The Warren Buffett Way

by Robert G. Hagstrom

One other psychological trap that beckons investors is the temptation to follow what everyone else is doing, whether or not it makes sense. We might call it the lemming fallacy.

To help us understand, Buffett shared one of Ben Graham’s favorite stories in Berkshire Hathaway’s 1985 annual report. An oil prospector, moving to his heavenly reward, was met by St. Peter with bad news. “You’re qualified for residence,” said St. Peter, “but as you can see, the compound for oilmen is packed. There’s no way to squeeze you in.” After thinking for a moment, the prospector asked if he might say just four words to the present occupants. That seemed harmless to St. Peter, so he gave his okay. The prospector cupped his hand and yelled, “Oil discovered in hell.” Immediately the gates to the compound opened and all the oilmen rushed out. Impressed, St. Peter invited the prospector to move in and make himself comfortable. The prospector paused. “No,” he said, “I think I’ll go along with the rest of the boys. There might be some truth to that rumor after all.”

Buffett has a different definition of risk: the possibility of harm or injury. And that is a factor of the “intrinsic value risk” of a business, not the price behavior of the stock.

Risk, for Buffett, is inextricably linked to an investor’s time horizon. This alone is the single greatest difference between how Warren Buffett thinks about risk and how modern portfolio theory frames risk. If you buy a stock today with the intention of selling it tomorrow, Buffett explains, then you have entered into a risky transaction. The odds are no better than the toss of a coin—you will lose about half the time. However, says Buffett, if you extend your time horizon out to several years, the probability of its being a risky transaction declines meaningfully, assuming of course that you have made a sensible purchase.

Because emotions are stronger than reason, fear and greed move stock prices above and below a company’s intrinsic value. When people are greedy or scared, Buffett says, they often will sell stocks at foolish prices. In the short run, investor sentiment—human emotion—has a more pronounced impact on stock prices than a company’s fundamentals.

two reasons why understanding the human dynamic is so valuable in your own investing: (1) You will have guidelines to help you avoid the most common mistakes. (2) You will be able to recognize other people’s mistakes in time to profit from them.

The cost of arbitrage is the amount of time your capital is invested; risk is the amount of uncertainty over the outcome; and return is the amount of money made on the investment.

3 factors that differentiate long tsrm vs shortterm investing

We calculated the one-year return, trailing three-year return, and trailing five-year return (price only) between 1970 and 2012. During this 43-year period, the average number of stocks in the S&P 500 index that doubled in any one year averaged 1.8 percent, or about nine stocks out of 500. Over three-year rolling periods, 15.3 percent of stocks doubled, about 77 stocks out of 500. In rolling five-year blocks, 29.9 percent doubled, about 150 out of 500.

Rationalism, according to the Oxford American Dictionary, is a belief that one’s opinions or actions should be based on reason and knowledge rather than emotional responses.

A rational person thinks clearly, sensibly, and logically.

University of Toronto, believes that intelligence tests like IQ tests or SAT/ACT exams do a very poor job of measuring rational thought. “It is a mild predictor at best,” he says, “and some rational thinking skills are totally dissociated from intelligence.”

At one end of the thinking spectrum are mechanisms that have great computational power. But this great computational power comes with a cost. It is a slower process of thinking and requires a great deal of concentration. At the opposite end of the thinking spectrum are mechanisms with very little computational power; they require very little concentration and permit quick decisions. “Humans are cognitive misers,” writes Stanovich, “because our basic tendency is to default to the processing mechanisms that require less computational effort, even if they are less accurate.”4

humans are lazy thinkers. They take the easy way out when solving problems; as a result, their solutions are often illogical.

System 1 thinking is where simple and straightforward ideas travel quickly. It takes little time and not much intellectual work to calculate a price-earnings ratio or a dividend yield. System 2 thinking is the reflective part of our cognition process. It operates in a controlled manner, slowly and with effort. Our “slow-moving ideas” that require “reflection, judgment, and special expertise” are housed in System 2 thinking.

He is surprised by the ease with which intelligent people appear satisfied enough with their initial answer that they stop thinking.

It appears to me that much of the decision making that goes on in Wall Street is System 1 thinking. It operates mainly by intuition. Decisions are made automatically and quickly with little or no time for thoughtful reflection. System 2 thinking is serious thought. It is deliberate and requires concentration. System 2 thinkers are naturally patient. For System 2 thinking to work effectively, you must allocate time for deliberation and, yes, even meditation.

“A piece of mindware is anything a person can learn that extends the person’s general powers to think critically and creatively.”

What mindware would you need to activate System 2 thinking? At a minimum, you would read a company’s annual report and the annual reports of competitors. If it appears the company has a strong competitive position with a favorable long-term outlook, you would next run several dividend discount models that include different growth rates of the company’s owner earnings over different time periods to get a sense of approximate valuation. Then you would study and understand management’s long-term capital allocation strategy. Last, you might call a few friends, colleagues, or financial advisers to see if they have an opinion about your company or, better yet, your company’s competitors. Take note: None of this requires a high IQ, but it is more laborious and requires more mental effort and concentration than simply figuring out the company’s current price-to-earnings ratio.

Process

In 1960, the annualized value-weighted NYSE/AMEX turnover was less than 10 percent. Today, that ratio is greater than 300 percent—a 30-fold increase over the past 50 years.11 It is hard to believe that this dramatic increase in activity has not had a transformative effect on both the market and its participants.

Whereas most individuals cannot endure the discomfort associated with declining stock prices, Buffett is not unnerved, because he believes that he can do a better job than the market in valuing a company. Buffett figures that if you can’t do a better job as well, you don’t belong in the game. It’s like poker, he explains—if you have been in the game for a while and don’t know who the patsy is, you’re the patsy.

Management consultants believe successful businesses have three distinct advantages: a behavioral advantage, an analytical advantage, and an organizational advantage.2 Studying Warren Buffett, we can see each of these components at work.

“In our view,” says Buffett, “investment students need only two well-taught courses: How to Value a Business, and How to Think about Market Prices.”

just as you would not take direction from an adviser who exhibited manic-depressive tendencies, neither should you allow the market to dictate your actions.

You know you have approached Buffett’s level when your attention turns to the stock market and the only question on your mind is: “Has anybody done anything foolish lately that will allow me an opportunity to buy a good business at a great price?”

Often investors begin with an economic assumption and then go about selecting stocks that fit neatly within this grand design. Buffett considers this thinking foolish. First, no one has economic predictive powers any more than they have stock market predictive powers. Second, if you select stocks that will benefit only in a particular economic environment, you inevitably invite turnover and speculation. Whether you correctly predict the economy or not, you’ll find yourself continuously adjusting your portfolio to benefit in the next economic scenario. Buffett prefers to buy a business that has the opportunity to profit regardless of the economy.

Time is more wisely spent locating and owning a business that has the ability to profit in all economic environments than by renting a group of stocks that do well only if a guess about the economy happens to be correct.

Companies with a high ratio of fixed assets to profits will require a larger share of retained earnings to remain viable than companies with a lower ratio of fixed assets to profits, because some of the earnings must be earmarked to maintain and upgrade those assets. Thus accounting earnings need to be adjusted to reflect the business’s cash-generating ability.

Buffett believes that wide diversification is required only when investors do not understand what they are doing. If these “know-nothing” investors want to own common stocks, they should own a large number of securities and space out their purchases over time. In other words, the know-nothing investor should use an index fund and dollar-cost average purchases. There is nothing shameful about becoming an index investor. In fact, Buffett points out, the index investor will actually outperform the majority of investment professionals.

You can measure the economic progress of the businesses you own by calculating their look-through earnings, just as Buffett does. Multiply the earnings per share by the number of shares you own to calculate the total earnings power of your companies. The goal of the business owner, Buffett explains, is to create a portfolio of companies that, in 10 years, will produce the highest level of look-through earnings.

It is wrong to assume that if you are not buying and selling, you are not making progress. In Buffett’s mind, it is too difficult to make hundreds of smart decisions in a lifetime. He would rather position his portfolio so he only has to make a few smart decisions.

The mind craves patterns, Johnson believes; patterns suggest order, which allows us to plan and make sense of our resources. What we have come to understand about Buffett is that he is continually seeking patterns—patterns that can be found when analyzing a business. He also knows that these business patterns will, at some point, reveal the future pattern of the stock price. Of course, a stock price pattern will not obligingly follow every change in the business pattern, but if your time horizon is long enough, it is remarkable how the price patterns eventually match up with the business patterns.

Too many investors are seeking patterns in the wrong places. They are certain that there is some predictable pattern for gauging short-term price changes. But they are mistaken. There simply are no predictable patterns for guessing the future direction of the stock market. The exact patterns do not repeat. Still, these investors keep trying.

Inside each company, there are business patterns, management patterns, and financial patterns. If you study these patterns, in most cases you can make a reasonable prediction about the future of the company.

One thing we can say with certainty is that knowledge works to increase our investment return and reduces overall risk. I believe we can also make the case that knowledge is what defines the difference between investment and speculation. In the end, the more you know about your companies, the less likely it is that pure speculation will dominate your thinking and your actions.

The financial writer Ron Chernow claims that “financial systems reflect the values of societies.”18 I believe that is largely true. From time to time, we seem to misplace our values, and then our markets succumb to speculative forces. Soon, we right ourselves and continue on with our financial walk, only to trip and fall back into destructive habits. One way to stop this vicious cycle is to educate ourselves about what works and what does not work.

investment success is not synonymous with infallibility. Rather, it comes from doing more things right than wrong. The Warren Buffett Way is no different. Its success as an investment approach is as much a result of eliminating those things that you can easily get wrong, which are many and perplexing (predicting markets, economies, and stock prices), as requiring you to get certain things right, which are few and simple (mainly, valuing a business).

Because you no longer worry about the stock market, the economy, or predicting stock prices, you are now free to spend more time understanding your businesses. More productive time can be spent reading annual reports and business and industry articles that will improve your knowledge as an owner. In fact, the degree to which you are willing to investigate your own business lessens your dependency on others who make a living advising people to take irrational actions.