Knowledge of psychology should help you inject rationality into your decisions.

The purpose of understanding psychology is to reduce the irrational component in your decision making.

To apply psychology in your stock buying and selling decisions, the first thing you should explore is your primary reason for making that decision.

Systematic thinking will help you determine what you know or do not know and overcome your psychological biases.  When you do not know the answer, you need to make a judgment call.

In computing intrinsic value, we have to make estimates or judgment calls.  Ultimately, everyone has to make judgment calls, but following a systematic approach will help you when you are making a judgment call.

Your ultimate question should always be "Is this rational based on all that I know?"  On average, if you go through a set of basic questions about the stock and psychology, you should do well in the stock market.

Of course, in the process of learning about yourself, if you conclude that you are likely to make irrational choices more often than not, maybe you should stay away from the stock market.  In that case, your situation may be similar to someone who knows the dangers of excessive drinking but cannot help but drink when he visits a bar.  He should learn not to go near a bar.

Overall, knowledge of fundamentals should help you estimate the company's long-term future, and knowledge of psychology should help you inject rationality into your decisions.


Related:

Strategies for Overcoming Psychological Biases

****Be a Better Investor

A Powerful Foundation for making intelligent decisions in the stock market: Knowledge of fundamentals of the company and human behaviour (psychology)

In recent years, behavioural finance has shed light on the psychology of stock prices and financial decisions by market participants.

Eventually, two main forces affect stock prices in the market:

• the fundamentals of the company, and,
• human behaviour.

Both forces have a role to play.

However, a combined knowledge of the two should make a more powerful foundation for making intelligent decisions in the stock market than relying on fundamentals alone.  

Many investors make dumb decisions by chasing stock prices.  Do you?  If so, what can you do about it?

We will get better answers by studying psychology than by boning up on finance alone.


The dumbest reason in the world to buy a stock is because it's going up.
- Warren Buffett

Related:

****Be a Better Investor

A V-Shaped Boom Is Coming

A V-Shaped Boom Is Coming

Published: Monday, 12 Apr 2010 | 11:01 AM ET Text Size
By: Larry Kudlow
CNBC Anchor


Conservatives shouldn’t fight the tale of the tape.

Sometimes you have to take out your political lenses and look at the actual statistics to get a true picture of the health of the American economy. Right now, those statistics are saying a modest cyclical rebound following a very deep downturn could actually be turning into a full-fledged, V-shaped, recovery boom between now and year-end.

I’m aiming this thought especially at many of my conservative friends who seem to be trashing the improving economic outlook — largely, it would appear, to discredit the Obama administration.

Don’t do it folks. It’s a mistake. The numbers are the numbers. And prosperity is a welcome development for a nation that has suffered mightily.

Credibility is at issue here.

Conservative credibility.

Capitalist credibility.

Now, I have written extensively about the tax-and-regulatory threats of the Obamanomics big-government assault. But most of that is in the future. The current reality is that a strong rebound in corporate profits (the greatest and truest stimulus of all), ultra-easy money from the Fed, and some small stimuli from government spending are working to generate a stronger-than-expected recovery in a basically free-market economy that is a lot more resilient than capitalist critics think.

Rather than blow their credibility over a cyclical rebound that is backed by the statistics, free-market conservatives should tell it like it is.

Let’s begin with the March employment numbers recently released by the Labor Department. Those numbers were solid. People say small businesses are getting killed by taxes and regulations from Washington, but the reality is that the small-business household employment survey has produced 1.1 million new jobs in the first quarter of 2010, or 371,000 per month. If that continues, the unemployment rate will drop significantly.

Additionally, the corporate payroll number for March increased by 224,000 -- not 162,000 as some claim -- with the prior two months being revised up by 62,000. And this is being led by private-sector job creation.

And according to just-released data, retail chain-store sales for the year ending in March were up a blowout 10 percent. Ten percent. That’s a V-shaped recovery. And the real-time ISM purchasing-managers reports for manufacturing and services indicate that the economy in the next few quarters could be much, much stronger than the consensus expects -- maybe 5 to 6 percent. Another V-shaped recovery.

Commodity charts, meanwhile, are roaring. All manner of raw industrial materials have been booming -- iron ore, steel, you name it. More V-shaped recovery. So with higher commodity prices running virtually across-the-board, there is every incentive for rapid inventory-rebuilding. (Inventory prices are going up as commodity prices go up.)

At this point it’s impossible to project a long-lived economic boom, such as we had following the deep recession of the early 1980s. For one thing, tax rates will rise in 2011 for successful earners and investors, quite unlike the Reagan cuts of the 1980s. So it’s possible that entrepreneurs and investors are bringing income, activity, and investment forward into 2010 in order to beat the tax man in 2011. This would artificially boost this year’s economy, stealing from next year’s economy.

Recall that when Hillary Clinton took her Rose Law Firm bonus in December 1992, rather than January 1993, she knew full well that her husband Bill would raise the top tax rate in 1993. So the fourth quarter of 1992 grew at nearly 4.5 percent, but the first quarter of 1993 saw less than 1 percent growth. The temporary growth spurt for all of 1992 was 4.3 percent, but activity dropped to 2.7 percent the following year.

It could happen again in 2010 and 2011.

Although the Obamacons deny it, tax-rate incentives matter a lot.

And at some point, monetary policy will tighten, with higher interest rates on top of higher tax rates. That, too, could slow growth markedly next year. And then there’s the dozen tax hikes in the Obamacare health takeover, and a possible VAT attack from Paul Volcker, all of which will work against growth in the out-years.

Clearly, we are not operating a supply-side, free-market model today. What I wish for is sound money and lower tax rates, which would promote sustainable economic growth. Instead, we’re getting easier money and higher tax rates, which could mean a temporary boom today and disappointingly slow growth after that.

But then again, who knows? Maybe the tea-party revolution overturns the obstacles to future growth and the boom is sustained. Free-market populism and a return to Reaganism, along with an anti-federal-spending coalition that is the most powerful force in politics today, could right the economic ship.

That’s the credible take.

http://www.cnbc.com/id/36421625

The Biggest Holders of US Government Debt

As the US government spends an unprecedented amount of money to fix the nation's economy, there is an equally great need to raise the cash to pay for it. This is accomplished through borrowing, whereby Uncle Sam sells Treasury securities of varying maturity.

For investors, the government bills, notes and bonds are considered a safe financial product because they have a guaranteed rate of return, based on faith in future US tax revenues. The government has been partially funding operations via Treasury securities for decades.

This borrowing adds to the national debt, which has climbed above $11 trillion and is rising every day. Much of that debt is held by private sector, but about 40 percent is held by public entities, including parts of the government. Here's who owns the most.



By Paul Toscano
Updated 17 Feb 2010


http://www.cnbc.com/id/29880401/?slide=1

The more you know about your psychological biases, the better you can function in the volatile stock market.

Everyone has opinions and psychological biases.  However, people may not know their own biases.

The more you know about your psychological biases, the better you can function in the volatile stock market.

The entire market may be influenced by psychological reasons, not by fundamental reasons alone.

From an investment perspective, the bottom line is that the market will continue to fluctuate and give you solid opportunities every so often.

Value in the long run is determined by fundamentals, while short-term gyrations reflect market participants' psychological weaknesses, such as herding.  

Knowledge is the best antidote to making wrong decisions.

If you are a long-term investor, the rational thing to do is to make decisions based on long-term fundamentals of the business.

Handling Mistakes and Bad Luck

Everyone makes mistakes, and bad luck strikes everywhere.

There is not much you can do about bad luck except to diversify and shy away from huge risks.

When you do make mistakes, take the time to ponder them and find ways to avoid making the same ones again.

Eliminate or severely limit your investments in companies with large downside risks to avoid huge losses

When you think that there is a large downside risk in investing in a company, you should be especially vigilant even if expected returns are high.

• A highly leveraged balance sheet is one indicator of high downside risk in a company.  

• Even countries that borrow large amounts of money are not safe:   Russia defaulted on its loans in 1998.

Since even a country the size of Russia can get into trouble, clearly you should never think of any country as "too big to fail."

By eliminating or severely limiting your investments in companies with large downside risks, you should be able to avoid the huge losses emanating from market volatility.

On the other hand, market volatility may cause good companies' stock prices to go down in the short run, giving you good buying opportunities.

Why Hold Cash?

Liquidity brings opportunities.

Do not rush to invest in stocks as soon as you have additional cash available for investing.  Be patient and wait for good investment opportunities.

Holding cash or cash equivalents is not just for safety; it can help you earn more on your investments by enabling you to take advantage of opportunities that arise with brief windows in which to strike.  

From this perspective, keeping some cash or investments in liquid, low-risk securities may prove to be a high-return proposition in the long run.  

In some cases, it might be helpful to invest in convertible preferred stocks or convertible bonds, as long as you stay with established firms the way Buffett does.

Investors and Accounting

Buffett encourages investors to develop a good knowledge of accounting.

In a Berkshire shareholders' annual meeting, a New York University MBA student asked Buffett for his advice on how to develop Buffett-like skills.  In his response, Buffett mentioned that the student should take as many accounting course as possible.  

Remember that you are a consumer and not a prepare of financial information.  Act like a detective trying to understand the company's business from reading financial statements.

Buffett reads a lot of financial reports; and for him, perhaps, that is like reading detective novels.  As a reader of financial statements, you could have fun discovering behind-the-curtain stories.

Accounting numbers are based on a large number of estimates, and hence, they are not really hard numbers.  Yet, academic  research shows that long-short investing strategies can often be developed by using accounting knowledge.  

When you study financial statements, be a skeptic.  Most accounting numbers are reliable, but you must remain vigilant.  


Related readings:

Videos-Financial Accounting by Susan Crosson

Where is Ze Moola

Visit this site to see how this blogger dissect the companies through using his accounting and other knowledge. 

When to Buy Any Stock: Consider Margin of Safety

Having computed intrinsic value of a stock, we know that a stock should be purchased only if the market price is below the stock's intrinsic value.

"How MUCH lower should the price be relative to the intrinsic value?"

Think of the margin of safety for any stock as the difference between a stock's intrinsic value and its market price.

If you buy a stock at its intrinsic value, you will have no margin of safety.  

• If everything goes as you assume in your calculations, you will earn an annual rate of return equivalent to the discount rate assumed.
• For example, if you assume a discount rate of 7 percent and purchase the stock at intrinsic value, your annual rate of return will be 7 percent.  

If the same stock is purchased at 25 percent below the intrinsic value, 

• the calculations show that the rate of return will be about 10 percent per year.  

And if the stock is at half the intrinsic value, 

• the rate of return will be about 15 percent.  

So it seems logical that you should buy a stock with a large margin of safety.

An alternate way of thinking about looking for a large margin of safety is to require a large discount rate.

Related posts:

Intelligent Investor Chapter 20: Margin of Safety as the Central Concept of Investment

The Intelligent Investor: “Margin of Safety” as the Central Concept of Investment

Value Investing: Provide a Margin of Safety

Everything Buffett Needs to Know, He Learned Right Here

****Price to Earnings Growth Ratio (PEG) Explanation

A great company can be a lousy investment. Always incorporate a margin of safety.

Buying when the price is right.

Computing Intrinsic Value

Individuals differ from one another in assessing companies' future prospects.  They also differ in their risk tolerance.  Hence, it should be no great leap to accept that there is no unique intrinsic value that can be assigned to a common stock upon which everyone will agree.  

In computing intrinsic value you should start by examining a company's balance sheet.  

• Some assets, such as cash and investments in marketable securities, are reported at market value.  
• As a first approximation, the intrinsic value of such items can be taken to be the same as their market values.  

For most companies, however, the major component of intrinsic value comes from their future earnings.
For valuation of future earnings:

1. You can start with estimating a growth rate based on your evaluation of the company's past performance.  
2. Then you can apply the estimated growth rate to current earnings to approximate expected earnings for a future year, say, 10 years from the current year.  
3. Finally, apply a P/E multiple to the future earnings per share to estimate the value of those earnings in the future and discount them to their present value.
4. In addition, dividends should be properly accounted for.

While it is a simple approach, it requires many assumptions.  For example, 

• you may have to adjust reported earnings in an attempt to obtain underlying or sustainable earnings. 
• You also need to assume a growth rate, a P/E multiple, and a discount rate.  

With this approach, it is important to know the company's business well for you to come up with reliable estimates.

Related posts:

Intrinsic value described by Ben Graham in Security Analysis.

Choosing a Discount Assumption

Intrinsic Value Model

Estimation of Intrinsic Value

Introduction to Valuation - Videos

Introduction to Valuation - Videos

Valuation is the process of determining what something is worth. It is arguably the most important, and most difficult thing we do in finance.

This gives an introductory look at valuation from Discounted CashFlow Analysis (DCF) to market multiples (comparables).

The Thrill of Investing in Common Stocks

The 2008-2009 stock market crash may have made you pessimistic about investing.

However, history tells us that you have an advantage.  This event actually offers you a great opportunity to find good stocks to invest in.

Buffett recently wrote in the New York Times that for his personal account, he bought common stocks in this market.

Another legendary investor with an outstanding record over several decades wrote, "One principle that I have used throughout my career is to invest at the point of maximum pessimism."

So, spend some time learning to invest wisely.

Based on a long historical record, the expected return on the market is about 7 percent to 10 percent per year.  Let's use the 10 percent as a benchmark.

If you have some money to invest for the long run, why not invest in common stocks?

With common stocks, you can improve your returns, especially if you enjoy the process and put some effort into learning the principles that master investors like Buffett have laid out.

Another great investor, Peter Lynch, echoes this viewpoint:

"An amateur who devotes a small amount of time to study companies in an industry he or she knows something about can outperform 95 percent of the paid experts who manage the mutual funds, plus have fun doing it."


Also read:
Commenting on selected KLSE stocks.

Buffett's investing philosophy is simple but not easy.

The thrill of investing in common stocks.

It is the fun of making money and watching it grow.

In the long run, rewards from playing the game of investing are large.

With some effort, you can also outperform the professional mutual fund managers and the market as a whole.

Buffett's investing philosophy is simple but not easy.

It is simple in the sense that all you need to do is to identify outstanding businesses that are run by competent and honest managers and whose common stock is selling at a reasonable price.

But how do you do that?

Growth in profits have LITTLE role in determining intrinsic value.

Growth in profits have LITTLE role in determining intrinsic value.  It is the amount of capital used that will determine value.  The lower the capital used to achieve a certain level of growth, the higher the intrinsic value.


Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor."

If understood in their entirety, the above paragraph will surely make the reader a much better investor.

Growth in profits will have little role in determining value. It is the amount of capital used that will mostly determine value. Lower the capital used to achieve a certain level of growth, higher the intrinsic value.

There have been industries where the growth has been very good but the capital consumed has been so huge, that the net effect on value has been negative. Example - US airlines.

Hence, steer clear of sectors and companies where profits grow at fast clip but the return on capital employed are not enough to even cover the cost of capital.

Buffett Investing = Value + Growth

Buffett-style Investing

Value Investing and Growth Investing are joined at the hip

The main message from value investing strategies is to invest with low downside risk.  

If a stock satisfies this criterion, you should then consider its growth in earnings to implement a value-plus-growth strategy (Buffett-style investing).

The focus in value investing is on the past, the focus in growth investing is on the future, and the focus in Buffett-style investing is on both the past and the future.

You should also pay special attention to management quality, because high-quality management is the source of growth in Buffett-style investing.

To implement the above strategy, you should compute the stock's intrinsic value and compare it with the stock's price.

As a general rule of thumb, if the price is about half the intrinsic value, it is worth investing in that stock.



The Renaissance Investor

There is more to Buffett than simply value and growth investing.

Buffett engages in

• arbitrage investing, 
• investing in silver futures, 
• betting on oil, 
• forward trading in foreign currencies, 
• managing a large number of wholly owned subsidiaries, and 
• writing derivative contracts.

He frequently narrates investment-relevant stories from other fields such as

• psychology, 
• sports, 
• country music, and
• life in general.

Given his broad knowledge and his deep understanding of investment-related topics, it is preferable to call him a renaissance investor rather than attempting to pin him down under more limiting monikers.

****Buffett (1992): Do not categorise stocks into growth and value types, the two approaches are joined at the hip

Warren Buffett's 1992 letter to his shareholders touched upon his views on short-term forecasting in equity markets and how it could prove worthless. In the following few paragraphs, let us go further down through the letter and see what other investment wisdom he has on offer.

Most of the financing community puts stock investments into one of the two major categories viz. growth and value. It is of the opinion that while the former category comprises stocks that have potential of growing at above average rates, the latter category stocks are likely to grow at below average rates. However, the master belongs to an altogether different camp and we would like to mention that such a method of classification is clearly not the right way to think about equity investments. Let us see what Buffett has to say on the issue and he has been indeed very generous in trying to put his thoughts down to words.

"But how, you will ask, does one decide what's 'attractive'? In answering this question, most analysts feel they must choose between two approaches customarily thought to be in opposition: 'value' and 'growth'. Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing.

We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.

In addition, we think the very term 'value investing' is redundant. What is 'investing' if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value - in the hope that it can soon be sold for a still-higher price - should be labeled speculation (which is neither illegal, immoral nor - in our view - financially fattening).

Whether appropriate or not, the term 'value investing' is widely used. Typically, it connotes the purchase of stocks having attributes such as 

• a low ratio of price to book value, 
• a low price-earnings ratio, or 
• a high dividend yield. 

Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments.

Correspondingly, opposite characteristics - 

• a high ratio of price to book value, 
• a high price-earnings ratio, and 
• a low dividend yield 

- are in no way inconsistent with a 'value' purchase.

Similarly, business growth, per se, tells us little about value. It's true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth. For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners.

Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor."

If understood in their entirety, the above paragraphs will surely make the reader a much better investor. We believe the most important takeaways could be as follows:

• Do not categorise stocks into growth and value types. A high P/E or a high price to cash flow stock is not necessarily a growth stock. A low P/E or a low price to cash flow stock is not necessarily a value stock either. 
• Growth in profits will have little role in determining value. It is the amount of capital used that will mostly determine value. Lower the capital used to achieve a certain level of growth, higher the intrinsic value. 
• There have been industries where the growth has been very good but the capital consumed has been so huge, that the net effect on value has been negative. Example - US airlines. 
• Hence, steer clear of sectors and companies where profits grow at fast clip but the return on capital employed are not enough to even cover the cost of capital.
  
  
  
  
  http://www.equitymaster.com/detail.asp?date=12/20/2007&story=2

Buffett (1992): Short-term market forecasts are poison and worthless.

Short-term market forecasts are poison and worthless. Over the long-run, share prices have to follow growth in earnings and anything more could result in a sharp correction.




Warren Buffett's 1992 letter to shareholders discussed his thoughts on issuing shares. Let us see what other nuggets he has to offer.

We have for long been a supporter of making long-term forecasts with respect to investing and we are glad that we are in extremely good company. For even the master thinks likewise and this is what he has to say on the issue.

"We've long felt that the only value of stock forecasters is to make fortunetellers look good. Even now, Charlie and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children. However, it is clear that stocks cannot forever overperform their underlying businesses, as they have so dramatically done for some time, and that fact makes us quite confident of our forecast that the rewards from investing in stocks over the next decade will be significantly smaller than they were in the last. "

The above lines were most likely written by the master in the early days of 1993, a year which was bang in the middle of the best ever 17 year period in the US stock market history i.e. the years between 1981 and 1998. However, this period did not coincide with a similar growth in the US economy. Infact, the best ever stretch for the US economy was a 17-year stretch, which started around 17 year before 1981 and ended exactly in 1981. Courtesy this economic buoyancy and the subsequent lowering of interest rates, the corporate profits started looking up and they too enjoyed one of their best runs ever. Thus, a period of buoyant GDP growth was followed by a period of strong corporate profit growth, which in turn led to increase in share prices. However, share prices grew the fastest because they not only had to grow in line with the corporate profits but also had to play catch up to the economic growth that was witnessed between 1964 and 1981.

Another extremely important factor that led to a more than 10 fold jump in index levels in the period under discussion had psychological origins rather than economic. Investors have an uncanny knack of projecting the present scenario far into the future. And it is this very habit that made them believe that stock prices would continue to rise at the same pace. However, nothing could be further from the truth. Over the long-run, share prices have to follow growth in earnings and anything more could result in a sharp correction. Thus, while the share prices can play catch up to economic growth and corporate profits and hence can grow faster than the two for some amount of time, expecting the same to continue forever, could be a recipe for disaster. And even the master concurs.

We believe similar events are playing themselves out in the Indian stock markets with investors expecting every stock to turn out to be a multi bagger in no time. But as discussed above, this could turn out to be a proposition, which is full of risk of a permanent capital loss. Investors could do very well to remember that over the long-term share prices would follow earnings, which in turn would follow the macroeconomic GDP and this could be a very reasonable assumption to make.

http://www.equitymaster.com/detail.asp?date=12/13/2007&story=3

Buffett (1992): His thoughts on issuing shares.

His thoughts on issuing shares.  He concentrated most of his investments in companies where shareholder returns have greatly exceeded the cost of capital and where the entire need for future growth has been met by internal accruals.


Here are the investment wisdom Warren Buffett doled out through his 1992 letter to Berkshire Hathaway's shareholders.

Up front is a comment on the change in the number of shares outstanding of Berkshire Hathaway since its inception in 1964 and this we believe, is a very important message for investors who want to know how genuine wealth can be created. Investors these days are virtually fed on a diet of split and bonuses and new shares issuance, in stark contrast to the master's view on the topic. Laid out below are his comments on shares outstanding of Berkshire Hathaway and new shares issuance.

"Berkshire now has 1,152,547 shares outstanding. That compares, you will be interested to know, to 1,137,778 shares outstanding on October 1, 1964, the beginning of the fiscal year during which Buffett Partnership, Ltd. acquired control of the company."

"We have a firm policy about issuing shares of Berkshire, doing so only when we receive as much value as we give. Equal value, however, has not been easy to obtain, since we have always valued our shares highly. So be it: We wish to increase Berkshire's size only when doing that also increases the wealth of its owners."

"Those two objectives do not necessarily go hand-in-hand as an amusing but value-destroying experience in our past illustrates. On that occasion, we had a significant investment in a bank whose management was hell-bent on expansion. (Aren't they all?) When our bank wooed a smaller bank, its owner demanded a stock swap on a basis that valued the acquiree's net worth and earning power at over twice that of the acquirer's. Our management - visibly in heat - quickly capitulated. The owner of the acquiree then insisted on one other condition: "You must promise me," he said in effect, "that once our merger is done and I have become a major shareholder, you'll never again make a deal this dumb."

It is widely known and documented that Berkshire Hathaway boasts one of the best long-term track records among American corporations in increasing shareholder wealth. However, what is not widely known is the fact that during this nearly three decade long period (1964-1992), the total number of shares outstanding has increased by just over 1%! Put differently, the entire gains have come to the same set of shareholders assuming shares have not changed hands and that too by putting virtually nothing extra other than the original investment. Further, the company has not encouraged unwanted speculation by going in for a stock split or bonus issues, as these measures do nothing to improve the intrinsic values. They merely are tools in the hands of mostly dishonest managements who want to lure naïve investors by offering more shares but at a proportionately reduced price, thus leaving the overall equation unchanged.

How is it that Berkshire Hathaway has raked up returns that rank among the best but has needed very little by way of additional equity. The answer lies in the fact that the company has concentrated most of its investments in companies where shareholder returns have greatly exceeded the cost of capital and where the entire need for future growth has been met by internal accruals. Plus, the company has also made sure that it has made purchases at attractive enough prices. Clearly, investors could do themselves a world of good if they adhere to these basic principles and not get caught in companies, which consistently require additional equity for growth or which issue bonuses or stock-splits to artificially shore up the intrinsic value. For as the master says that even a dormant savings account can lead to higher returns if supplied with more money. The idea is to generate more than one can invest for future growth.

http://www.equitymaster.com/detail.asp?date=12/7/2007&story=3

Buffett (1991): Better to look for stable businesses run by competent people (the superstars) available at attractive prices.

Better to look for stable businesses run by competent people (the superstars) available at attractive prices than trying to look out for companies possessing the next revolutionary product or a service.




In his letter in 1991, Warren Buffett explained the difference between a 'business' and a 'franchise'. Continuing with the letter from the same year, let us see what other wisdom he has to offer.

With the kind of fortune that the master has amassed over the years, one could be forgiven for thinking him as rather infallible and the one fully capable of identifying the next big industry or the next big multi-bagger. However, this myth is easily demolished in the master's following comments from the 1991 letter.

"Typically, our most egregious mistakes fall in the omission, rather than the commission, category. That may spare Charlie and me some embarrassment, since you don't see these errors; but their invisibility does not reduce their cost. In this mea culpa, I am not talking about missing out on some company that depends upon an esoteric invention (such as Xerox), high-technology (Apple), or even brilliant merchandising (Wal-Mart). We will never develop the competence to spot such businesses early. Instead I refer to business situations that Charlie and I can understand and that seem clearly attractive - but in which we nevertheless end up sucking our thumbs rather than buying."

There are two things that clearly stand out from the master's above quote. 

• One is his ability to flawlessly identify his circle of competence and
• the second, his objectivity, from which comes his rare trait of accepting one's own mistake and working to eliminate it.

For those investors who believe that big fortune usually comes from identifying the next big thing or the next wave, they must have been surely forced to think again after coming face to face with the master's candid admission that he will never develop the competence to identify say the next 'Microsoft' or 'Pfizer' or how about the next 'Infosys' or the next 'Ranbaxy'. Indeed, outside one's industry of knowledge, it becomes very difficult to identify the next multi-bagger as it is just not high growth potential but a lot of other factors that go into making a highly successful company. In fact, even within one's industry of knowledge, it may prove to be a tough nut to crack.

So, if not the next multi-baggers, then how else can one become a successful long-term investor? The answer could lie in the master's quote from the same letter and given below.

"We continually search for large businesses with understandable, enduring and mouth-watering economics that are run by able and shareholder-oriented managements. This focus doesn't guarantee results: We both have to buy at a sensible price and get business performance from our companies that validate our assessment. But this investment approach - searching for the superstars - offers us our only chance for real success. Charlie and I are simply not smart enough, considering the large sums we work with, to get great results by adroitly buying and selling portions of far-from-great businesses. Nor do we think many others can achieve long-term investment success by flitting from flower to flower."

Thus, in investing as in other walks of life, easy does it. Hence, look around for stable businesses run by competent people and available at attractive prices. Trust us, it is much better than trying to look out for companies possessing the next revolutionary product or a service.

http://www.equitymaster.com/detail.asp?date=11/29/2007&story=3