»Profit Hunter by Equitymaster

On This Day - 20 AUGUST 2018
Think Like Graham and Invest Like Buffett... or Think Like Buffett and Invest Like Graham?

Rahul Shah, Editor, Profit Hunter

Say you are driving home from work and you stop at a traffic signal. A spanking new BMW glides into view and occupies the lane right next to yours...

And while you are admiring the red beauty, the driver pulls out a cigarette, takes a long drag and flicks the ashes on the upholstery of the brand-new car without a care in the world.

You look away and go back to waiting for the lights to turn green.

Did you find anything amiss in this chain of events?

Well, now say a cop also saw this entire scene unfold before his eyes. In fact, as he watched it he had a stroke of insight that helped nab the driver of the BMW and solve a high-profile carjacking case.

What is it that made the cop suspicious? Well, it was the driver's flicking of the ash on the car's upholstery.

The owner of the car wouldn't be so careless so as to ash his cigarette in a brand-new car. Neither would a friend who borrowed the car.

What about a car thief?

Bam! A flash bulb lit up and further inspection revealed that it was indeed a stolen car.

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Now, how about a flash of insight from the investment world.

Sometime in 2002, Warren Buffett was going through the annual report of one of the largest companies in China and what he saw left him amused.

The company was valued at US$ 35 bn by the market back then, and Buffett figured that even by conservative estimates, the real value of the company is no less than US$ 100 bn.

In other words, Mr. Market was giving a huge 65% discount on the intrinsic value of the company.

That's it. That was all the information Buffett needed. No further due diligence. No getting into the details of the company's management and no further shenanigans.

He immediately made a US$ 500 m investment in the company.

How did the investment turn out? Well, Buffett went in with a thimble and walked out with a big, fat, bucket, multiplying his initial investment by 8x over just a five-year period.

To the uninformed mind, decisions taken by both the cop as well as Buffett could come across as rash and relying solely on gut instincts.

But not to Gary Klein, who's made a living out of studying such decisions.

Gut instincts are not that bad, says Klein. We villainize them because to us they look purely emotional, and not rational at all.

Klein chooses a different tack, though. He thinks it would be dangerous to label all such decisions as emotional. Especially the ones honed through years of building expertise in one's chosen area of field.

The cop and Warren Buffett had such a deep understanding of their respective fields that they had lots of different patterns stored in their brain. And when one in the real world matched one they had in their heads, voila, they wasted no time in deciding what to do.

There are hundreds of thousands of investors out there wanting to be the next Warren Buffett.

And that would, of course, be a nice thing to do. What better role model than the best investor in the world?

But what they don't realize is it will be some time before they come anywhere close to having an understanding of the nature of the beast the way Buffett does.

You don't just wake up one day thinking like Buffett... it takes years of practice, and focused effort.

Therefore, when they see all their ducks lined up, it is usually the gut instinct of overconfidence, and not the one that Klein says we should tap. Because the latter doesn't still have enough number of patterns stored in the mind's reservoir to take decisions anywhere close to the accuracy the Oracle of Omaha brings to the table.

The end result? Eggs on faces more often than not.

It is exactly because of this difficulty in following Buffett's approach, which makes it difficult to identify great stocks.

Instead, I recommend that investors do the following...

A great long term track record comes from two things: Making lesser mistakes i.e. not losing money; and, identifying great stocks.

Thus, while investors are in the process of reading more, understanding businesses better, and building their patterns of reservoirs in their heads so they can identify brilliant stocks - they should invest more in the spirit of the down arrow i.e. trying not to lose money.

And when enough hard work is done and they think they can consistently pick winning stocks with a high success rate, they should start switching to the up arrow.

I see a lot of investors jump straight to the up arrow first and end up with eggs on their faces.

The first approach is similar to how Benjamin Graham thought about investing, especially in his later years - so I recommend that people invest like Ben Graham first - at the same time cultivating Warren Buffett's thinking pattern.

I've been following this Ben Graham approach for more than four years with stellar returns. The approach has outperformed the Sensex by a factor of more than 2x, returning 175% against the Sensex's 85% returns.

It is a classic down arrow approach if I were to put it based on the image above. All we are trying to do is not lose money every step of the way and letting the upside take care of itself. It has worked like charm so far.

So, Think Like Graham and Invest Like Buffett... or Think Like Buffett and Invest Like Graham?

While investors look to cultivate a Buffett-like thinking habit, they should approach investing based on this Ben Graham system.

Good Investing,

Rahul Shah
Rahul Shah (Research Analyst)
Editor, Profit Hunter

PS: Rahul Shah is a stock market expert in his own right - in fact, he will be speaking at an online summit that is free for Equitymaster subscribers on 24th August - where he will reveal his own market-beating system. Reserve your spot now by clicking here.

Note: The cop and the BMW story has been borrowed from Gary Klein's insightful book 'Seeing What Others Don't'.

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