Warren Buffet’s hamburger example

One of the most classic Buffet analogies is the hamburger example. In his example Buffet says that everyone who eats hamburgers will be happy if hamburger prices were to go down for the next five years.

However, investors will not be happy if stock prices were to go down for the next five years, even if they are long – term investors. The way investors think about stock prices is at loggerheads with the way they think about anything else.

Normally, when stock prices are down, there is a plethora of bad news in general and there is a depressing mood in the markets. In such circumstances it is difficult for investors to go out and make purchases in the stock market. It is difficult to value companies and know when the economy will recover, and all this makes it very difficult to boost investor confidence.

So even though the burgers are cheap, no one wants to touch them.

Hamburgers are cheap now

If P/E multiples are anything to go by, then stocks are really cheap at this point in time. Here is a graph that shows you how the P/E of Nifty (which is a key Indian stock market index) has fared from the beginning of this century. One glance at this will tell you that stock prices, relative to their earnings are at their lowest in the last eight years or so.

PE Value Nifty Jan 08 till Oct 08
PE Value Nifty Jan 08 till Oct 08

Despite this there is very little investor interest in the stock markets and there is a negative mood in the markets. A lot of this can be attributed to the recession which is expected in the coming months. There are fears that the recession may turn into a depression and most of these companies will lose their earnings and P/E chart will adjust itself, not because the prices go up, but because the earnings will go down.

Even if that happens, for a long term investor who recognizes a deep recession or depression as part of an economic cycle, this may be the best time to buy stocks. The prices seen today are the lowest in about a decade. They may go lower but in the long run, just as we must face a recession, we will see a recovery too.

The hamburgers are cheap, but are you willing to buy them now?

Meet Mr. Market

Mr. Market was an imaginary character that was created by Ben Graham. Ben Graham wrote “The Intelligent Investor”, which is considered to be the bible of investing and happens to be Warren Buffet’s favorite investment book.

Ben Graham wrote that Mr. Market came to you every morning and offered to buy and sell certain stocks from you at a certain price. For him, Mr. Market was the collective representation of the entire stock market and was meant to be your servant. A servant that offers to buy and sell stocks at a certain price.

Mr. Market is not there to advice you about the stock market prices or tell you whether you are right or wrong, he is just there to make the deal for you.

In short, Mr. Market is the collective representation of all the buyers and sellers in the market and sometimes epitomizes the greed and fear that drive the entire stock market.

Mr. Market offers you a price, sometimes this price may truly reflect the value of the company, and at other times, the price may be outright silly.

The key lesson in this story is that Mr. Market only makes the trade for you, he doesn’t tell you whether the price is right or wrong.

This story helps you differentiate between the price and value of stocks. Look around you and you will find thousands of investors who invested in stocks just because others were doing so. And then they dumped stocks because others were doing the same thing.

Very often, you tend to think that if the market is paying such a low price for a stock, then it must really be worth that much. Nothing could be farther from the truth. The market is just the aggregation of thousands of greedy and fearful investors (many of who you even know in your personal life).

Do not let the opinions of such investors sway your decision making. Warren Buffet says, that you should be able to buy a stock, regardless of whether others like or dislike it. This is central to treating Mr. Market as just the deal maker and not the one who knows whether price is right or not.

Trust your own instinct and analysis, and when Mr. Market offers a good deal to you, take it. You may just know more than him.