God is a Capitalist

Tuesday, March 4, 2014

Buffet's Investing Advice

Fortune magazine recently published an excerpt from Warren Buffet's annual letter to investors in which Buffet offers advice for the average investor. He starts by telling two investing stories:

This tale begins in Nebraska. From 1973 to 1981, the Midwest experienced an explosion in farm prices, caused by a widespread belief that runaway inflation was coming and fueled by the lending policies of small rural banks. Then the bubble burst, bringing price declines of 50% or more that devastated both leveraged farmers and their lenders. Five times as many Iowa and Nebraska banks failed in that bubble's aftermath as in our recent Great Recession.

In 1986, I purchased a 400-acre farm, located 50 miles north of Omaha, from the FDIC. It cost me $280,000, considerably less than what a failed bank had lent against the farm a few years earlier. ...I calculated the normalized return from the farm to then be about 10%.

In 1993, I made another small investment. Larry Silverstein, Salomon's landlord when I was the company's CEO, told me about a New York retail property adjacent to New York University that the Resolution Trust Corp. was selling. Again, a bubble had popped -- this one involving commercial real estate -- and the RTC had been created to dispose of the assets of failed savings institutions whose optimistic lending practices had fueled the folly.
Here, too, the analysis was simple. As had been the case with the farm, the unleveraged current yield from the property was about 10%. But the property had been undermanaged by the RTC, and its income would increase when several vacant stores were leased. 
Buffet used those stories to emphasize a few points about investing:

  • Focus on the future productivity of the asset you are considering. If you don't feel comfortable making a rough estimate of the asset's future earnings, just forget it and move on. 

  • With my two small investments, I thought only of what the properties would produce and cared not at all about their daily valuations. Games are won by players who focus on the playing field -- not by those whose eyes are glued to the scoreboard.
  • When Charlie Munger and I buy stocks -- which we think of as small portions of businesses -- our analysis is very similar to that which we use in buying entire businesses. We first have to decide whether we can sensibly estimate an earnings range for five years out or more. If the answer is yes, we will buy the stock (or business) if it sells at a reasonable price in relation to the bottom boundary of our estimate. If, however, we lack the ability to estimate future earnings -- which is usually the case -- we simply move on to other prospects. 
For investors not willing to put in that kind of work, Buffet advises them to invest in a stock index.
I see one more lesson from Buffet's examples - the importance of buying in a recession. Neither of Buffet's real estate purchases would have returned 10% had he bought them at the prices that they sold for during the boom. In other words, the purchase price determines the yield as much as the productivity of the business.

A lot of people became rich by buying businesses during the Great Depression and holding on to them until the economy turned around. I know of an oil company entrepreneur who refused to borrow and invest during boom times and saved his cash instead. Then when the cyclical oil business collapsed, as it does every few years, he would use his cash to buy failed companies. 

So how does all of this apply to the stock market? The market has periods of bullishness and bearishness, usually tied to the business cycle. Yields are highest during bear markets that follow long bull markets in which valuations become inflated as they did in the real estate markets of Buffet's examples. As Buffet did, investors want to wait for the stock market to bust as it did in 2008, wait longer until it appears to have bottomed and then invest. You'll be guaranteed of excellent yields from those investments regardless of what the market does later. 

 But that means spending a year or two when the market is highly valued refraining from investing and storing up cash. It also means violating one of the most sacred principles of mainstream finance: never try to time the market. But in order to achieve good yields, investors must time the market in the respect that they do most of their buying during bear markets.

Of course, learning as much as one can about the Austrian business-cycle theory would be enormous help.

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