Lets try to first appreciate the origin of Warren Buffett’s 3 rules of investing.
Warren Buffett learned investment in ‘Columbia Business School’.
In that school Benjamin Graham was the teacher of Warren Buffett.
Those were the days of early 1950’s when Warren Buffett learned investment under Benjamin Graham.
Back then, Warren Buffett was only 21 years of age.
Buffett was young, and in Benjamin Graham he found a perfect investment Guru.
Warren Buffett learnt his top 3 rules of investing from Benjamin Graham in Columbia Business School.
These 3 rules of investing are so powerful that they have power to “transform“.
These rules can transform even a common man into Warren Buffett.
What are the 3 rules of investing practised by the Great Warren Buffett?
Lets see all 3 with simple explanations…
#1. Take right investment decisions…
What should be the driver of ones investment decisions?
At least the market should not drive ones investment decisions, right?
This is a very important precondition.
We all know that the market is volatile. So within a short period of time it can both peak and bottom.
Hence, if investment decision are taken based on market movements, it will only cause mistake and stress.
So what should be the right approach?
Well the answer is easy, do nothing. Surprised?
Ok, but this is better than taking too many panic decisions.
#1.1 Investors are not trader…
Do you know why there are more traders in stock market than investors?
Traders love to be always busy, involved and tensed.
On the other hand, investors are relaxed, focused and always calm.
Look around your work place, you will find many people who like to pose as if they are busy.
I accept, some may even be actually busy.
But by only being busy, serves the bigger purpose. Generally no.
People like to keep doing something or the other all day.
But what’s more important is to be:
- Goal focused, and
- Render efficient work.
A software programmer doing job of an office boy all day is good work? No.
So coming back to our topic, how to take right investment decisions?
First step is, do nothing.
It is not good to invest money all the time. Let your savings accumulate.
Do not keep investing habitually simply because the savings are piling up.
#1.2 Do some maths…
So what must be done when one is doing nothing?
Learn to do stock research. How I do it?
- First: I shortlist good stocks.
- Second: I use my stock analysis worksheet to estimate intrinsic value of screened stocks.
This activity may drain a beginner initially.
But in long-run it will prove to be “the best investment skill you gathered in lifetime”.
Warren Buffett does this all day.
He keeps reading companies financial reports to analyse if their stocks are good buy or not.
#1.3 Do not look only at the price
Low price may not always mean a ‘good buy’.
Combination of strong fundamentals & low price mean a good buy.
But what price is a ‘low price’?
When a stocks market price is less than its ‘intrinsic value’, it said to be undervalued.
Only undervalued stocks can be tagged as low-priced.
But how to know stocks intrinsic value?
This is where Warren Buffett proves to be the master. He knows best how to estimate the intrinsic value of stocks.
#2. Never ignore the intrinsic value…
Again, what should be the driver of the decision related to stock investment?
The decision should be driven by the intrinsic value, period.
But the problem is, most people do not what is intrinsic value and how to estimate it.
They buy and sell stocks without being aware of the stocks intrinsic value.
#2.1 What is intrinsic value?
What we see in price charts is the stock’s “market” value.
More often than not, this is not the stock’s true value. This value is generally very inflated.
This market value of stocks says virtually nothing about the stock.
When we look at price, it only says what we must spend to buy one share of a company.
But it does not say if this price is a “fair price”.
What is fair price?
(Fair price = 2/3 x intrinsic value) > Market Price
The above equation talks about 3 things:
- Buy stocks when its market price is less than its fair price.
- Fair price is 2/3rd of stocks intrinsic value.
What does it mean? Unless we know the intrinsic value, investing is not possible.
When fair price is more than the stocks market price, it is said to be undervalued.
The whole value investing game is based on these two words (quality & undervalued):
Buying quality stocks at undervalued price levels.
#2.2 Fair price formula…
(Fair price = 2/3 x intrinsic value) > Market Price
If the formula is so simple, why people do not follow it?
The difficulty lies in estimating the stocks intrinsic value.
People like Warren Buffett has spend all their life, learning this unique skill.
Today Warren Buffett is the world’s most successful investor only because he knows how to estimate stocks intrinsic value.
But we common men never learnt the skill of intrinsic value estimation.
What makes intrinsic value estimation by common men more difficult is “a combination of the required skills”.
What are the required skills
- Read the financial reports
- Interpret the financial reports
- Convert the interpretation into intrinsic value.
Not many people can read financial reports.
Very few can actually interpret the numbers.
Even fewer know the procedures and formula’s that can estimate intrinsic value of stocks.
It is my wild guess that, probably only 1 in 1,000 in this world can even attempt to estimate intrinsic value of stocks.
#2.3 Think like a business man…
These are many people who know how to read, interpret and convert numbers in intrinsic value.
But even they have a limitation.
Having ability to calculate the intrinsic value based on numbers is good.
But to do it the Warren Buffett’s way, one must also “understand the business”
Yes, Warren Buffett buy stocks of only those companies whose business he/his team can understand.
This is very important.
To estimate the intrinsic value of a company like Warren Buffett, one must:
- Interpret &
- Convert – financial reports and also
- Understand its Business
In fact the point number 4 is so important that, it should be actually point number 1.
Never ignores it while buying stocks.
#3. Understand the business…
Buy stocks as if you are buying the whole business.
Lets read a story:
Suppose you have a small tyre repair shop adjacent to your office.
Would you like to buy it from its owner? Possibly No.
There could be several reasons for the “No”.
But one major reason could be related to the “understanding of this business”.
It is easy to understand the nature of this business, right?
A tyre repair shop mends the flat tyres of automobiles.
People having issues with their tyres approach the shop, their problems gets resolved, and in turn they pay.
What is known here about the business?
- Type of work,
- Cash flow (source of income, expense),
- Skill required,
- Type of customers, etc everything is known.
So should you go ahead and buy this business? At least you know how it is done.
The problem with this business is its future growth prospects.
Our automobiles are quickly shifting to tubeless and more sophisticated tyres.
Compared to our olden days, these days we go to a tyre repair shop less frequently.
A tyre repair shop’s business is understandable, but it has very weak future growth prospects.
So the story ends with a conclusion that you will not buy this business.
What was the idea behind telling this story?
Knowledge/awareness of the business is essential before buying its stocks.
It is the deep understanding of a business that gives investors an edge over other people.
Warren Buffett is so successful because not only he buys good stocks, but the knowledge of his stocks underlying business makes his purchases even more profitable. How?
Lets read another story:
Suppose there are two investor’s Mr. X and Mr. Warren Buffett.
Mr.X is an IIT and IIMA alumni. He also had special training in companies valuation.
Mr. X estimates the intrinsic value of Company called “ABZ Corp.” as $10 Million.
Hence Mr. X offered $6.7 Million to the owner of ABZ Corp for the takeover.
Though Mr.X’s calculation are mathematically correct, but he had little know-how of how ABZ Corp functions.
Warren Buffett had this edge.
He did his research and exactly know how ABZ Corp was running its business.
Being aware of this fact, Warren Buffett estimated the intrinsic value of ABZ Corp as $12 Million.
Hence Buffett offered $8.0 Million to the owner of ABZ Corp for the takeover.
What is your guess, the owner of ABZ Corp will accept whose offer?
Of course, the owner will accept Warren Buffett’s offer, as it is on the higher side ($8.0 million over $6.7 million).
Though, at this moment of time, it may look like that Warren Buffett has overpaid for the ABZ Corp.
But over a period of time this investment will pay Warren Buffett very handsomely.
So the idea is, the more a investor knows about how the business is done, more accurate will be his/her intrinsic value estimation.
Warren Buffett’s 3 rules of investing are simple to understand.
If one can start putting these 3 rules to practice, success is guaranteed.
These are the ultimate 3 rules of stock investing.
These 3 rules has the capacity to change ones thought process about stock investing.
As a result, the investor will start to buy better stocks for great long term returns.
How he/she can buy better stocks?
These are stocks of such companies which are fundamental power houses.
What does it mean?
Consider this, you bought 1,000 stocks of Apple Inc yesterday.
Today for some reason, the stock market closed for next 1 year.
Does these 1,000 stock will becomes a trash? Not at all.
Even if stocks market is closed, the business of Apple Inc is still running.
The company will be driving ‘sales’, and also will make loads of ‘profits’.
What shareholders should be more interest is in companies profits, or stock market operations?
Even if there is no stock market, companies like Apple Inc can still make money for its shareholders in form of dividends alone.
Higher dividends will come from higher profits.
But in order for companies to make higher profits each year, its business fundamentals should be very strong.
Hence investor must learn how to analyse companies fundamentals and estimate its intrinsic value.
The above listed Warren Buffett 3 rules of investing helps stock investors to do just that.
Have a happy investing.