By Danielle Town & Phil Town
43-Minute Audio / 6,000 words (24 pages)
For the 43-minute audio version join Plus
Do you long for the day when you can work less and travel more? Do you fear that you’ll never have enough money to be able to retire? By following Warren Buffett’s approach to value investing, you can learn how to build an investment portfolio that will give you the financial freedom you need.
The key to Buffett’s approach is to look for companies that you can understand, that have an intrinsic and durable competitive advantage, and that have talented management. Then, calculate a good price at which to buy that company’s shares.
Value investing does involve diving into the sometimes-complex world of financial statements, but with practice you can figure out which are the most important numbers on any company’s Income Statement, Balance Sheet, and Cash Flow Statement, and use them to decide whether a company meets your investment criteria.
Once you have calculated the right price for your target companies, wait until the share price falls to that level and then buy, confident in the knowledge that you have an anti-fragile portfolio that will not just give you a great rate of return but will also be able to survive the next – inevitable – market downturn.
Fear keeps most of us from controlling our own investment decisions but following Warren Buffett’s value investing approach can give you financial freedom. The key is to look for a handful of companies that will give you great investment returns over the long term. There are four simple rules to follow: pick a business you are capable of understanding; one with a durable competitive advantage; whose management has integrity and talent; and that you can buy for a price that makes sense. This way, you can build an anti-fragile portfolio that will not only survive the inevitable next market downturn but will thrive in the long term.
1. Getting started
Most of us yearn for some level of financial freedom, but are busy juggling work-life stress, paying off student loans, servicing a mortgage, and perhaps raising kids while pursuing a career. In the middle of all of this it’s tough to take the plunge and create your own investment portfolio. Many of us are too afraid of the risks involved in anything to do with the financial markets. However, with some education and practice it is possible to follow in the footsteps of Warren Buffett and his ‘value investing’ strategy.
In 1956 Warren started the Buffett Partnership in Omaha, Nebraska, investing his money and that of friends and family. Over the next fourteen years his investments averaged annual returns of 31.5%. In 1969 Buffett closed that partnership and put all his money in Berkshire Hathaway, a public company controlled by Buffett and his investment partner Charlie Munger. Berkshire buys the shares of publicly traded companies like Coca-Cola as well as entire companies like Geico. Now known as the Oracle of Omaha and the elder statesman of the value investing world Buffett’s strategy is simple: buy a wonderful company when it is a bargain and only when you are certain that it will be worth more in ten years than it is today; and hold onto it even if the price goes down.
The problem with inflation
Recessions have taught us that the stock market is a fickle partner. For many of us, it is tempting to become a financial hoarder and put everything in the financial equivalent of ‘under the mattress,’ i.e., buy U.S. Treasury Department bills or T-bills, which are guaranteed by the federal government and considered as close to risk-free as it’s possible to get. Unfortunately, inflation happens. Inflation is a good thing in that relatively low and steady price increases lead to what economists call a virtuous cycle of rising production and demand, leading to higher wages and more consumption. Of course, a high rate of inflation is a bad thing – it devalues money so quickly that wages and jobs can’t keep up. However, even moderate inflation is bad for savers as it erodes the purchasing power of your money. The $100 you have today won’t buy you as much ten years down the road, when prices have gone up an average of 3.0% every year.
In fact, you have to earn at least a 3.0% return on your money every year just to stop its value from eroding. Stock markets typically rise with inflation as company revenue and earnings also rise. So, the only way to grow your savings is through investment.
Fear of the market
The problem with the stock market, of course, is that it goes down as well as up – and a lot of things can cause a stock price to fall. Women investors in particular tend to have a low risk tolerance, making many of them unwilling to invest in the market. It seems safer to pay a professional to manage your money for you – but, that money manager has to be paid whether or not they actually make money for you. If you learn how to practice value investing, you can manage your own money with confidence.
As you go through these steps you will progress from Unconscious Incompetence (you don’t realize how little you know), through Conscious Incompetence (you know what you need to do but don’t know how), to Conscious Competence (you know how to do this!), and finally to Unconscious Competence (you’re so good at this you don’t even have to think about it anymore). The key thing to bear in mind right now is that you won’t actually be buying anything until you’ve worked your way through all these steps and arrived at a level of Conscious Competence.
So, how much do you really need to invest? To figure this out, you need to understand how the market works, and what your investment number really is.
‘The market’ is short-hand for the many stock exchanges around the world. In the U.S., the best known is the New York Stock Exchange or NYSE. The concept of trading shares on the market has been around since the Dutch invented the idea in the 1600s, dividing up a corporation into fractions that can be owned. When you buy or sell a share on a stock exchange you are buying it from, or selling it to, another investor, not to the corporation itself. Today, a lot of the actual buying and selling is done electronically rather than in a Dutch coffee house, but the principle is the same.
A few hundred years after the Dutch created the first stock exchange, the British came up with the idea of the limited liability company – exactly what it sounds like, this is a corporate structure that limits the liability of corporate owners to the assets of the company, keeping their private assets safe. This is great for encouraging the kind of risk-taking needed for entrepreneurialism but can also lead to corporations with no sense of responsibility for their actions.
Another aspect of the stock market to bear in mind is that management has a lot more information about the company than do shareholders. Theoretically, the shareholders indirectly run the company by electing a board of directors; but in reality, this is at best arms-length control, with the board overseeing the major decisions and appointing executive officers to actually run the company.
About 85% of the money in the stock market actually comes from individual investors, ordinary people trying to build their nest eggs through 401k plans, IRAs, and insurance policies. However, most of this investment is done through proxies:
Mutual funds: A collection of stocks and bonds, chosen by a financial advisor who charges a fee whether or not they grow your money.
Market index funds: A market index is a group of stocks that tell us how the market is doing overall, e.g., the S&P 500 – five hundred stocks that indicate how the overall 6,000 or so stocks on the market are performing. Market index funds buy the stocks in the index to passively follow the market, charging a lower fee than an actively managed mutual fund. Buffett says this is the best option if you’re not willing to do your own value investing, but it also means you will only average a return of about 7.0% a year.
Exchange traded funds (ETFs): Another index tracking idea, but a fund that you buy and sell direct from a broker like an individual stock, the fees tend to be higher than for market index funds but lower than for mutual funds.
Robo-advisors: A computer program that offers the same kind of investment options as a human advisor, but at a lower fee.
All of these money managers charge you a fee to invest your money, whether or not they actually grow your savings; and, at best, most barely manage to beat the market average. If the market rises an average of 7.0% a year, but your money manager charges you 2.0%, the actual earning on your savings is only 5.0%. In other words, it gets even harder to beat the rate of inflation and build up your money enough to gain financial freedom.
On the other hand, studies have shown that Buffett-style value investing returns over 20% a year.
Calculate your number
The first step to building your own investment practice is to write down what financial freedom means to you – perhaps the ability to work less, pay off your debts, travel, or just feel less stressed?
To figure out what you need to attain your own financial freedom, you just need to know four things: how much you actually need to spend every year; how many years you have left to build your investment total; how much you can afford to put into investments; and, based on these first three things, your required rate of return.
What is your mission?
Given this asymmetry of information and the sheer number of publicly traded companies, how do you start to narrow your choices? Find your mission – what you really care about, the values that you want to bring to your investing practice. Take some time to come up with the list that defines your mission. Perhaps your focus is on treating employees well, not exploiting animals, supporting local communities, and so on.
The mission is the first step you will use in creating the story of a company you are considering investing in.
2. Value Investing
Charlie Munger laid out the basics of the value investing strategy in four simple principles, the things that must apply before putting money into a company:
- It must be a business you are capable of understanding
- It must have a durable competitive advantage
- It has management with integrity and talent
- You can buy it for a price that makes sense and gives a margin of safety
Before looking at each of these principles in more depth, we need to consider the way the market really works.
The Efficient Market Hypothesis or EMH assumes that people are rational actors who buy and sell a stock based on what it is worth, and that a stock’s price therefore reflects all available information at any given moment. EMH says that the reason professionals rarely ‘beat the market’ is because the price always adjusts as soon as new information is available.
And yet, the original Buffett Partnership had average annual returns of over 30%. One academic proponent of the EMH claimed Buffett was just lucky, like a monkey flipping coins. In 1984 Warren published his response, an article in the Columbia Business School magazine in which he pointed out that if you found a bunch of lucky monkeys that all came from the same zoo in Omaha, you’d be pretty sure you were onto something!
In fact, said Buffett, the market is far from efficient because investors can exploit gaps between price and value. What’s more, fund managers often buy and sell based on greed or fear, not on rational and fully informed decisions. In 1999 Yale economics professor Robert Shiller published the book Irrational Exuberance in which he showed that the market regularly behaves irrationally. Nassim Nicholas Taleb then weighed in with his book, The Black Swan, arguing that the market is neither random nor unbeatable; supposedly impossible Black Swan events actually happen quite regularly.
Additional academic research has shown that people tend to make decisions based on biases and emotions, not on rational pursuit of self-interest. In other words, EMH is wrong and value investing really does work.
Events happen – things that are unexpected, that affect the company or the whole market, but that are temporary and rectifiable. Thanks to the nature of their industry, fund managers react to Events – they cannot wait for months or even years for a company to recover. The key to value investing is that, thanks to your research into the company and the industry, you will know when something is a temporary Event rather than a terminal problem in a badly run company.
Bubbles and crashes happen in the market, and they can seem random and unpredictable. However, there are two good sources for market-pricing information that help the value investor to tell when the market is mis-priced.
Robert Shiller won a Nobel Prize for creating this indicator that shows how over- or under-priced the market is. Shiller calculates the cyclically- and inflation-adjusted earnings of the S&P 500 over the past ten years and divides that number into the total market price of the S&P 500. Over the past 140 years the average Shiller P/E is 16.4, so when...