It's no secret that the key to Warren Buffett (Trades, Portfolio)'s success has been buying assets for less than they are worth. "Buy low, sell high" is probably the most commonly used adage in the investing book. But what does that actually mean? Why would someone want to sell something for less than it is worth? Surely the answer cannot simply be chalked up to stupidity - it's a dangerous thing to assume that you are smarter than all other investors. At the 1997 Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) annual shareholder meeting, Buffett explained how these sorts of bargains arise.
A friend who is sometimes depressed and sometimes manic
Where does Buffett find these bargains? He doesn't pay attention to day-to-day price fluctuations and goes looking for his best friend, Mr Market:
"It doesn't make any difference to us whether the volatility of the stock market averages 0.5% a day or 5% a day - in fact, we would make a lot of money if volatility were higher, because it would create more mistakes in the market. So volatility is a huge plus to the real investor. Ben Graham used an example of 'Mr Market' - imagine you bought stock in a business where you had this obliging partner who comes around every day and offers you a price at which you'd either buy or sell...It's a big advantage if your partner is a manic-depressive - the crazier he is, the more money you make!"
Buffett's point is that rather than fearing wild price swings, value investors should embrace them. The more volatility that Mr. Market serves up, the more opportunities there are for undervalued assets to be bought up.
The reason why this happens is because psychology, rather than economics, is the deciding factor in market valuation (in the short term). It's why one day an energy company can trade for $20 a share, and the next it can be trading at $10 just off the back of a rumor about an OPEC deal falling through. The best investors are able to see through the noise and keep their eye on the long-term prospects for their portfolio.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Charlie Munger: The Best Investors View Stocks Like Their Own Businesses​
- Why Did Warren Buffett Move on From 'Cigar Butt' Investing?
- Howard Marks Explains Why Investors Need to Pay Attention to Market Value
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