Buying Shares---Basic Principles to Remember
Before you Start
If you do not START to do your home-work and understand what businesses you are investing in, you will Definitely lose your hard earned money. A sure way to gamble your money away is to buy shares without doing your homework.
So, before you start to invest, constantly ask and remind yourself:
Am I investing or speculating or betting or actively trading?
the two keys to investing are:
1. Quality of the business and
2. Valuation of the business
Anything else is speculation.
Thus, I would recommend that you study and adapt from what the two greatest investors in the world say on:
1. What to Buy ----Charlie Munger on his Investment Evaluation Process and
2. At what Price ----Buying Berkshires Shares by Warren Buffett
Warren Buffett’s Basic Rules in Investing:
"Rule No. 1: Never lose money.
Rule No. 2: Never forget Rule No. 1.”
Charlie Munger’s Rules in Investing:
Rule No. 1: Don’t make big financial mistakes.
Rule No. 2: Is the same as the first rule.
Two RISKS (Downsides) you should Avoid:
1. Shun permanent or Huge capital loss ---don’t invest in large gearing (high lleverage) and low profitability Firms
2. Firms that are heading for Suspension in the Market
Two possible ways to Make money in the Stock Market:
1. The way of Timing ---speculation with speculative outcomes
2. The way of Pricing---large discount with larger margin of safety
Two types of MISTAKES according to Charlie Munger:
1) Doing nothing; what Warren calls “sucking my thumb” and
2) Buying with an eyedropper thing we should be buying a lot of.
1. By periodically investing in an index fund that charges minimal fees, for example, the know-nothing investor can actually outperform most investment professionals.
2. But it is given to human beings who work hard at it—who look and sift the world for a mispriced bet — that they can occasionally find one. And the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple.
John Maynard Keynes said:
“As time goes on, I get more and more convinced that the right method in investments is to put fairly large sum into enterprises which one thinks one knows something about and in management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no special reason for special confidence. One’s knowledge and experience is definitely limited and there are seldom more than 2 or 3 enterprises at any time which I personally feel myself entitled to put full confidence”.
Benjamin Graham advocated:
1. All throughout his career, he advocated Diversification but
2. Ironically enough, the aggregate of profits accruing from the SINGLE investment decision, GEICO, far exceeded the sum of ALL the others, realized through 20 years of wide-ranging operations in the partners’ specialized fields, involving much investigation, endless pondering, and countless individual decisions. [p. 533, The Intelligent Investor, Revised Edition, 2003]
Philip Fisher assigned:
1. Significant weight to the quality of the underlying business.
2. Believe that an investor should focus on a relatively small number of stocks if he or she expects to outperform a market.
Charlie Munger Advises:
No matter how wonderful [a business] is, it's not worth an infinite price. We have to have a price that makes sense and gives a margin of safety considering the normal vicissitudes of life.
-CHARLIE MUNGER, BBC INTERVIEW, 2009
The investment game always involves considering both quality and price, and the trick is to get more quality than you pay for in price. It's just that simple.
-CHARLIE MUNGER, DAMN RIGHT, 2000
We've really made the money out of high-quality businesses. In some cases, we bought the whole business. And in some cases, we just bought a big block of stock. But when you analyze what happened, the big money's been made in the high-quality businesses. And most of the other people who've made a lot of money have done so in high-quality businesses.
-CHARLIE MUNGER, USC BUSINESS SCHOOL, 1994
Munger believes the greater the quality of a company, the greater the strength of the wind at your back over the long term.
“I’m happy having 90% of my net worth in Berkshire stock [only one stock]. We’re going to try to compound it at a reasonable rate without taking unreasonable risk or using leverage. If we can’t do this, then that’s just too damn bad.” http://www.fool.com/news/foth/2001/foth010508.htm
“I have more than skepticism regarding the orthodox view that huge diversification is a must for those wise enough so that indexation is not the logical mode for equity investment. I think the orthodox view is grossly mistaken.
In the United States, a person or institution with almost all wealth invested, long term, in just three fine domestic corporations is securely rich.” (http://www.tiff.org/pub/library/Other_Resources/Munger_Speech.html) in October 14, 1998
Warren Buffett Does:
Forbes columnist Mark Hulbert ran some numbers and determined that if you remove Buffett's 15 best decisions from the hundreds of others, his long-term performance would be mediocre in pg 124 of “Warren Buffett speaks.”
Charlie Munger said, “If you look at Berkshire Hathaway and all of its accumulated billions, the top ten insights [10 Stocks] account for most of it. And that's with a very brilliant man. Warren's a lot more able than I am and very disciplined devoting his lifetime to it. I don't mean to say that he's only had ten insights. I'm just saying, that most of the money came from ten insights.” (http://jameslau88.com/charlie_munger_on_art_of_stock_picking.htm)
Equity securities represent a significant portion of our investment portfolio. Strategically, we strive to invest in businesses that possess excellent economics and able and honest management, and we prefer to invest a meaningful amount in each investee. Consequently, equity investments are concentrated in relatively few issuers. At December 31, 2017, approximately 65% of the total fair value of equity securities was concentrated in five issuers. (Berkshire Hathaway 2017 Annual Report, pg 90)
What that says to me is that Warren Buffett lets the compound interest of his 5 to 10 best investments works their magic for him. He holds all these investments for a long, long time:
1997 Buffettology, $20 Billion---pg27
2002 The New Buffettology, $30 Billion---pg1
2008 Interpretation of Financial Statement, $60 Billion—pg101
2014 Forbes $73.7
2018 Forbes $84 Billion
Warren Buffett advised in general against investing in:
• Textile manufacturers
• Producers of raw foodstuffs such as corn and rice
• Steel producers
• Gas and oil companies
• Lumber industry
• Paper manufacturers
• Internet portal companies
• Internet service providers
• Memory-chip manufacturers
• Automobile manufacturers
• Penny Stocks
• IPO (Initial Public Offering)
Leaving the question of price aside, the best business to own is one that, over an extended period, can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite---that is, consistently employ ever-greater amounts of capital at very low rates of return.
-WARREN BUFFETT, 1992 BERKSHIRE SHAREHOLDER LETTER, 1993
Buying a fraction of the Business
When you buy shares, you are buying a fractional amount of the company; never consider yourself as buying scripts or pieces of paper. Thus, you want the company to work for you and to give you a good return in 3 to 5 years’ time. You don’t work for the company by spending your money for a quick return like playing in a casino.
1. Investing is Company works for you to give a good return in 3 to 5 years’ time
2. Speculating is You work for the company for an immediate return like gambling in a casino
Mr Market----Benjamin Graham on the Investor and Market Fluctuations--Chapter 8
1. The Market is there to SERVE you, Not to Guide you.
2. Wait Patiently and Swing (buy or Sell) Only when it is to your advantage
Margin of Safety---Benjamin Graham on Margin of Safety--Chapter 20
“The idea of a margin of safety, a Graham precept, will never be obsolete. The idea of making the market your servant will never be obsolete. The idea of being objective and dispassionate will never be obsolete. So, Graham had a lot of wonderful ideas.”
In the forty-seven years that Warren Buffett has run Berkshire Hathaway, the company’s stock has fallen roughly 40 percent to 50 percent at four different times. We will identify three of those episodes--- 1973–1974 [Arab oil embargo], 1987–1988 [financial crisis], and 2007–2008 [sub-prime crisis]--- and move on to the other perpetrator, the Internet bubble [2000-2001]. (p. 204, Tap Dancing to Work).
“Berkshire, itself, provides some vivid examples of how price randomness in the short term can obscure long-term growth in value. For the last 53 years, the company has built value by reinvesting its earnings and letting compound interest work its magic. Year by year, we have moved forward. Yet Berkshire shares have suffered four truly major dips. Here are the gory details:
March 1973-January 1975
This table offers the strongest argument I can muster against ever using borrowed money to own stocks. There is simply no telling how far stocks can fall in a short period.” [Berkshire Hathaway Annual Report 2017, pg 10]
It should be noted that Warren Buffett has stated the following in regards to the repurchasing of Berkshire Shares:
a) In September 2011, Buffett announced that Berkshire would repurchase its shares at a price of up to 110% of Book Value. [p 185, The essays of Warren Buffett, 3rd edition]
b) Purchases of Berkshire that investors make at a price modestly above the level at which the company would repurchase its shares, however, should produce gains within a reasonable period of time. Berkshire’s directors will only authorize repurchases at a price they believe to be well below intrinsic value. [2014 annual report http://www.berkshirehathaway.com/letters/2014ltr.pdf]
c) In May 1 2016 2:25 AM
Berkshire, says Buffett, would likely buy a lot of stock if the price falls below 1.2 times book value, but it won't "prop up" the price.
Buffett: Anytime you can buy stock for less than its worth it benefits the shareholders, but it has to be by a large margin.. [http://www.cnbc.com/2016/04/30/warren-buffett-in-omaha-for-berkshires-annual-meeting.html ]
d) Common Stock Repurchase Program Berkshire’s
Board of Directors has approved a common stock repurchase program permitting Berkshire to repurchase its Class A and Class B shares at prices no higher than a 20% premium over the book value of the shares. The program allows share repurchases in the open market or through privately negotiated transactions and does not specify a maximum number of shares to be repurchased. There were no share repurchases under the program in 2017. [Berkshire Hathaway 2017 Annual Report, pg 62]
It should also be noted that in the purchases of other company shares, sometimes Warren and Charlie pay 2 to 3 times Book Value:
As, Warren Buffett stated, “It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” and Charlie Munger stated, “A great business at a fair price is superior to a fair business at a great price”
Charlie Munger explains “We realized that some company that was selling at two or three times book value could still be a hell of a bargain because of momentums implicit in its position, sometimes combined with an unusual managerial skill plainly present in some individual or others some system or other.”
Some of their purchases that fit this pattern are: See’s Candies, Coca-Cola, The Washington Post Co, Wells Fargo Bank, Geico, American Express, Capital Cities/ABC Inc and Disneyland.
Many things can go wrong in buying shares. So it vitally important to ask oneself before any purchase, “Is there sufficient Margin of Safety in this buy?”
1. Wait Patiently for the Market to fall drastically to invest in high quality businesses
2. Buy great firms with large Margin of Safety---like 10 to 30% below Book Value (Net Asset Value) or 40 to 50 % below Intrinsic Value [https://www.youtube.com/watch?v=2-nf0_voeQ4 ]
When to Buy:
The standard advice is Buy low and Sell high to make a profit. What this means is that you Buy when others are Fearful and Sell when others are Greedy. Times when you can Buy Low are when the Headlines News are really bad and the economic situations are turbulent and uncertain. People are scared. They panic and they just want to get out of the stock market to go for other types of investments. At such times, you must already have made your decisions and calculations before hand so as to know What to buy and at What price.
Buy the shares that you have decided on and ONLY when ALL the conditions below are satisfied:
1. Buy at Bargain price or Discount --- Why? So as to have some Margin of Safety.
2. Buy Big amount --- Why? It is difficult to find a bargain
3. Buy Long-term for 5 to 10 Years --- Why? To allow for market fluctuations
4. Buy More when market goes down further --- Why? You are Investing, not Speculating
5. Don’t borrow to buy --- Why? To avoid being forced to sell
When all the above conditions are met, allocate (bet) heavily one’s hard earned money in Shares rather than in Fixed Bank Deposit or CD. It is a Mistake if one doesn’t load quickly and big. Why? Such conditions do not come often and wouldn’t last long. Shares snap back quickly and when one isn’t prepared and ready to buy at such times, one misses the opportunity.
S&P 500 Index Fund
But for the unsophisticated investor, Warren Buffett recommended S&P 500 Index Fund as he said in his 2013 Annual report:
“My money, I should add, is where my mouth is: What I advise here is essentially identical to certain instructions I’ve laid out in my will. One bequest provides that cash will be delivered to a trustee for my wife’s benefit. (I have to use cash for individual bequests, because all of my Berkshire shares will be fully distributed to certain philanthropic organizations over the ten years following the closing of my estate.) My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.”
When to Sell:
1. SELL when market prices are significantly overvalued and/or irrationally over-Exuberant.
2. Sell when the P/E ratio is ridiculously high