Core Philosophy: Anchoring to Business Quality, Not Price

 

Core Philosophy: Anchoring to Business Quality, Not Price

The guide's foundation is pure quality-focused, long-term ownership. It echoes the philosophies of Warren Buffett, Charlie Munger, and Philip Fisher (whose quote concludes it). The central message is: your decision to sell should be tied to the underlying business's fundamentals and your personal capital needs, not to stock price movements or market noise.

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Analysis of "WHEN TO SELL" (The Valid Reasons)

1. WRONG FACTS: This is the "admit your mistake" clause. It requires intellectual honesty. If your initial thesis was flawed (you overestimated management, misunderstood the business model, or missed a weak moat), selling is correct. Pride and ego are the enemies here.

2. CHANGING FACTS: This is crucial for dynamic investing. A business is not a static asset. Deteriorating fundamentals (falling returns on capital, poor acquisitions, ethical lapses in management) invalidate the original reason to hold. This forces continuous monitoring of the business, not the stock quote.

3. NO CASH FOR A BETTER OPPORTUNITY: This is a sophisticated portfolio management concept. It acknowledges opportunity cost. However, it comes with a major caveat: you must be highly confident that the new opportunity is significantly better. Swapping a great business for a marginally cheaper one is often a mistake.

4. NEED CASH: A practical, non-investment reason. It underscores that investing serves life goals. This reason should be planned for (via an emergency fund or staggered liquidity needs) to avoid forced selling at inopportune times.

The common thread: Each valid reason is fundamental or personal, not technical or speculative.

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Analysis of "DO NOT SELL" (The Behavioral Pitfalls)

This section brilliantly tackles the emotional reflexes that destroy long-term returns.

1. "STOCK IS OVERPRICED":

   • Challenges Market Timing: It rightly questions the investor's ability to define "overpriced" for a compounding machine. A high P/E ratio can persist for years if growth continues.

   • Forward-Looking Perspective: It shifts focus from static multiples to the 10-year potential. This is the heart of value investing—estimating future cash flows.

   • The Compounding Argument: The "quadruple in size" example is powerful. If you expect 15% annualized returns, paying a 50% premium today might still deliver outstanding absolute returns over a decade. The real risk is selling a compounder and missing the entire journey.

2. "OTHER REASONS": These are pure behavioral errors:

   • Anchoring to Purchase Price: Irrelevant to the stock's future. The market doesn't care what you paid.

   • "Surged 50%" / "Paper Profits": Reflects a scarcity mindset, treating profits as something to be "captured" rather as evidence of a working thesis. It confuses volatility with permanent loss.

   • "Sell to Buy Lower": Attempts to time the market, a famously losing game. The risk of the stock continuing upward and never returning to your buy price is high.

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Commentary & Practical Insights

Strengths:

• Discipline Framework: It provides a clear checklist to curb emotional selling.

• Emphasis on Business Quality: It keeps the investor's eyes on what matters—durable competitive advantages and capable management.

• Long-Term Orientation: It forcefully aligns the investor with the power of compounding.

Challenges & Nuances:

• Execution is Hard: The discipline requires immense patience and the ability to watch portfolios decline 30-40% without panicking, trusting the business quality.

• Valuation Still Matters (Subtly): While arguing against selling for being "overpriced," the philosophy doesn't advocate buying at any price. The "expected returns over 10 years" inherently includes a judgment on current price. A price so high that it guarantees poor returns for a decade is a valid reason not to buy, and arguably to sell if you own it.

• "Almost Never" is Extreme: Philip Fisher's quote is inspirational, but few businesses remain outstanding for 50 years. Industries disrupt, scales diseconomies emerge, and management changes. The "Changing Facts" reason is the necessary counterbalance to "almost never."

• Portfolio Concentration: This approach works best for a concentrated portfolio of high-conviction ideas. It is difficult to follow if you own 50 stocks, as you cannot know each business well enough to judge "changing facts."

Conclusion

This guide is a masterclass in investor psychology and business-focused investing. It's not a trading manual; it's an ownership manual. Its greatest value is inverting the typical investor's mindset: instead of asking "Should I take profits?" it forces the questions "Is the business still great?" and "Do I need the capital for something more pressing?"

For the individual investor, adopting this framework means:

1. Doing deep research before buying (so you have a "fact base" to judge later).

2. Developing the fortitude to ignore short-term price volatility.

3. Having a systematic process to periodically review business fundamentals—not stock charts.

It’s a simple, but not easy, path to long-term wealth creation.

A significant inaccurate notion - Equating a lower absolute share price automatically to a better value.

When Ben Graham was teaching his investing course at Columbia University in the 1950s, he used a brilliant form of instruction to illustrate relationship between price and value.  He often took two consecutive securities from the stock tables and analysed the fundamentals.  This method roved to be an effective tool for illustrating the price/value relationship.  Of significant importance is the inaccurate notion that a lower absolute price automatically equates to a better value.

The "Good Investment". Clarify your Investment Goals.

By pinpointing what you think represents value, you can now create your definition of a good investment.   You should be able to summarize it in one sentence.

Consider these examples:

Warren Buffett:  a good business that can be purchased for less than the discounted value of its future earnings.

George Soros:  an investment that can be purchased (or sold) prior to a reflexive shift in market psychology/fundamentals that will change its perceived value substantially.

Benjamin Graham:  a company that can be purchased for substantially less than its intrinsic value.

A few more examples:

The Corporate Raider:  companies whose parts are worth more than the whole.

The Technical Analyst:  an investment where technical indicators have identified a change in the price trend.

The Real Estate Fixer-Upper:  run-down properties that can be sold for much more than the investment required to purchase and renovate them.

The Arbitrageur:  an asset that can be bough low in one market and sold simultaneously in another at a higher price.

The Crisis Investor:  assets that can be bought at fire-sale prices after some panic has hammered a market down.


Coming to your definition of a good investment is easy - if you're clear about the kinds of investments that interest you and have clarified your beliefs about prices and values.

Handling stock price falls

• 30 May 03

When a stock price falls, do you sell, buy more or hold on? It all depends, but there are some techniques to help you with your thinking, and your emotions.

One of the questions we're frequently asked is how to handle a tumbling stock price. Should you cut your losses, buy more or sit on your hands nervously and do nothing?

Unfortunately, the Zen art of value investing doesn't lend itself particularly well to never-fail formulas, so absolute answers are impossible. There are, however, some basic principles that you can look to for guidance.

First of all, you should be looking to sell (or not buy) shares that look expensive and aiming to buy shares that look cheap. The direction in which a share price has recently travelled is not in itself an indicator of this.

When to hold

Secondly, too much trading will just hand the returns from your portfolio over to your broker. That means that there's usually a large grey area between buy and sell where you should be happy simply to hold.

Finally, you should always maintain a sensibly diversified portfolio so that your fortunes are not too closely tied to a few holdings.

If a share falls and you keep adding large chunks, then it might end up accounting for too much of your portfolio. That's not a happy situation even if you think it's the cheapest share on the market.

It's worth noting that all of this has just as much relevance if a stock in your portfolio has gone up in price, or even if it hasn't moved at all. What matters is the relationship between the price and the underlying value, subject to diversification and keeping your trading costs down. Putting this all together, we can get an idea of what to do in certain situations.

If a share has fallen by, say, 20%, but you estimate that its underlying value has fallen by less, or indeed grown, then generally we believe it makes more sense to at least consider buying more (subject to keeping sensibly diversified).

An example of this would be Macquarie Bank (see page 4), which we've consistently seen as being undervalued. As its price fell from above $30 last year, we continued to recommend buying and it became a strong buy in issue 114/Oct 02 (Strong Buy up to $21 - $20.39). The shares have now recovered to $27.70.

Time to sell

If a share has fallen by a certain amount but you estimate that its underlying value has fallen by more, then you certainly shouldn't be buying more. That would just compound the original mistake. Instead, you'd want to face up to the mistake and think about selling.

If a share has fallen and you estimate that its underlying value has fallen by a similar amount, then you'd sit on your hands and do nothing.

To avoid too much expensive trading, this should probably be your starting point. To either buy more or sell, your views should be very strongly held.

Our recommendations on AMP are an example of the sell and hold situations. At the beginning of last year, with its share price up near the $20 mark, we had it as a hold. But we were unimpressed by its results in March 2002 noting, in particular, that its 'international or bust attitude' was cause for concern.

So we downgraded it to sell in issue 98/Mar 02 (Sell/Switch to Suncorp - $19.12) and continued to recommend selling as the price fell (and as its underlying value evaporated).

We finally reverted to a hold in issue 113/Oct 02 (Hold while Unstable - $11.78), because we considered that the fall in the share price had finally caught up with the deterioration in the underlying value of the stock.

Since then, we've felt that the falling share price has been matched by a fall in business value (such as we're able to judge it) and have continued with the Hold while Unstable recommendation.

Different thinking

It can sometimes help to imagine that you don't actually own your downtrodden shareholding, but instead have its value in cash. If that was the case, would you use the cash to buy those shares at the current price or invest in something else?

If you find you get a definite no, then it might be time to sell. If you get a definite yes, then you'd think of buying more.

If you get a maybe, then you're probably in the area where the transaction and tax costs of taking any action would outweigh any potential benefits. In this case, it's usually best to to sit on your hands and hold on to your shares.

It's never easy to deal with a falling share price and there are no clear-cut rules to follow. But this approach, used advisedly, can be a useful way of addressing the issue. We hope it helps.

http://www.intelligentinvestor.com.au/articles/128/Handling-stock-price-falls-.cfm

I don't understand why business schools don't teach the Warren Buffett model of investing.

I don't understand why business schools don't teach the Warren Buffett model of investing.


Or the Ben Graham model. Or the Peter Lynch model. Or the Martin Whitman model. (I could go on.) In English, you study great writers; in physics and biology, you study great scientists; in philosophy and math, you study great thinkers; but in most business school investment classes, you study modern finance theory, which is grounded in one basic premise--that markets are efficient because investors are always rational. It's just one point of view. A good English professor couldn't get away with teaching Melville as the backbone of English literature. How is it that business schools get away with teaching modern finance theory as the backbone of investing? Especially given that it's only a theory that, as far as I know, hasn't made many investors particularly rich.

Meanwhile, Berkshire Hathaway, under the stewardship of Buffett and vice chairman Charlie Munger, has made thousands of people rich over the past 30-odd years. And it has done so with integrity and a system of principles that is every bit as rigorous, if not more so, as anything modern finance theory can dish up.

On Monday, 11,000 Berkshire shareholders showed up at Aksarben Stadium in Omaha to hear Buffett and Munger talk about this set of principles. Together these principles form a model for investing to which any well-informed business-school student should be exposed--if not for the sake of the principles themselves, then at least to generate the kind of healthy debate that's common in other academic fields.

Whereas modern finance theory is built around the price behavior of stocks, the Buffett model is centered around buying businesses as if one were going to operate them. It's like the process of buying a house. You wouldn't buy a house on a tip from a friend or sight unseen from a description in a newspaper. And you surely wouldn't consider the volatility of the house's price in your consideration of risk. Indeed, regularly updated price quotes aren't available in the real estate market, because property doesn't trade the way common stocks do. Instead, you'd study the fundamentals--the neighborhood, comparable home sales, the condition of the house, and how much you think you could rent it for--to get an idea of its intrinsic value.

The same basic idea applies to buying a business that you'd operate yourself or to being a passive investor in the common stock of a company. Who cares about the price history of the stock? What bearing does it have on how the company conducts business? What's important is whether you can purchase at a reasonable price a business that generates good returns on capital (Buffett likes returns on equity in the neighborhood of 15% or better) without a lot of debt (which makes returns on capital less dependable). In the best of all worlds, the company will have a competitive advantage that allows it to sustain its above-average ROE for years, so you can hang on to it for a long time--just as you would live in your house--and reap the power of compounding.

Buffett further advocates investing in businesses that are easy to understand--Munger calls it "clearing one-foot hurdles"--so you can come up with more reliable estimates of their long-term economics. Coca-Cola's basic business is pretty staid, for example. Unit case sales and ROE determine the company's future earnings. Companies like Microsoftand Intel--good as they are--require clearing much higher hurdles of understanding because their business models are so dependent on the rapidly evolving world of high tech. Today it's a matter of selling the most word-processing programs; tomorrow it's the Internet presence; after that, who knows. For Coke, the challenge is always to sell more cases of beverage.

Buying a business or a stock just because it's cheap is a surefire way to lose money, according to the Buffett model. You get what you pay for. But if you're evaluating investments as businesses to begin with, you probably wouldn't make this mistake, because you'd recognize that a good business is worth buying at a fair price.

Finally, if you follow the Buffett model, you don't trade your investments just because our liquid stock markets invite you to do so. Activity for the sake of activity begets high transaction costs, high tax bills, and poor investment decisions ("if I make a mistake I can sell it in a minute"). Less is more.

I'm not trying to pick a fight with modern finance theory enthusiasts. I just find it unsettling that basic business-school curricula don't even consider models other than modern finance theory, even though those models are in the marketplace proving themselves every day.

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/articles/teachbuffet.htm

You have to Know the Story: Confusing the price with the story is the biggest mistake an investor can make.

If you're going to invest in a stock, you have to know the story.  This is where investors get themselves in trouble.  They buy a stock without knowing the story, and they track the stock price, because that's the only detail they understand.  When the price goes up, they think the company is in great shape, but when the price stalls or goes down they get bored or they lose faith, so they sell their shares.

Confusing the price with the story is the biggest mistake an investor can make. 

• It causes people to bail out of stocks during crashes and corrections, when the prices are at their lowest, which they think means that the companies they own must be in lousy shape. 
• It causes them to miss the chance to buy more shares when the price is low, but the company is still in terrific shape.

The story tells you what's happening inside the company to produce profits in the future - or losses, if it's a tale of woe. 

• It's not always easy to figure this out. 
• Some stories are more complicated than others. 
• Companies that have many different divisions are harder to follow than companies that make a single product. 
• And even when the story is simple, it may not be conclusive.

But there are occasions when the picture is clear and the average investor is in a perfect position to see how exciting it is.  These are the times when understanding a company can really pay off.