In our previous blog we have learned about the first lessons that we can pick from Warren Buffett’s 2014 letter and in this article, we will continue delving in the wisdom that Warren shared.
- Bad Behaviour is Destructive
“A human being is a dark and veiled thing,” writes Daniel Kahneman, “…and whereas the hare has seven skins, the human being can shed seven times seventy skins and still not be able to say: This is really you, this is no longer outer shell. So said Nietzsche, and Freud agreed: we are ignorant of ourselves.”
As these philosophers said, human beings are ignorant but they are more so ignorant in what they really want when it comes to investing, This is what Buffett has exactly echoed in his letter. He listed five ways investors commonly do to destroy their wealth and these are trading, timing, inadequate diversification, high fee, and leverage.
This is a direct quote from the letter, “Investors, of course, can, by their own behavior, make stock ownership highly risky. And many do. Active trading, attempts to “time” market movements, inadequate diversification, the payment of high and unnecessary fees to managers and advisors, and the use of borrowed money can destroy the decent returns that a life-long owner of equities would otherwise enjoy.
Decades ago, Ben Graham pinpointed the blame for investment failure, using a quote from Shakespeare: “The fault, dear Brutus, is not in our stars, but in ourselves.”
- Avoid Borrowing to Invest
Warren suggests at all costs, to avoid buying stocks with borrowed money because doesn’t make anything a better investment or increase the probability of gains. It merely magnifies whatever gains or losses may materialize.
Nassim Taleb says that we should judge people by the costs of the alternative, that is if history played out in another way. As he wrote in his brilliant book Fooled by Randomness – “Clearly, the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (those who succeed attribute their success to the quality of their decision).”
In the same way, be very careful of judging your stock market success by the outcome you achieve, but by the decision you made. “Leverage can help me magnify my returns” is a great statement to make. But more often now, leverage – which is a result of arrogance created by good short-term returns or a result of survivorship bias, which is concentrating on the people or things that “survived” some process and inadvertently overlooking those that did not – will not only your destroy your savings and sleep, it will also destroy your reputation.
Buffett writes this about using leverage in investing, “…borrowed money has no place in the investor’s tool kit: Anything can happen anytimein markets. And no advisor, economist, or TV commentator – and definitely not Charlie nor I – can tell you when chaos will occur. Market forecasters will fill your ear but will never fill your wallet.”
- Big Investors, Small Investors – All Are Same
It is common to have small investors get enamoured by jargon-spitting stock market experts and big investors who appear on business TV to dispel their next predictions. The reason is often ‘authority bias’ – we considers someone an authority, when he/she is dressed or speaks like one. But Buffett reiterates what he has been saying for years – that all investors behave the same, and big investors behave more badly due to the great number of biases that they suffer from, as compare to the small investor.
Therefore, before you trust a big investor with your time and money, remember what Buffett says, “The commission of the investment sins is not limited to “the little guy.” Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades.
A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool’s game. There are a few investment managers, of course, who are very good – though in the short run, it’s difficult to determine whether a great record is due to luck or talent.
Most advisors, however, are far better at generating high fees than they are at generating high returns. In truth, their core competence is salesmanship. Rather than listen to their siren songs, investors – large and small – should instead read Jack Bogle’s The Little Book of Common Sense Investing.”
- What to Look for in an Investment
Warren has outlined six key points of Berkshire’s acquisition criteria in his 2014 letter, something he has done several times in the past as well. While the first point can be immaterial for you, the next five points must be core to your investment philosophy, if you want to be a sensible, long term investor.
We are eager to hear from principals or their representatives about businesses that meet all of the following criteria:
(1) Large purchases (at least $75 million of pre-tax earnings unless the business will fit into one of our existing units),
(2) Demonstrated consistent earning power (future projections are of no interest to us, nor are “turnaround” situations),
(3) Businesses earning good returns on equity while employing little or no debt,
(4) Management in place (we can’t supply it),
(5) Simple businesses (if there’s lots of technology, we won’t understand it),
(6) An offering price (we don’t want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown).
- Cigar Butt Approach – Does It Work Anymore?
Shortly after Ben Graham’s death in 1976, Buffett became the designated steward of the former’s value approach to investing. Indeed, he himself became synonymous with value investing. It is easy to see why. Buffett was the most famous of Graham’s dedicated students, and never missed an opportunity to acknowledge the intellectual debt he owed to his teacher. Even today, he considers Graham to be the one individual, after his father, who had the most influence on his investment life.
This is despite the fact that, as early as 1965 and while working under Graham, Buffett was becoming aware that the latter’s strategy of buying cheap stocks (what Graham called ‘cigar-butts’, or companies selling for less than their net working capital) was not ideal, for it did not consider the quality of businesses, and just a stock’s cheapness. In fact, following Graham’s approach, Buffett bought some genuine losers.
Several companies that he had bought at cheap prices (they met Graham’s test for purchase) were cheap because their underlying businesses were suffering (so they were “value traps”). As such, Buffett began moving away from Graham’s strict teachings of focusing only on the price and a few balance sheet numbers, and not on the underlying quality of the business.
“I evolved,” he admitted, “but I didn’t go from ape to human or human to ape in a nice even manner.”
In his 2014 letter, Buffett outlines when the cigar-butt strategy worked for him, and when it didn’t, and why buying stocks just because they are priced ‘cheap’ can be a dangerous strategy.
My cigar-butt strategy worked very well while I was managing small sums. Indeed, the many dozens of free puffs I obtained in the 1950s made that decade by far the best of my life for both relative and absolute investment performance.
Even then, however, I made a few exceptions to cigar butts, the most important being GEICO…Most of my gains in those early years, though, came from investments in mediocre companies that traded at bargain prices. Ben Graham had taught me that technique, and it worked.
But a major weakness in this approach gradually became apparent: Cigar-butt investing was scalable only to a point. With large sums, it would never work well.
In addition, though marginal businesses purchased at cheap prices may be attractive as short-term investments, they are the wrong foundation on which to build a large and enduring enterprise. Selecting a marriage partner clearly requires more demanding criteria than does dating.