Investment Lessons from Warren Buffett

Warren Buffett has educated millions of investors around the world for many decades. He has written and spoken extensively—not only about investments but a lot of important aspects about life in general.

This is my attempt to summarise his most important teachings to the investors that I have learned from his letters to the shareholders of Berkshire Hathaway and from other authentic sources.

Invest in index funds

When an investor’s stock-picking ability is constrained due to inadequate time or know-how, such an investor is better off investing in index funds and space out his purchases. In fact, regularly buying index funds will provide more-than-satisfactory results. Mr. Buffett strongly recommends index investing for the common investors.

"By periodically investing in index funds, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when “dumb” money acknowledges its limitations, it ceases to be dumb."

This is the most important lesson a common investor can take from Mr. Buffett. Investing regularly in an index fund is bound to deliver much better returns for the common investor than what will be delivered trying to imitate Warren Buffett. He says, "If you like spending six to eight hours per week working on investments, do it. If you don't, then dollar-cost average into index funds."

Here is my earlier article on index investing.

Valuation is essential

“Price is what you pay; value is what you get”, he often reminds. Investing involves buying something at a price lesser than its value. A sound investment process involves figuring out the value of a business, buying it when it is available at a price much lesser than this value, and milking the returns for many years in the future. Valuation is, therefore, the most essential part of the investment process.

“Long ago, Ben Graham taught me that 'Price is what you pay; value is what you get.' Whether we're talking about socks or stocks, I like buying quality merchandise when it is marked down."

Investment without consideration of value is merely speculation, in which the focus is not on what the asset will produce, but on what the next fellow will pay for it.

What is 'value'?

Unlike what is normally believed by the majority of investors, financial ratios such as Price to Earnings, Price to Book Value, Dividend Yield, etc. do not directly convey whether the stock is overvalued or undervalued. Hence, merely buying a stock with low P/E or P/B will not ensure better results.

Value of any business is, unambiguously, the Net Present Value of all of its future cashflows. The difficult part in valuing a business is not the mathematical equation. It is estimating the future cashflows with reasonable accuracy. Since it is impossible to precisely estimate the future cashflows of any business, the exact value cannot be found—in fact, it does not exist. Instead, you can only predict a broad range of values. Even that too will vary widely between person to person. Mr. Buffett says that the range of values of businesses estimated by himself and Charlie Munger (his partner at Berkshire, and friend) varies greatly, even when both know the same facts about the businesses and have been working together for around 60 years! This holds true also for their own company, Berkshire Hathaway.

Margin of safety, because uncertainty is always there

Since the value of a business cannot be known with any precision, the most important thing an investor can do to minimize the chances of loss and maximize the returns is to ensure a high margin of safety in the purchase price. That means, buy a business only when the price being paid is significantly less compared to the value estimated using conservative assumptions. A good business is not always a good investment—the purchase price matters. Don't try to drive a 9800-pound truck over a bridge that has a capacity of 10,000 pounds.

Mr. Buffett disagrees with the commonly conceived notion that risk and returns go hand in hand. When an investment is made at a high margin of safety, the prospects of returns improve significantly, while at the same time, the risk is reduced. Those who misunderstand volatility as risk, fail to realise this. Risk is not volatility. Rather, it is the probability of loss from an investment.

Mr. Market

Ben Graham, Warren Buffett’s guru and his early employer, taught him this concept which he recognizes as one of the most important learnings of his investment career.

Mr. Buffett teaches that one should consider the stock market as a psychologically disordered person. 'Mr. Market' is highly emotional and suffers from mood swings between manic depression and euphoria. He will come to you every morning and quote prices of the stocks based on his mood on the day. He would be ready to buy from you or sell to you—as per your wish—at the prices quoted by him.

When he is ultra pessimistic, Mr. Market will quote prices that are too low compared to the value of the stocks. The intelligent investor should take advantage of his pessimism by buying stocks from Mr. Market at low prices. On the other hand, when he is over-optimistic, he will quote prices that are unreasonably high compared to the underlying values. On such days, you may benefit by selling to Mr. Market. On all the other days, ignoring Mr. Market is the correct way. And he does not mind being ignored, even for very long durations! The intelligent investor understands that he has to take advantage of the irrationality of Mr. Market and never be guided by him.

Mr. Buffett has repeatedly suggested that you must not allow the emotions of the market forces to take over your rationality. He stays away from buying anything when the market is highly bullish. It is during such times when the biggest mistakes are made.

“Only when the tide goes out do you discover who's been swimming naked."

Circle of competence - know what you don't know

Estimating value of a business is an essential part of the investment process. However, it requires that the investor should be able to forecast the future cashflows of the business—not exact, but a broad range of it. Mr. Buffett has repeatedly conveyed his inability to understand some businesses and industries and stays away from them as he cannot predict their future cashflows with any certainty. He humbly acknowledges his intellectual shortcoming being the reason in some cases, whereas in other cases, identifies the complex nature of the industries as the reason for the same.

He strictly avoids investments in businesses he does not understand. He famously stayed away from Google and Amazon, and does not mind missing those opportunities.

"You only have to do a very few things right in your life so long as you don't do too many things wrong."

Mr. Buffett’s methods were highly criticised and even laughed at during the dot-com boom in the late 1990s. He stayed away from tech companies when many investors were doubling their money every few days. When the bubble did finally burst, he was proven right, like so many other times in his very long investment career.

Contrarianism—don't follow or defy the crowds blindly

Because you are going to be buying vegetables for all your life, you will obviously benefit if the price of the vegetables fall—assuming you are not a farmer. In the same way, if you are going to be a net buyer of stocks, falling prices of stocks benefit you. The most common cause of low prices is pessimism—sometimes universal, sometimes specific to a company or an industry. The investor should want to buy stocks during such times because of the prices the pessimism produces. It is optimism that is the enemy of the rational buyer.

“We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”

That does not mean, however, that a stock is an intelligent purchase only because it is unpopular. A contrarian approach is as much foolish as a follow-the-crowd strategy if applied mindlessly. The investor must be able to broadly estimate the value of a business and buy if it is available at a price much lower than such value. He emphasises, "You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right."

Which companies to invest in?

Mr. Buffett predominantly invests in businesses that provide high return on capital employed (RoCE) and are easily understandable. The business must have long durability, which means, there must be a high probability that the business will keep earning high returns on capital for many many years in the future. If ‘Company A’ earns Rs. 25 on the investment of Rs. 100 and ‘Company B’ earns the same amount on the investment of Rs. 200, ‘Company A’ is the superior business - provided it is expected to continue such a performance in the long run. Further, the business must be run by competent and honest people (how to find out competence and honesty of the management is a vast topic in itself).

He prefers purchasing such businesses when they are available for reasonable, if not cheap, price. In other words, he buys only when he is sure that the value of the business is much higher then the price being paid.

Obviously, the businesses that fulfil such criteria are very rare, and therefore, one cannot diversify greatly. Therefore, there are so many years when Mr. Buffett makes no new investments. He has drawn blanks in many years. Berkshire’s portfolio contains comparatively small numbers of stocks, especially considering the huge sum being managed. Mr. Buffett does not believe in buying poor businesses just to achieve diversification.

“If the choice is between a questionable business at a comfortable price or a comfortable business at a questionable price, we much prefer the latter. What really gets our attention, however, is a comfortable business at a comfortable price."

And he never compromises when it comes to quality of the people running the business: “We do not wish to join with managers who lack admirable qualities, no matter how attractive the prospects of their business. We’ve never succeeded in making a good deal with a bad person.”

When he examines the quality of a business, he stays away from mere promise of future performance. No matter how strong is the potential, he only considers businesses with a proven track record of strong earnings. No matter how smart the management, some businesses are fundamentally weak and cannot be cured with any amount of managerial brilliance.

“When a management with a reputation of brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact."

Don't sell you crown jewels

He recommends investing strictly for the long-term. You can never predict the market behaviour in the short term; however in the long-term, price will always follow the value. Quoting Ben Graham he says, "In the short-run, the market is a voting machine - reflecting a voter-registration test that requires only money, not intelligence or emotional stability - but in the long-run, the market is a weighing machine.

Because opportunities of investing in businesses of exceptional quality are rare, it is not possible to make hundreds of smart decisions every year. Settling for one good investment a year - on average - is adequate to achieve extraordinary results. When a great opportunity comes, he invests giant amounts.

"Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble."

Since great opportunities are rare, it is foolish to sell stocks of businesses that are both exceptional and understandable. Mr. Buffett rejects the idea of booking profits.

Berkshire has been invested in some exceptional businesses for several decades. Most notable of these are Geico and Coca Cola. Since finding great businesses and outstanding managers is so difficult, why should we sell our proven crown jewels?

But when you realise that you are stuck with a poor business, do not hesitate to exit: "The most important thing to do if you find yourself in a hole is to stop digging."

To finish first, you must first finish - avoid debt

Mr. Buffet prefers avoiding debt. He acknowledges that the use of a small amount of leverage would increase the returns for the shareholders of Berkshire without increasing the risk very significantly. However, he prioritises survival even in the worst case scenario. There are quite a few examples of great businesses gone bankrupt when some unforeseeable destructive event (‘black swan’) occurs, such as the financial crisis of 2008. Mr. Buffett is happily willing to forgo the returns of a few percentage points to ensure that Berkshire can survive even during the once-in-multiple-generations crisis.

"A small chance of distress or disgrace cannot, in our view, be offset by a large chance of extra returns."

In addition to avoiding debt, he maintains huge cash reserves to ensure service to his insurance customers during the worst of the times as well as to take advantage of ultra-low prices prevailing during the difficult times. The absence of debt and availability of cash reserves enables an investor financially and emotionally to take advantage of the prices when everyone is in the selling mood during a financial chaos.

"Over the years a large number of very smart people have learned the hard way that a long string of impressive numbers multiplied by a single zero always equals zero."

Apart from investment, his thoughts on varied topics like management, honesty, frugality, happiness, work ethics, charity, etc. are highly influential. I hope to write more in the future. Thanks for reading!

In the book The Essays of Warren Buffett by Lawrence A. Cunningham has topic-wise collated the letters of Warren Buffett.