It has been said often that investing is 50% science and 50% art. Wall Streeters always remind others of the old saying that no one has ever gone broke by selling at a profit. But for Warren Buffett, no one has ever become super-rich either.
Then which philosophy should an investor stand by?
Let's start with Graham's approach. According to his philosophy the key is to sell securities when they have reached their intrinsic value. When the values have been reached, no potential profit can be expected and thus, it's better to go for a new undervalued situation.
But careful! Graham discovered that holding a stock for a long time to see if it achieved its intrinsic value involved a lower estimated annual compounding rate of return.
For instance, you buy stock at $20 with an intrinsic value of $30. If at the end of year one the stock value jumps to $30, the rate of return would be 50%. However, if time goes by and the intrinsic value is not reached, the compounding rate of return begins to drop. In year two it would drop 22.14%; in year three, 14.4% and so on.
He found a solution for this drop in the concept of margin of safety. He considered it was worth buying stock when the market price was significantly below the stock's intrinsic value to be able to have a margin of safety that would provide protection if the intrinsic value was not realized soon. Then, how long should an investor wait? If a long term was foreseen, the margin of safety had to be large. In case a short term was expected, a smaller margin was adequate. For Graham, an adequate period of time was from two to three years. If that period was exceeded, he considered the stock would never reach its intrinsic value and it was better to turn to a new situation.
This approach doesn’t seem very convincing. Charlie Munger and Philip Fisher suggested another solution based on the economic nature of the business.
They held that investing in a good business where management focused on the shareholder's financial gain was an excellent choice. Impressive results would be obtained, even if the investor never sold the business.
Warren began to follow this strategy. He began to do business based on the economic nature approach. He focused on businesses with high ROE and shareholder-oriented management.
However, he never set aside the market price of the stock, as it would dictate whether he should buy or not and let him assess what the ROE could be.
By following the economic nature approach Buffett was able to make some of his best investments. That was the case of the Washington Post and GEICO. Both have given him a compounding ROE of 17% in the last 20 years.
There is still another approach related to the bear and bull markets. It is widely known that investors are victims of the bear market threat. Thinking that the bear market may be around the corner causes panic. Stockbrokers suggest you better turn your assets into cash (and thus, are able to obtain commissions).
This is not strictly so. It is very difficult to foresee whether the market will decline or not. What if you are told that there will be a drop in the market, you end up selling your assets, and a bull market appears? You will answer: Well I have cash and can get the stock back, can't I? Yes, of course you can. But you have to bear in mind that when you sold your assets you paid commissions to your stockbroker, and probably taxes. And the amount of cash left is much lower than the one originally obtained from the sale of stock.
Besides, if you want to rebuy you have to wait till the price is considerably low to make a good deal.
What does Warren think about this situation? About the paralysis investors face when things go wrong? His solution is a very simple one: not to follow the markets swings. Only focus on price.
He considers that the best opportunities may appear in bull or bear markets. The key is neither to panic nor remain aloof until the problem is solved. The other way about: a decline in the markets means that many companies are sold cheap. It's time to pull the trigger. Sooner or later, the situation will get back on track.
I think that now you have an overview of the philosophies that you may or may not follow. If you want high profits, don't hesitate in holding stock for the long term. It is the only way to reach a high compounding rate of return. Definitively, it's Buffett's goal and it didn’t turn out that bad. What do you think?
Then which philosophy should an investor stand by?
Let's start with Graham's approach. According to his philosophy the key is to sell securities when they have reached their intrinsic value. When the values have been reached, no potential profit can be expected and thus, it's better to go for a new undervalued situation.
But careful! Graham discovered that holding a stock for a long time to see if it achieved its intrinsic value involved a lower estimated annual compounding rate of return.
For instance, you buy stock at $20 with an intrinsic value of $30. If at the end of year one the stock value jumps to $30, the rate of return would be 50%. However, if time goes by and the intrinsic value is not reached, the compounding rate of return begins to drop. In year two it would drop 22.14%; in year three, 14.4% and so on.
He found a solution for this drop in the concept of margin of safety. He considered it was worth buying stock when the market price was significantly below the stock's intrinsic value to be able to have a margin of safety that would provide protection if the intrinsic value was not realized soon. Then, how long should an investor wait? If a long term was foreseen, the margin of safety had to be large. In case a short term was expected, a smaller margin was adequate. For Graham, an adequate period of time was from two to three years. If that period was exceeded, he considered the stock would never reach its intrinsic value and it was better to turn to a new situation.
This approach doesn’t seem very convincing. Charlie Munger and Philip Fisher suggested another solution based on the economic nature of the business.
They held that investing in a good business where management focused on the shareholder's financial gain was an excellent choice. Impressive results would be obtained, even if the investor never sold the business.
Warren began to follow this strategy. He began to do business based on the economic nature approach. He focused on businesses with high ROE and shareholder-oriented management.
However, he never set aside the market price of the stock, as it would dictate whether he should buy or not and let him assess what the ROE could be.
By following the economic nature approach Buffett was able to make some of his best investments. That was the case of the Washington Post and GEICO. Both have given him a compounding ROE of 17% in the last 20 years.
There is still another approach related to the bear and bull markets. It is widely known that investors are victims of the bear market threat. Thinking that the bear market may be around the corner causes panic. Stockbrokers suggest you better turn your assets into cash (and thus, are able to obtain commissions).
This is not strictly so. It is very difficult to foresee whether the market will decline or not. What if you are told that there will be a drop in the market, you end up selling your assets, and a bull market appears? You will answer: Well I have cash and can get the stock back, can't I? Yes, of course you can. But you have to bear in mind that when you sold your assets you paid commissions to your stockbroker, and probably taxes. And the amount of cash left is much lower than the one originally obtained from the sale of stock.
Besides, if you want to rebuy you have to wait till the price is considerably low to make a good deal.
What does Warren think about this situation? About the paralysis investors face when things go wrong? His solution is a very simple one: not to follow the markets swings. Only focus on price.
He considers that the best opportunities may appear in bull or bear markets. The key is neither to panic nor remain aloof until the problem is solved. The other way about: a decline in the markets means that many companies are sold cheap. It's time to pull the trigger. Sooner or later, the situation will get back on track.
I think that now you have an overview of the philosophies that you may or may not follow. If you want high profits, don't hesitate in holding stock for the long term. It is the only way to reach a high compounding rate of return. Definitively, it's Buffett's goal and it didn’t turn out that bad. What do you think?
