Essays of Warren Buffet... Chapter 2

This chapter begins with the most useful concept in value investing - Mr. Market, originally introduced by Ben Graham. In Buffet's words:


"You should imagine market quoatations as coming from a remarkably accommodating fellow named Mr. Market... Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations are anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is manic depressive and can see nothing but trouble ahead for both the business and the world. One these occasions, he will name a very low price, since he is terrified that you will unload your interest on him."


And now the killer:


"Mr. Market has another endearing characteristic: He doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you... Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom that you will find useful."


Buffet quotes Ben Graham again on the issue of holding: "In the short run, the market is a voting machine but in the long run it is a weighing machine." According to Buffet, the speed at which a business's success is recognized, is not that important as long as the company's intrinsic value is increasing at a satisfactory rate. In fact, delayed recognition can be an advantage: It may give us the chance to buy more of a good thing at a bargain price.


Buffet elaborates a bit on how he generally resists selling when the price is high which he contrasts with Wall Street attitude of: "You can't go break taking a profit". He explains that he is quite content to hold so long as the prospective return on equity capital of the underlying business is satisfactory. He doesn't explain this much further except for quoting David Ogilvy: "Develop your eccentricities while you are young. That way when you get old, people won't think you are going ga-ga".


The next section is an interesting one. Here Buffet talks about how a successful investor gets happier to see stocks falling. He poses a simple question: "If you expect to be net saver during the next five years, should you hope for a higher or lower stock market" ? "Even though people are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice becauses prices have risen for the "hamburgers" they will be buying soon. This reaction makes no sense... So smile when you read a headline that says "Investors lose as stocks fall"".


Arbitrage.


The next essay is on Arbitrage. This section carries a few of Buffet's experiences making and losing money in arbitrage positions, especially "risk arbitrage".


Efficient Market Theory.


In the next essay, Buffet lambasts Efficient Market Theory (EMT)... "Observing correctly that the market was frequently efficient, they [academics] went on to conclude that it was always efficient. The difference between these propositions is night and day". Buffet akins this ideology as "not even trying" when it comes to evaluating business principles of prospective investments.


Portfolio concentration - Too much of a good thing can be wonderful.


Another interesting point in this essay is related to portfolio concentration. Buffet says "we believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characterstics before buying into it". He explains that the difference between portfolion-diversification and portfoloio-concentration is really the difference in how risk is defined. Proponents of portfolio diversification define risk as the relative volatility of stock - that is, the volatility of the stock as compared to a larger universe of stocks. Under this definition, stocks whose prices have dropped severely are considered riskier. In contrast, the definition of risk accepted by proponents of portfolio concentration is from the point of view of the owner of business - "the possibility of loss or injury". I noticed that this is a recurring theme in the book - Buffet indeed thinks about his investments a lot like an owner rather than a speculator.


Buffet provides some guidance about how to evaluate risk. He cautions that these characteristics are often difficult to quantify, but that does not negate their importance:


1. The certainty with which long term economic characteristics of the business can be evaluated.
2. The certainty with which management can be evaluated...
3. The certainty with which management can be counted upon to channel the reward from the business to the shareholders rather than to themselves.
4. Purchase price,
5. Taxation, inflation, and competition.


Portfolio insurance.


Portfolio insurance is a money management strategy which dictates that ever-increasing portions of a stock portfolio, or their index future equivalents, be sold as prices decline. So, a downtick of a given magnitude produces a huge sell order. In fact, one popular corollary is to repurchase these companies, once the stock has rebounded significantly. Apparently, in the crash of October 1987, $60 to $90 billion of equities were offloaded on this hair trigger. Buffet concludes by saying that a smart investor only stands to benefit from such speculative acts of others. In fact, he can be hurt by such volatility only if he is forced, by either financial or psychological pressures, to sell at untoward times.


Value-investing: A redundancy.


This is well stated by these four rules. The business should be one (1) that you can understand, (2) with favorable long term prospects (durable competitive advantage), (3) operated by honest and competent people, (4) available at an attractive price.


When deciding what is an "attractive price", the Margin of Safety rules may come handy... "If we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success".


Buffer believes that an intelligent investor buying common stocks will do better in secondary markets than he will do buying new issues. The favorable factor for secondary markets being Mr. Market. For new issues, Buffet mentions that issuing corporation has little incentive to undersell their stocks than its intrinsic value, since they can set the price and time the IPO.