Here are the condensed principles I took from this excellent book. Enjoy.
Look at results over 5 years.
You cannot predict general stock market or business fluctuations.
Choose your investments based on value, not popularity.
Have a wide margin of safety and diversity to reduce capital loss.
The market can and will at times be completely deranged and irrational in the short term, but over the long term it will price securities in line with their underlying intrinsic values.
Investors buy businesses; speculators “play” markets.
When you own a stock, you own a business. Focus on the business.
Concentrate on what should happen, not when it should happen.
Find the right business for the right price and ignore the timing of when to buy or when to expect the investment to work out.
Predictions often tell you more about the forecaster then they do about the future.
If a 50% decline in the value of your securities portfolio is going to cause you hardship, you need to reduce your exposure to the market.
Investment decisions should be made on the basis of the most probable compounding after-tax net worth with minimum risk.
Measure your relative performance compared to market. Analyse your own techniques and performance. Is your performance better than the market average? If the market is down and you are down less, you’ve had a good year, and vice versa.
Almost anything can be made to look good in relation to something or other.
Measure your performance against a fixed yardstick.
Incentive dictates behaviour. More often than not, people will behave according to what they’re being rewarded for.
Understand how and why an investment manager gets paid so you can compare their expected behaviour with your own best interest.
Ensure your interests are aligned.
When we know what motivates people, we pretty much know how they will behave.
Look at who is in charge of your assets.
What would a well informed private buyer pay for the entire company.
Just because something is cheap does not mean it is not going to go down.
Intrinsic value can be estimated by the value of the company’s assets or earning power.
Qualitative factors would buy the right company and the price will take care of itself. Quantitative factors would buy at the right price and the company will take care of itself.
Avoid what doesn’t work.
Checklist for evaluating a potential investment:
1. What tools or special knowledge is required to understand the situation? Do you have them?
2. What are the economics inherent to the business and the industry? How do they relate to my long-term expectations for earnings and cash flows?
3. What are the likely ways I’ll be wrong? If I’m wrong, how much can I lose?
4. What is the current intrinsic value of the business? How fast is it growing or shrinking?
5. Does the discount to intrinsic value, properly weighted for both the downside risk and upside reward, compare favourably to all other opinions available to you?
While principles never change – they are timeless – methods can and often should change according to a given investing environment.
Arbitrage opportunities:
1. What chance does the deal have of going through?
2. How long will it take to close?
3. How likely is it that someone else will make an even better offer?
4. What happens if the deal busts?
Generals, workouts, controls.
When you invest in a stock, you are in the business.
What is the value, in terms of the assets involved and the earnings produced and how can it be maximised?
Investment is most intelligent when it is most business-like and business is most intelligent when it’s most investment-like.
What is the asset really worth? Are you capable of estimating what these assets are worth?
Assets are always worth what they can be sold for and liabilities are always assumed to be due in full.
Be both a business owner and an investor. They are both capital allocators.
Understand the actual economic value (realisable liquidation value) of a company’s assets.
The value of a business will be determined by:
1) What the assets are worth if sold, or
2) the level of profits in relation to the value of the assets required in producing them.
Operationally, a business can be improved in only three ways:
1. Increase the level of sales
2. Reduce costs as a percent of sales
3. Reduce assets as a percentage of sales
When profitability goes up and the capital required to produce it goes down, the returns and the value of the business go straight up.
Without tangible assets, there would be no earnings in the first place.
Convert unproductive assets into cash.
Being part of the herd means your investment views will lack sufficient variance. It is very hard for the majority to do better than average.
Do your own thinking and be comfortable going against the crowd.
Be hubris enough to think you can have insights that are superior to the collective wisdom of the market and have humility enough to know the limits of your abilities and be willing to change course when errors are recognised.
Be willing to be different and wrong.
Better to be roughly right than precisely wrong. – Keynes
Why buy your tenth-best idea when you can still buy more of your favourite at attractive prices?
If it’s rational, it’s conservative.
What is a good idea in the beginning is often a bad idea in the end.
Compare any new ideas to the best of what you already have.
When a new idea comes along, only buy it when it’s more attractive than buying more of what you already own.
The optimum portfolio depends on the various expectations of choices available and the degree of variance in performance which is tolerable.
The greater number of selections, the less will be the average year-to-year variation in performance which is tolerable. Also, the lower will be the expected results, assuming different choices have different expectations of performance.
6-8 stocks in different businesses.
When the tax rate is equal, the better return will come from the one taxed later.
Don’t minimise the tax rate ahead of the compounding rate.
Asses the value of your holdings as if they’ve already been liquidated.
Your net worth is the market value of your holdings less the tax payable on sale.
At what point does the incremental addition of capital flip from positive to negative? The moment capital outgrows ideas.
There are advantages to having little capital. Tiny, obscure, and underfollowed companies tend to be least efficiently priced and offer the most fertile ground for opportunities.
Our methods, not our principles, should change as the market ebbs and flows.
You must understand it and it must be priced right.
Find the securities selling well below the value to a private owner.
Your productivity decreases when: 1) the market environment changes; 2) your size increases; 3) more competition.
Focus on business valuations rather than anticipate market action.
It’s much cheaper to learn from other people’s mistakes than to make them on your own.
Those who don’t know their history are destined to repeat it.
Buy and sell what makes sense. The best return for minimum risk.
There is no way to eliminate the possibility of error when judging humans particularly in regard for future behaviour in an unknown environment.
Look for intelligence, energy and integrity. Integrity is most important.
If someone doesn’t have integrity, then you want them to be dumb and lazy.
Avoid a decision where there is nothing to gain (personally) and considerable to lose.
An exceptional manager was apt to grow assets both through performance and capital additions that would inevitably drag down performance.
You will likely underperform in the late stages of a bull market top.
Give yourself 3-5 years to perform.
If something’s not worth doing, it’s certainly not worth doing well.
Do you buy bonds, buy stock, or stay in cash?
Sometimes, bonds are less risky and sometimes they are not. The types of securities you choose are the means to an end; don’t confuse the former with the latter.
In any investment there are two key questions: What is the most likely return, and what’s the risk?
Think a lot about money management rather than becoming too involved in the detail of the operation.
Think over the next 5-10 years. It is easier to think about what should develop over a relatively long period of time than what is likely in any short period.
Evaluate weights dictated by fundamentals than votes dictated by psychology.
The best expectable after-tax rate of return makes the most sense – given a rising, declining or stable currency.
You will have to make your own decision as between bonds and stocks and, if the latter, who advises you on such stocks.
In many cases, I think the decision should largely reflect your tangible and intangible (temperamental) needs for regularity of income and absence of large principal fluctuation, perhaps balanced against psychic needs for some excitement and the fun associated with contemplating and perhaps enjoying really juicy results. If you would like to talk over the problem with me, I will be very happy to help. – Buffett
Market prices for stocks fluctuate at great amplitudes around intrinsic value but, over the long term, intrinsic value is virtually always reflected at some point in market price.
Results you achieve will reflect your attitudes and behaviour.
When buying companies or common stocks, look for first-class businesses accompanied by first class managements.
Investing is done best when it’s most business-like and business is done best when it’s most investment-like.
Equities are simply the conduit through which shareholders literally own their portion of the assets held within a corporation. The assets can be bought or sold and are therefore fungible.
Assets are simply a form of capital in a given state. Make sure you maintain the state of your capital in the highest and most productive form possible.
The primary determinants in selection of bond maturity should be:
1. The shape of the yield curve;
2. Your expectations regarding future levels of interest rates;
3. The degree of quotational fluctuation you are willing to endure or hope to possibly profit from.
The wider the swings in interest rates and the longer the bond, the more the value of a bond can go up or down on an interim basis before maturity.
Thoughts
I really enjoyed this book. I wanted to read through all the old Partnership letters and see how Buffets style was back in his early years. Fortunately, this book condenses all the old partnership letters down to about 300 pages.
It was interesting seeing how Buffets style of investment has changed since finishing the partnership and becoming Berkshire.
He was more of a speculator in his early days looking for very cheap assets that sold for way less than book value, and preferably for less than the cash in the bank of the business. These were the cigar butt businesses, which are quantitative in nature. Once Buffet was operating with much larger amounts of capital, it was harder to move the needle and grow his book value easily. That’s when he changed more toward his investments in what he calls ‘generals’, which are qualitative. He is looking for reasonably priced businesses run by exceptional people with a large moat.
I’ve took what I believe are the main ideas from the book and put them into this post, but for any serious asset allocator it’s well worth studying the book.
Alan
