Warren Buffett
How do you achieve excellence in any area within a short period of time? The key is through modeling. Modeling is the technique of fi nding role models who are the best in their fi eld and then studying and distilling the mental models and strategies that make them the best in what they do. By learning and applying their strategies, you will be able to produce the same phenomenal results they do, or maybe even better. While the role model may have taken thirty years of trial and error to fi nd the winning formula and perfect his strategy, you will be able to shorten your learning curve considerably by replicating his winning patterns.
In fact, if you study the most successful people in history, they all employed the power of modeling. They believed in standing
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my investments. Many others have done the same. Using Buffett’s investing methodology, Curtis Montgomery who runs an investing education website called wallstraits.com has managed to achieve a 20% annual rate of return since 2000! On www.wallstraits.com, he displays his winning portfolio to anyone who registers as a member.
How did Warren develop his genius? Was he just born with the talent for picking stocks? No. In fact, he developed his phenomenal abilities at a very young age by modeling two geniuses of the stock-investing world at the time. They were Benjamin Graham (the father of value investing) and Philip Fisher (the father of growth investing).
At the age of 19, Warren Buffett read Benjamin Graham’s groundbreaking book ‘The Intelligent Investor’. It was here that Buffett fi rst learnt that it was impossible to consistently predict trends in stock prices (which goes against what most fi nance books and professionals teach and advocate... even till today). While fi nance academics taught that the market was rational and effi cient (even up till today), Benjamin Graham taught that the stock market was irrationally driven by fear and greed and always tended to overvalue a company’s stock when there was good news and undervalue a company’s stock when there was bad news.
He developed a systematic way to determine a stock’s true intrinsic value and taught that by buying a stock when it was undervalued, the investor could make a huge profi t when the market eventually overvalued the stock. Buffett was inspired by what he read and began applying all the principles taught, and that was how he fi rst started making huge returns in the stock market.
He further modeled Graham by becoming his student at Columbia College and by later joining Graham’s fi rm as a stock analyst. In a few years, Buffett eventually surpassed Graham in his stock picking abilities.
While Graham only taught investors to buy cheap, undervalued stocks, another genius investor named Philip Fisher developed a new approach known as growth investing. Besides just looking for cheap companies, Fisher taught people how to identify strong businesses that would grow their profi ts into the future.
Warren started modeling Fisher’s techniques by reading his book ‘Common Stock and Uncommon Profi ts’. By combining the ideas of both geniuses and further refi ning them, Buffett has
become the most powerful investor in the world! So what stops you from modeling Buffett and becoming a powerful investor?
Absolutely nothing.
If you learn and use the same recipe, you are going to produce the same cake. So, let’s get started! Before modeling someone’s strategies and techniques, it is fi rst important to understand and model the person’s beliefs. A person’s beliefs is what drives their decision-making patterns and the actions they take. The reason why Buffett is able to make more money than any other investor in the world is because he has very different beliefs about how stock markets acts and how to buy stocks. If you want to model his success, the fi rst thing to do is to adopt his beliefs!
Beliefs & Behavior of the Average Investor
1. The market is rational. Stock prices refl ect the value of the company stock.
2. I must predict the market’s next move to make returns. If I can’t predict the market, there is someone else who can.
3. I must take big risks to make big returns
4. I should diversify funds into many small-holdings to reduce risk.
5. Buy when price is rising (good news) and sell when price is falling (bad news). Focus on the short term.
6. Tends to make decisions based on emotions. Buys motivated by prospects of immediate/big profi ts (greed) and sells based on fear of loss when prices fall.
Beliefs & Behavior of Warren Buffett
1. The market is irrational – it is driven by fear and greed such that prices do not refl ect the true value of stocks in the short term.
2. The ability to make predictions has nothing to do with investing success. No one can predict the market consistently.
3. When you understand the business behind the stock, you can make huge returns with little risk.
4. Identify a few great companies and make substantial investments in these companies.
5. Buy great companies when price is falling (bad news) and sell when price is rising (good news).
Long-term value focused.
6. Make decisions based on strict criteria. Buy stocks when undervalued and sell when overvalued.
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The Market is Irrational. Stock Prices Do Not Always Refl ect the True Value of a Company
All fi nance textbooks and courses teach us that the market is rational and effi cient (That’s what taught me in school) and that stock prices accurately incorporate all available information. As a result, most investors believe that stock prices refl ect the true value of a stock and that it is impossible to beat the market unless you have insider information or special tips.
Master investors like Warren Buffett believe that in the short-term, the market, which is made up of millions of buyers and sellers, is irrational. Stock prices are driven by the demand and supply of a stock, which in turn is driven by the emotions of greed and fear. When there is bad news (e.g. high oil prices, threat of war, recession etc...), fear makes the market over-react and causes stock prices to plunge below their true value. At the same time, when there is good news (e.g.
company reports higher profi ts, low interest rates and high economic growth), optimism and greed causes the market to overreact and this sends stock prices rocketing above their intrinsic value.
Warren believes that the irrational pricing of stocks gives him the perfect opportunity to make money. By knowing the true value of a company’s stock, he buys when the market undervalues the stock because of bad news and sells when the market fi nally recovers or overvalues the stock because of good news. Buffett never uses insider tips – he believes that the greatest source of information is a company’s annual report, because it will tell you the true worth of the company.
Predicting the Market’s Next Move has Nothing to Do with Investing Success Most people believe that you must predict the market’s next move in order to make profi ts. They believe that good investors are those that can accurately predict whether stock prices will go up or down the next day. This is driven by the fact that most investment newsletters, news and reports focus on making stock market predictions (e.g. the Market will rally up to September and hit 10,800 points). And the average person believes that if they cannot predict the stock market, then there are gurus who can.
The truth is that it is impossible to consistently predict the way the market will move. Hundreds of events in the world like oil prices, war, terrorism, economic downturns/upturns and political developments (eg. Death of a Prime Minister), drive prices up and down randomly everyday. Most predictions by so-called experts are usually wrong, but a lucky guess once in a while will keep people believing that the market can be predicted.
Master investors like Buffett believe that they cannot predict the market’s short-term ups and downs so they don’t bother to do so. Instead, by understanding and analyzing a company’s business fundamentals, he can predict with certainty that a particular company’s profi ts and stock value will increase overtime and that the stock price will eventually rise to refl ect the true value or even beyond its true value when the market picks up.
For example, Buffett bought Nike’s stock because after analyzing the company’s business model, he could predict with certainty that its earnings (in green) would continue to increase over time. As a result, although its stock price moved up and down randomly in the short-term (from random good and bad news), it increased together with the earnings and the value of the company over time.
The stock price moves randomly up and down in the short-term.
However, it increases together with the company’s earnings in the long-term
Belief #1
Belief #2
Source: www.corporateinformatiom.com
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I Can Make High Returns at Minimal Risk
All fi nance courses, investment textbooks and experts teach the general public that they must take high risks to make high returns.
As a result, most people believe that you must be a risk taker to succeed in the markets.
The truth is that master investors like Warren Buffett do not believe in taking big risks. In fact, Warren believes in capital preservation. Recall that his fi rst rule of investing is; ‘never lose money’. As mentioned earlier, risk depends on your level of competence. When you know little about what you are investing in, stocks are extremely risky. Because Warren will put his money only into investments which he fully understands and that have a very high probability of success, there is little or no risk.
It is Better to Concentrate My Funds in a Few Great Companies
Again, the general belief most people have and what most fi nance experts’ advise is to diversify one’s money into hundreds of stocks, bonds & funds spread over different countries. The belief is that by spreading your money everywhere, you reduce your risk.
However, master investors believe that broad diversifi cation is only for investors to protect themselves against their own ignorance. When you don’t know what you are doing, of course it makes sense to put your money everywhere so that you have a lower chance of losing it all. The problem is that when you diversify into too many stocks, it is impossible to understand any single investment well enough to make good decisions. While broad diversifi cation reduces risk, it also reduces your chances of high returns.
Warren believes in identifying and focusing only on a few great companies and taking huge positions in them. By focusing only on companies that he understands (within his circle of competence) and can analyze thoroughly, he is able to generate the highest returns from these companies.
Buy a Great Company’s Stock When the Price is Falling
and Sell When the Price is Rising
Most people who make up the stock market (including professionals on Wall Street) are short-term price focused. They believe in buying a stock when its price is rising as a result of good news and selling it when its price is falling as a result of bad news. While this form of trading, known as momentum trading, can certainly make money, luck and entry timing are crucial. Unless you are staring at the stock monitor for nine hours a day, you will usually enter too late or exit too early.
Master investors like Warren take a selective contrarians’ view instead. They believe in buying great companies when the price is falling because of bad news and selling when the price is rising because of good news. This way, he buys companies that are highly undervalued and sells them when they are overvalued.
Make Decisions Based On Strict Criteria, Never On Emotions
Most people allow their emotions to drive their investment decisions.
When they see stock prices rising and other people making money, their greed drives them to buy, usually at an overvalued price. At the same time, when they see prices falling because of bad news, their fear causes them to panic and they stampede to sell at a low price, thus ending up in a loss situation.
Master investors like Warren Buffett never let their decisions be driven by emotions or what other people are doing. Master investors always follow strict criteria for buying and selling companies and stick to their criteria, no matter what. In the next part of this chapter, you will learn the 8 criteria that master investors use.
Caution: Be aware that the above-mentioned strategy is only used under two factors. First, the company must be fi nancially strong with a high certainty of earning higher future profi ts. Second, the bad news that drives the price down must be temporary and must not affect the company’s long-term ability to make profi ts. Examples of bad news that depress a company’s stock temporarily are war, recessions, rumors or stupid mistakes made by the management that are recoverable.
Belief #3
Belief #4
Belief #5
Belief #6
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Important:Once again, it is very important to remember that you should only buy a stock when the bad news that hits the company is only temporary and will not affect its long term growth and profi tability. If the bad news may cause permanent damage to the company’s profi ts, (e.g. costs of raw materials spiral up, profi t margins drop because of intense competition) then it is a poor investment and the stock’s value will probably never recover.
Now you know why most people lose money in the stock market? It’s because most people’s fundamental beliefs with regards to investing are totally different from those of master investors. In other words, we have all been brainwashed to become poor investors.