A few days ago, I wrote an article titled, "The First Question to Ask Before Investing," in which I covered some timeless advice from Charlie Munger:
"It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent."
The takeaway from the article was, that with investing, it is essential not to make stupid decisions and by asking yourself "am I being stupid" before making any trade, you can significantly reduce the chances of you making a serious investing mistake that could cost you years of hard earned savings.
There's another Warren Buffett (Trades, Portfolio) quote that I believe has a similar meaning. This quote comes from a series of lectures given by Buffett to the Notre Dame Faculty in Spring 1991.
"You shouldn’t buy a stock, in my view, for any other reason than the fact that you think it’s selling for less than it’s worth, considering all the factors about the business.
I used to tell the stock exchange people that before a person bought 100 shares of General Motors they should have to write out on a [piece of paper:] “I’m buying 100 shares of General Motors at X” and multiply that by the number of shares “and therefore General Motors is worth more than $32 billion” or whatever it multiplies out to, “because ... [fill in the reasons]” And if they couldn’t answer that question, their order wouldn’t be accepted.
That test should be applied. I should never buy anything unless I can fill out that piece of paper. I may be wrong, but I would know the answer to that. “I’m buying Coca Cola right now, 660 million shares of stock, a little under $50. The whole company costs me about $32 billion dollars.” Before you buy 100 shares of stock at $48 you ought to be able to answer “I’m paying $32 billion today for the Coca Cola Company because...” [Banging the podium for emphasis.] If you can’t answer that question, you shouldn’t buy it. If you can answer that question, and you do it a few times, you’ll make a lot of money."
This advice goes back to to the core of value investing. The idea that a stock is not just a lottery ticket to make money, but a piece of business, with a solid underlying fundamental story.
Buffett's advice, to write out on a piece of paper a purchase order, not just for a few years, but for the whole business, helps reinforce the idea that shares are part of a business, and by buying the stock you are buying part of the business.
Would you buy the whole business at that price?
If the answer is no, then you shouldn't consider the purchase of the stock. Take Netflix (NFLX, Financial), for example. I would not be comfortable owning a business that could be on track to spend $13 billion on content this year but has hardly any cash flow -- that's excluding the group's $20 billion in debt and other liabilities. Above all else, I don't know how it's going to be possible for the firm to meet the gap between spending and obligations.
This is not to say that the company cannot be a success. It is possible that it will eventually dominate the content world. However, I don't know enough to feel comfortable buying it, so I cannot make this judgment.
I mentioned in my previous article that Buffett is well-aware that to be a successful investor he needs to invest inside his comfort zone and not buy businesses he does not understand. This is very much the same principle, and it makes sense to apply it to any investment strategy. If you wouldn't feel comfortable buying the whole business, it does not make sense to buy the stock.
Disclosure: The author owns no stock mentioned.
