Investment Strategies Part II: Warren Buffett: Finding Wonderful Companies
And discrediting the efficient portfolio theory.
Warren Buffet does not need an introduction.
The Oracle of Omaha has become famous by investing his way to the top 10 richest people in the world.
While Buffett is the most famous investor, his strategy remains little known.
We explain how it works in this article.
We can’t speak about Warren Buffett without speaking about Benjamin Graham.
Benjamin Graham was a British-born US economist, author of the book The Intelligent Investor.
The Intelligent Investor is one of the most influential books about investment.
The strategies outlined are intimately linked to Graham’s life.
Ben Graham began investing at the end of the 1910s. A mere decade later, he lost everything in the crash of 1929.
That traumatized him forever. He took the lessons of the crash to write The Intelligent Investor.
The book (re)introduces the concept of value investing. Value investing is the idea to invest in under-valued stocks with long-term growth prospects.
This notion was rather new at the time. The common belief was that the stock market was efficient. Investors believed that all companies at all times were rationally priced.
The crash showed Graham otherwise.
In the short-term, he said, the market behaves irrationally. Some stocks are priced too high, others are priced too low. The latter are the ones you, as an investor, should focus on.
By buying stocks at a lower price than their real worth and by holding them, the market will eventually price them right and they will increase in value.
You will then be able to earn some money by selling them.
Graham devised some mathematical formulas to buy the right stocks, but as his book made its way into the world, the market noticed the inefficiency and killed it off.
This is one of the most remarkable things about Benjamin Graham. He kept on updating his book throughout his life, and warned people when what he had written had become obsolete.
While the principles didn’t change, the way to buy stocks did because the players in the market changed as well.
Today, we estimate that between 60% to 73% of all trading in the US is algorithmic.
Wonderful Stocks VS Wonderful Companies
Warren Buffett took Benjamin Graham’s lessons and improved them with his partner Charlie Munger.
Buffett summarized value investing with the saying “buying fair companies at a wonderful price”.
Value investing meant buying stocks at a lower price than they were worth, waiting for the price to rise, and selling the stocks once they reached their correct price.
But why sell at all?
Graham, as we said above, had lost everything in the 1929 market crash. He never wanted to go through that again, so he didn’t want to hold stocks for too long and sought to cash out as soon as he could.
That was his mistake.
Buffett and Munger took Graham’s strategy one step further.
Instead of focusing on wonderful stock prices from fair companies, they decided to focus on fairly-priced stocks of wonderful companies.
What does that mean?
Munger noticed that in the long term, investing wasn’t as much about buying at a low price as it was buying the right company.
Focusing on any companies, even if their stock prices were low, wasn’t as profitable as focusing on great companies who had a potential of 10X, or 100X returns.
So they shifted their approach and began to study companies themselves, instead of mere company finances.
That meant studying marketing, HR, management, and all other business principles that don’t intervene in companies’ financial reports.
“Lose money for the firm, and I will be understanding; lose a shred of reputation, and I will be ruthless.”
Buffett and Munger didn’t only understand finance. They understood business as well.
That made them a unique duo of investors. Most investors did (and still do) look at the balance sheet and the income statement of companies.
But few were interested in the marketing, or even, in the actual product.
Munger and Buffett understood that finance was only one part of investing.
They never followed traditional investing principles, like the Modern Portfolio Theory, for example.
The Modern Portfolio Theory
The Modern Portfolio Theory (MPT) is a theory invented by the US economist Harry Markowitz, a Nobel Prize winner.
He based his theory on the idea that investors are averse to risk. As a result, they should seek stocks with the highest returns for the lowest amount of risk (as measured by past volatility).
The efficient portfolio is assembled by selecting stocks that have the highest amount of return with the lowest level of risk.
To do so, investors use diversification and select different companies that aren’t correlated to one another.
This strategy is very famous in the investment world, and is still applied nowadays thanks to equities-traded funds (ETFs) or mutual funds.
These funds aggregate several companies according to one or several criteria in order to decrease the risk.
Warren Buffett never practised MPT, and he never bought ETFs.
The reason is that MPT is based purely on financial calculations (namely measurement of past performances).
Things like what the business does, who operates it, will the demand for the product increase or decrease…are not taken into account.
Buffett invests in what he calls “wonderful businesses”, and part of what makes them wonderful is that “they don’t” lose any money.
Buffett would rather invest money in “three wonderful businesses” and get high results than invest money in 30 companies and get average results.
Diversification gets you average, and Warren Buffett doesn’t want average. He wants the best.
Warren Buffett holds many stocks of companies. He also invests in real estate.
And that’s about it. He never invested in gold.
Because Buffett understands that finance, economics, and entrepreneurship are intimately related. He understands that companies that earn money are companies that deliver significant value to their customers.
He always takes the example of a farm. A farm produces food which you can sell for a profit. That’s how you increase your net worth.
Gold doesn’t produce anything. BTC doesn’t produce anything. So, he doesn’t buy them.
Warren Buffet, like Peter Thiel before him, is a contrarian investor.
He buys when everyone sells and sells when everyone buys.
He doesn’t buy gold and doesn’t diversify.
He’s an activist investor — that means he directly intervenes in how the company he invested in is managed.
That doesn’t mean he didn’t lose money. In fact, he lost a lot of money on a lot of investments. But in the end, he still made more than he lost.
His own track record testifies that his theory on “finding one great business” is true.
Out of the 450 companies he’s owned at some point throughout his life, Warren Buffett made 87% of his money with only 10 companies.
In the world of investing, like in many other things, it’s not so much about quantity.
It’s about quality.
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