Buffett's Simple Secret by Mark Sellers, Editor of Morningstar StockInvestor
news.morningstar.com
Psst…wanna know the secret to Warren Buffett’s investment success?
Eliminate the risk of permanent capital loss when buying stocks.
Before I explain what I mean by this statement, I should admit that I’ve left out the finer details of Buffett’s success, such as the fact that he studied under famed value investor Benjamin Graham, and that his use of insurance "float" has the effect of juicing his returns, similar to a margin loan. And hey, the guy is just plain smarter than most of us.
But in general, his investing style is deceptively simple. So simple, in fact, that almost everyone misses it, including many Buffett devotees.
When I say Buffett tries to eliminate the risk of permanent capital loss, I mean that he’ll only buy a stock that he’s almost certain will eventually be worth a higher price than he paid for it.
You might be saying to yourself, "Wait a minute…it can’t be that simple. That’s too easy. Hold any stock long enough and it will get back to what you paid for it, no matter how much it may fall in the meantime." To which I say "not true."
The people who paid $173 for Ariba ARBA or $150 for JDS Uniphase JDSU last year may never get their money back, even if they wait 20 years. Investors simply paid too high a price for these companies. Even if they’re acquired by a competitor, it will almost certainly be at drastically lower prices than their former highs.
To avoid this, Buffett uses a technique he calls "margin of safety," which he defines (following his mentor Graham) as buying a stock well below its fair value. He does this so that, even if he makes a mistake in valuing the company, he can sell the stock at a higher price than he paid for it.
Buffett’s margin of safety is a 50% discount to fair value, which he calculates by estimating the future cash flows of a business and discounting them back to today. If you don’t know how to do a discounted cash-flow model, that’s ok. Just look at five years (or more) of price/earnings ratios and try to buy only stocks selling at the very low end of their historical P/E range. This is critical to long-term investment success. If you don’t do any valuation work, you run the risk of suffering permanent capital loss by overpaying for a stock without even knowing you're doing it.
Unfortunately, though, buying a company that's undervalued isn’t enough. There’s a second form of permanent capital loss that Buffett avoids like the plague: bankruptcy. If you buy a company destined for bankruptcy, you’ll probably lose money on the shares no matter how undervalued the stock price seems now. Examples of companies that seemed cheap just before they went bankrupt include Comdisco CDO and eToys.
What do these companies have in common? All were one-time highfliers, and none had a large "economic moat," or sustainable competitive advantage, surrounding it. To use a baseball analogy, investors in these types of stocks go up to the plate swinging for the fences, but often swing at horrible pitches.
Buffett, on the other hand, waits for a pitch to come right down the middle that he is almost certain he can hit, and only then takes a swing. What he (and others who follow a similar investment style) tries to do is think about the company’s business as a whole, not just the financial aspect of it, to determine whether it will survive indefinitely. He asks questions like "am I fairly certain that this company’s products will be around in 20 years?" and "does this company have a unique competitive advantage over others in its industry?"
If the answer to both of these questions is yes, and the company’s financial condition isn't deteriorating, he’ll consider the stock. If the answer to either of those two questions is no, he moves on to evaluating another company. So, according to Buffett, a good investor must be able to analyze businesses, not just financial statements.
With a time horizon of 10 years or more, Buffett figures that as long as a company doesn’t go bankrupt, the odds are good that its stock will do well if he buys it well below fair value. If a company’s stock stagnates for too long, another company will eventually come in and buy it out. That’s the nature of the capital markets: Eventually, undervalued companies either rise to fair value or are acquired. Thus, the key is to find greatly undervalued companies that will survive long enough to reach fair value. This reversion to fair value can take weeks, months, or years.
That, in a nutshell, is Warren Buffett’s secret to success: Invest in companies with wide economic moats at a large discount to fair value and hold them. By applying this technique to your own investing, you’ll stand a good chance of outperforming the averages. |
