I just finished reading Warren Buffett’s 2014 annual letter to shareholders, and he has devoted a section to investing in common stocks in it which is titled “Some Thoughts About Investing”.
The section is a great read for any long term equity investor, and I’m going to excerpt the part where he lists down lessons for investors.
I tell these tales to illustrate certain fundamentals of investing:
- You don’t need to be an expert in order to achieve satisfactory investment returns. But if you aren’t, you must recognize your limitations and follow a course certain to work reasonably well. Keep things simple and don’t swing for the fences. When promised quick profits, respond with a quick “no.”
- Focus on the future productivity of the asset you are considering. If you don’t feel comfortable making a rough estimate of the asset’s future earnings, just forget it and move on. No one has the ability to evaluate every investment possibility. But omniscience isn’t necessary; you only need to understand the actions you undertake.
- If you instead focus on the prospective price change of a contemplated purchase, you are speculating. There is nothing improper about that. I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so. Half of all coin-flippers will win their first toss; none of those winners has an expectation of profit if he continues to play the game. And the fact that a given asset has appreciated in the recent past is never a reason to buy it.
- With my two small investments, I thought only of what the properties would produce and cared not at all about their daily valuations. Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.
- Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important. (When I hear TV commentators glibly opine on what the market will do next, I am reminded of Mickey Mantle’s scathing comment: “You don’t know how easy this game is until you get into that broadcasting booth.”)
- My two purchases were made in 1986 and 1993. What the economy, interest rates, or the stock market might do in the years immediately following – 1987 and 1994 – was of no importance to me in making those investments. I can’t remember what the headlines or pundits were saying at the time. Whatever the chatter, corn would keep growing in Nebraska and students would flock to NYU.
I think the two factors that I’ve had most trouble dealing with are the following:
1. Ignoring the macro situation: There hasn’t been a panic in the markets for a while now so it’s easy to forget how these situations look like but if you remember the last panic or the one before it — the biggest thing that stands out from them is how hard it is to ignore all the doomsday predictions and focus on investing.
Even without panic, it is hard to ignore things like say the election results, and say that you will invest no matter what the outcome of elections are, and that in no way will influence your investing decision. It’s hard but it is precisely what needs to be done. The people who have benefitted the most from the stock market are the ones who remained invested, and continue to invest more when the markets crashed. It is just the nature of the market to over-react at both extremes, and if you comprehend that and position yourself to take advantage of that then you can take advantage of the macro situation.
2. Valuing an asset: The other difficult thing I find is to value stocks, and there are several ways to value a stock but how do you know that you have accounted for all important factors in your valuation and you’re making the correct assumptions?
There is simply no way to make sure that you have done all this, and that’s precisely why so many professionals fail at this. The best that you can do is to pick a simple measure, use that consistently, ensure that you have plenty of margin built into your calculation, diversify, and give yourself a lot of time. What I usually do is look at free cash flow, and then calculate the value based on how much free cash flow the company is generating, and that’s proved to be an easy measure for me. Sometimes I invest in stocks that don’t have any free cash flow, and in those cases I have to look at other measures, but the point I’m trying to make is you can use a simple measure for doing these type of calculations, and also that you have to value a stock like you value a business, and that exercise in itself will save you from investing in a lot of bad companies that have bleak prospects.
Equity investing is not for everyone, but for the people who want to invest directly in stocks, there are some great lessons to be drawn from investors like Warren Buffett, and learning from the experiences they’ve had.