  • This is true. A dollar in your hand can prove to be priceless at a time when asset prices are falling across the board. It could help you buy great stocks at discounted prices.

    Imagine that the markets have nosedived. There's a sale everywhere in the investment world. It's a world of opportunities. But...you don't have the cash available to buy these bargains. You would not be happy at all.

    Further, liquidity ensures that you don't have to borrow. It saves you the interest.

    We can briefly state the takeaways as follows:

    1. Stay within the boundaries of your circle of competence.
    2. Solve problems by inverting them.
    3. Be aware of the significance of liquidity.

    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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