The Berkshire Hathaway annual meeting takes place this weekend, where throngs of investors converge upon Omaha Nebraska to listen to Warren and Charlie dispense their worldly wisdom. Here are some things I have learned from Buffet:
Emotion has no place when making investment decisions
Investors listen to their emotions to their own detriment. This graph, which I first spotted over at The Big Picture is one of the most insightful representations of the stock market I have seen.
The story of the stock market is one of booms and busts. Booms are created when prices of an asset are pushed beyond what that asset is actually worth. What I mean by ‘actually worth’ is the market clearing price at which demand exactly equals supply. When we are in a boom, an asset has been temporarily pushed beyond its equilibrium price. When we are in a bust, the market is correcting back to the equilibrium price.
There are a couple of actors with different motivations and thought processes that work together, both knowingly and unknowingly, to manufacture a boom. There are three archetypes of investors during a boom.
There are some buyers who simply don’t know that the asset is over-valued. They are being duped and think that they are getting a deal.
There are others who are well aware that a boom is occurring, but believe themselves to be able to get in and out of the market before the collapse.
And yet there are others who are so caught up in the hype that they are completely tone-deaf to any discussion about equilibrium price and market clearing and other economic mumbo-jumbo. All their friends are making a ton of money in this market- why shouldn’t they be too?!
The most recent boom-bust cycle was the subprime crisis that sprung up in the US and reverberated around the world (as expertly detailed in Michael Lewis’s Boomerang – but that is only the latest in a multi-century history of such events.
Why does this boom-bust cycle continue to occur and reoccur, as a sort of economic perpetual motion machine?
There are a couple of reasons. The answer has way less to do with economics or any technical understanding of financial markets as it does with an understanding of human behavior.
One reason is a cognitive fallacy called recency bias, which is the (mistaken) thought that because something hasn’t happened in the recent past it can’t or won’t happen- or if it does then chances are quite slim.
The other explanation is the very simple fact that emotion is a much stronger motivator and impetus for human behavior than rational thought and reasoning.
The range of human emotion is quite complex- yet for this model we need to focus on only two emotions- fear and greed.
Let’s start at the beginning. People make investments because they want to get a return on their money. They believe that investing their money now will result in more money in the future. That is the only reason that people invest. Price is driven by supply in demand. When the demand for a good increases relative to the supply- the price goes up.
Someone buys a house because he believes it is going to go up in value in the future. As population continues to grow and economic prosperity increases, more people want to buy homes. Therefore- the price of homes goes up.
He sells his house for more money and his neighbor notices. His neighbor buys another home. All of a sudden- people are chasing returns that aren’t there. Demand drops out- more homes have been built than there are people to buy them.
Anyone who stepped back and examined the fundamentals of the market- supply and demand, could see that that a bubble was forming. Looking at house price to median income- house construction to household formation, or just the rate of house price increase overtime would have shown that the home prices were going up at a much too rapid rate.
But instead, people flipped homes because it was easy to get approved for a mortgage, and it seemed like a quick way to make some cash.
Investors who were buying homes were not analyzing the market in any sort of calculated or rational way. They were simply listening to their intuition and emotions, which gave them a good feeling that they would be able to make money.
Warren Buffet was not hurt by the housing bust because he does not rely on his emotions to make investing decisions.
Buy companies in industries immune to or armored against disruption.
(Wide moat theory)
Think of a business as a castle. A castle is strong- it has thick walls and archers and a king that directs the flow of behavior and works to ensure that his castle won’t be overrun by bandits, marauders, and other would-be kings.
The strongest defense a castle has is a wide moat. A pit filled with noxious water, alligators, and other ominous and lethal creatures that will destroy and consume any and all scheming intruders.
Successful businesses, like castles, are under constant attack. A business survives and thrives by selling a unique product that cannot be easily replaced or overtaken by something better, cheaper, faster, sleeker or more tasty. The product is the moat. Tech companies in general and computer manufacturers specifically have thin moats. Someone is always coming out with a faster hard drive. Do you really care if you have an intel or an AMD? I’m buying whichever is cheaper and faster. Or maybe chip manufactures will be replaced by tablet computers that rely on flash memory. Buffet doesn’t like these companies.
One of Warren Buffet’s favorite businesses that he owns is Coca-Cola. He likes Coca-Cola because it has a very wide moat. It is not going to be hurt by the internet. It is not susceptible to disruption- there is no soda 2.0 that is going to dismantle Coca-Cola. It is reliably strong. It has reached the apex of its technological potential. It is as good as it can be.
Buy companies that have strong mind-share
Mind share is related to market share but it is not the same thing. Mind share refers to the strength of a brand- the loyalty, devotion and fidelity of its consumers. It refers to the personal attachment its consumers feel the brand: The extent to which they have integrated the brand into their own identity.
Companies with strong mind-share among a core demographic may be stable. And the converse is that companies with a high percentage of market share don’t necessarily have a lot of mind-share. They may have the best product right now- but when something newer and better comes along from a competitor consumers will be quick to switch brands.
Buffet likes to buy companies that have strong mind-share; such as coca-cola. People like to drink coke because they like to drink coke. It sounds like a tautology because it is. Who cares what the origin story is? At some point these folks decided that they like coke and they have been drinking it ever since. Now it is just a habit that they continue to practice.
Fade the Noise
Warren Buffet doesn’t have a computer in his office. And his office is in Omaha, Nebraska. Buffet visits Wall Street maybe once a year, to meet with a few, select, trusted people. He doesn’t watch CNBC or listen to blog posts or scroll through a twitter feed on his iPhone. He uses his years and years of accumulated knowledge that he has gleaned from reading annual reports to make sound investment decisions.
What is the lesson here? Be a relentless culler of information sources. Practice discernment. In a world where there is more information than ever before – there is also more useless information than ever before. How do you know what matters? Listen to Buffet himself. The only investment book he says you need to read is The Intelligent Investor, by Benjamin Graham. Other than that, read annual reports and listen to conference calls. Look at the numbers of a business. Don’t pay attention to what some pundit on CNBC is telling you.
Knowable and Important
Warren Buffet doesn’t pay attention to economic forecasts or the direction that interest rates are going or the unemployment number. While he believes all these things to be important- he doesn’t think that that they are knowable. Studies have shown that the predictions of pundits are no more accurate than guesswork. Buffet understands this and therefore doesn’t clutter his mind or waste his time paying attention to things that are unknowable. He focuses on what he can measure. What are a company’s sales numbers? What are its margins? How fast is the business growing? Who are the main competitors? By focusing all his attention on what is knowable and important, Buffet can make smart decision based in fact, and avoid speculation and guesswork.
The best holding period is forever
Warren Buffet likes to buy businesses that are going to remain profitable for decades down the road, and that are strong and sturdy enough to be able to withstand the vicissitudes of the global economy, and the political and social events that will shake and destroy its less able competitors. He likes to buy businesses that will be able to remain strong when the going gets tough, because of their fortress balance sheets, because of the insatiable, non-cyclical demand of their product, and because of strong and consistent management that will steer the ship smoothly and forcefully through choppy waters.
In conclusion- we all have a lot to learn from Warren Buffet. It is one thing to understand his investment process- it is quite another to internalize and practice it. The number one take away is that in the world of investing acting on your emotions does not pay off. This is his most tough lesson to practice and also the most valuable. If you can become a master of your emotions- you are on the right track to becoming a successful investor.
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