Lessons from Warren Buffett - XVIII - Views on News from Equitymaster

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Lessons from Warren Buffett - XVIII

Nov 15, 2007

In the preceding letter of the series, we saw how Warren Buffett gained significantly from the phenomenon of 'double-dip' that engulfed two of his investment vehicle's best holdings and how we as investors, stand to benefit from the same. In the following write-up, let us see what other tricks the master has up his sleeve through the remainder of his 1991 letter to his shareholders. "We believe that investors can benefit by focusing on their own look-through earnings. To calculate these, they should determine the underlying earnings attributable to the shares they hold in their portfolio and total these. The goal of each investor should be to create a portfolio (in effect, a "company") that will deliver him or her the highest possible look-through earnings a decade or so from now.

An approach of this kind will force the investor to think about long-term business prospects rather than short-term stock market prospects, a perspective likely to improve results. It's true, of course, that, in the long run, the scoreboard for investment decisions is market price. But prices will be determined by future earnings. In investing, just as in baseball, to put runs on the scoreboard one must watch the playing field, not the scoreboard."

Revealing at 5pm Today: The Great Indian Wealth Project

Yet again, the master's crystal-clear thinking and his ability to draw parallels between investing and other fields shines through in the above quote. The master is trying to highlight a simple fact that the probability of success in investing increases manifold if one is focused on building a portfolio that comprises of companies with the best earnings growth potential from a 10-year perspective. However, this is easier said than done. The attention of a multitude of investors in the stock markets is focused on the stock price rather than the underlying earnings. These gullible sets of investors seem to confuse between cause and effect in investing. One must never forget the fact that it is the earnings that drive the returns in the stock markets and not the prices alone. Thus, any strong jump in prices without a concomitant rise in earnings should be viewed with caution.

However, if the trend in the Indian stock market these days is any indication, investors seem to be turning a blind eye towards earnings growth and are buying into equities with promising growth prospects but very little actual earnings to justify the price rise. The risk of indulging in such practices becomes clear when one considers the tech mania of the late 1990s. In anticipation of strong earnings, investors had bid up the price of a lot of tech stocks to such levels that when the earnings failed to meet the lofty expectations, prices crashed, resulting into huge capital erosion. But alas, the investor memory seems to be very short and a similar event is waiting to be played out, although this time in some other sectors.

Hence, one would do well to heed to the master's advice and try and focus not on the stock prices but the underlying earnings. Further, the master is also in favour of having a 10 year view so that the tendency of investors to invest based on a short term view of things gets nipped in the bud and there emerges a portfolio, having companies with a proven track record and a strong and credible management team at the helm.

We will discuss other nuggets from the master's 1991 letter to shareholders in the next article of the series.

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