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Robert Stephens, CFA
Robert Stephens, CFA
Articles (419) 

Warren Buffett: Use Fundamentals, Not Formulas, When Investing

Relying on facts and figures may lead to an efficient capital allocation

January 20, 2021 | About:

The stock market's 70% surge since March 2020 has prompted various forecasts that seek to call the "top" of the market. For example, since the global market capitalization of all listed companies reached 120% of world GDP recently, some market analysts condier this to be a "sell" signal that suggests stock prices are now vastly overvalued.

In my opinion, it is impossible to successfully determine when the stock market will rise or fall. There an infinite number of variables that can impact its performance over the short run. A better idea is to focus on specific companies and determine whether they offer good value for the money on a long-term basis.

Seeking to predict market movements

A tendency to try and predict the stock market's future performance is not limited to bull markets. For example, investors used a variety of formulas and data to try and justify when the stock market would reach its "bottom" in the February 2020 market crash.

As well as being susceptible to investor biases, the range of factors that can affect the stock market means that a single formula or algorithm is very unlikely to be consistently accurate.

Some factors that could have an impact are fiscal and monetary policy action (or inaction). Meanwhile, the ongoing Covid-19 pandemic could yet have further effects on stock prices.

Accurate predictions in any of these areas are unlikely to be achieved on a consistent basis. Therefore, it may be prudent for value investors to instead focus on company fundamentals rather than where the stock market in general may be headed.

Using a fundamental-led approach to allocating capital

As well as the difficulties in predicting the future performance of the stock market, not all shares will trade in line with the index. For instance, some large-cap tech stocks have significantly outperformed the S&P 500 in the current bull market. However, other companies still trade at prices that may undervalue their long-term financial prospects.

Therefore, in my opinion, it is logical to focus on company fundamentals. They can provide guidance as to whether a specific stock is a quality company trading at a fair price. Should it offer a margin of safety, it could represent an efficient allocation of capital on a long-term basis – no matter how the wider stock market performs in the short run.

This viewpoint was succinctly described by Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) chairman Warren Buffett (Trades, Portfolio):

"In my opinion, investment success will not be produced by arcane formulae, computer programs or signals flashed by the price behaviour of stocks and markets. Rather an investor will succeed by coupling good business judgement with an ability to insulate his thoughts and behaviour from the super-contagious emotions that swirl about the marketplace. In my own efforts to stay insulated, I have found it highly useful to keep Ben's Mr Market concept firmly in mind."

Undoubtedly, it is difficult to ignore other investors when they are adamant that the stock market will rise or fall in future. However, using company fundamentals is a means of relying on facts and figures instead of flawed predictions. This could make it easier to become less reliant on potential biases other investors may have, as well as the emotions that can run high in bull markets and bear markets alike.

Disclosure: The author has no position in any stocks mentioned.

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