Because emotions in investing can sometimes run wild, it is crucial to have a framework that guides investment decisions. My investing framework is derived from Warren Buffett’s reply to a question received during one of his shareholder meetings. (Link at the bottom of the post)
Stocks are not pieces of paper but fractional ownership in a business
The first part of my framework deals with how to think rationally about stocks. Stocks represent an ownership in a business, that’s it! There is no need for fancy theories or complicated mathematics. We should approach investing in stocks just the same as investing in a private business. You want to determine what a business is worth (intrinsic value) and pay less for it. The intrinsic value of a business is the sum of all the cash flows you will receive from here to eternity discounted at an “appropriate rate”. You can easily see now how there are two ways to make money in investing: the buy&hold approach and the buy&sell approach. The distinction is not as trivial as it looks. If you are not willing to invest in a business for an indefinite period, you are exposing yourself to market risk. There is no guarantee that the market will offer you a good price to exit. This is why Warren Buffett says he only buys stocks he is willing to own if the stock market would be closed for the next ten years. Buffett is constrained to these kind of business because of his size of assets. I am unfortunately less constrained but recognize the risks of relying on the market to realize my investments.
The market is your servant, not your master
The second part deals with how to rationally behave in the stock market. Benjamin Graham had a nice allegory that describes it best. He suggested to compare the stock market with your manic-depressive business partner called Mr. Market. Mr Market offers you to buy or sell his share in the business you own together with him. Most days he is quite efficient and bids or offers around the intrinsic value of the business but some days he is very pessimistic or overly optimistic. The behaviour of Mr. Market symbolizes the wild fluctuations of the market. A good example of this is the Facebook share price. This time last year, Facebook was trading at 180$, around Christmas it was at 125$ and now it is trading at 180$ again. Surely, the intrinsic value of Facebook did not change that much in a years time.
The concept of Mister Market teaches us that the wild fluctuations in the stock market are just the emotions of our business partner. We should be patient and take advantage of the bargains he will now and then offer us and ignore him the rest of the time. This also means that short term mark to market performance of your portfolio does not mean anything. It is purely driven by the emotion of the market. That’s why it is much better to evaluate your performance based on the performance of the underlying businesses. This is what Warren Buffett calls look-through earnings. Your share of the underlying performance of the businesses in your portfolio.
Incorporate a margin of safety
The margin of safety concept is typically explained as buying securities at a price which is substantially below intrinsic value. This makes an investment more robust to errors. I apply this framework not just in the buying decisions but also in selling decisions and portfolio management. The way I apply the margin of safety principle is a little bit different than most value investors.
Most value investors like a concentrated portfolio. They claim diversification is a cure for ignorance. And they are exactly right. I don’t have the skills nor confidence to ever know the exact future of company. This is even more true nowadays than in the past. Consumer preferences and technologies are changing so fast. The consequence of this is that I will have a well diversified portfolio.
Secondly, most value investors don’t like turnover. I would understand this behavior if intrinsic value and market value would track each other closely. We know this is not the case. Mr. Market offers us not only opportunities to buy but also to sell. When Mr. market becomes very enthusiastic we should sell the shares to him because at the quoted value our margin of safety is not good enough. We can recycle the capital into businesses where the return and margin of safety are to our liking.
This sums up my framework for investing. In my next blog post, I will analyze the first company I will invest in.
Link to the shareholder meeting: https://www.youtube.com/watch?v=5Iq_gkk5CKo. The question asked was about some valuation techniques. At first Buffett describes a few different styles but around 1:30 he start to describe his general framework.
