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Lessons from Warren Buffett - XVI

Nov 2, 2007

Last week, we got to know the major mistakes that the master thought he made in his illustrious career through his 1989 letter to shareholders. Let us now see what the master has to say through his 1990 letter to shareholders:

Warren Buffett has always been a believer of the theory that stock investments should be made after taking into account an adequate margin of safety. But in euphoric times such as the current one on the Indian bourses, it is difficult to come across a good quality stock with an adequate margin of safety. However, when markets tumble and panic sets in, quite a few stocks start trading at an adequate margin of safety but the same stocks become risky for investors who not so long ago where willing to pay a hefty premium for them. The master, after observing a similar behavior pattern among the investors in those times, had the following to say on this rather weird psychological trait of majority of them:

"Investors who expect to be ongoing buyers of investments throughout their lifetimes should adopt a similar attitude toward market fluctuations; instead many illogically become euphoric when stock prices rise and unhappy when they fall. They show no such confusion in their reaction to food prices: Knowing they are forever going to be buyers of food, they welcome falling prices and deplore price increases. (It is the seller of food who doesn't like declining prices.)"

"The most common cause of low prices is pessimism - some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It is optimism that is the enemy of the rational buyer."

However, the master cautions that not every thing should be bought at low prices and this is what he has to say on the issue.

"None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What is required is thinking rather than polling. Unfortunately, Bertrand Russell's observation about life in general applies with unusual force in the financial world: "Most men would rather die than think. Many do."

Thus, while low price scenario may be a good time to buy stocks that provide adequate margin of safety, one should look for good quality businesses that have delivered consistently on a long-term basis and are being run by shareholder friendly managements. One can hence use the current bull-run not to invest but to make ready a list of such stocks and then strike when opportunity arises. Please bear in mind that long-term wealth has been made in the market not by investing in the latest overpriced fads but by investing in a good quality company trading at valuations that have built in a considerable margin of safety.

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