Buffett’s Two Most Important Secrets To Investing

Warren Buffett is currently the fourth-richest person on Earth. He has famously built up his wealth by making shrewd and wise investing decisions through his holding company, the American conglomerate Berkshire Hathaway.

His investing exploits have earned him legions of fans around the world and his famous Berkshire Hathaway Annual Shareholder Meetings, held in Omaha in the USA, have been described as a ‘Woodstock for Capitalists’ after the famous music festival.

His success has naturally led many to chase after his secrets. Scores of books, like the best-selling Buffettology series authored by Mary Buffett and David Clark, have been written to unravel the mystery of his lifetime of successful investing.

But the thing is, Buffett has never shied away from revealing his secrets. This is a snippet of his speech given at the University Of Florida School Of Business in Oct 1998:

There’s a chapter 8 in Ben Graham’s Intelligent Investor about the attitude toward stock market fluctuations. That and the chapter 20 on the margin of safety are the two most important essays ever written on investing as far as I’m concerned.

There it is. Buffett’s secrets to investing contained in two chapters in an investing book that was first published in 1949, more than 64 years ago. What do these chapters reveal?

Chapter 8: The Investor and Market Fluctuations

This chapter is perhaps most famous for introducing the character of Mr Market. Here’s what Ben Graham had to say about it:

Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis.

Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.”

Graham’s genius was in putting in simple terms, how stock market prices can get carried away by euphoric or gloomy extremes in the aggregate psychology of market participants.

As investors, we shouldn’t be scared off by falling prices and nor should we be enticed to invest just because prices keep rising. The overarching idea is to base our investing decisions on the intrinsic value of a business.

Investors taking advantage of extreme fear during the Great Financial Crisis of 2007-2009 could have sat on huge gains of 156% and 147% in local banks like Oversea-Chinese Banking Corporation (SGX: O39) and DBS Group Holdings (SGX: D05) in the four-and-a-half years since the Straits Times Index’s (SGX: ^STI) bottomed at 1,455 points on 10 March 2009.

Those are just some of the many bargains that appeared during the crisis as Mr Market let “his fears run away with him.”

On the other hand, investors who were chasing ever higher stock prices without regard for fundamentals in Blumont Group (SGX: A33) were eventually left to pick up the pieces.

The company had grown by 3,980%, from six cents a share on Aug 2012 to a high of S$2.45 on 30 Sep 2013, in just over a year.

It subsequently lost 94% of its market value in the space of three trading days from 4 Oct 2013 to 8 Oct 2013. Near its peak, Blumont’s shares were valued at 500 times trailing earnings and 60 times book value – an absurd valuation to say the least.

If only punters chasing Blumont Group’s seemingly unending share price ascent had known Graham’s dear friend, Mr Market, prior to its collapse.

To sum up, here’s what Graham has to say in Chapter 8:

”Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal.

At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.”

Chapter 20: “Margin of Safety” as the Central Concept of Investment

Graham opens the chapter with a forceful paragraph:

In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, “This too will pass.” Confronted with a like challenge to distil the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.”

That tells you how much Graham valued the concept of a margin of safety. But what exactly is it? Simply put, it’s the idea of giving ourselves plenty of room for error in our investing activities while still being able to enjoy decent results.

Marine-engineering firm Sembcorp Marine’s (SGX: S51) earnings per share grew by almost 80% from Oct 2007 to June 2013. But in the interim, its shares lost 20% of its value.

The reason? SembCorp Marine was priced for perfection back then with a trailing price-earnings ratio of 37. A lot of things had to go right for its investors to profit; there was no margin of safety.

On the other hand, investors in the Straits Times Index back on 10 March 2009 had room for plenty of error as it was valued at around six times trailing earnings, way below its long-term average of about 16.

Profits could continue falling, or the economy could continue worsening, but there was already a ‘soft-floor’ on the STI’s price. In other words, it had a margin of safety. Investors in the index, through an index-tracker like SPDR STI ETF (SGX: ES3), would have more than doubled their money as the STI eventually rebounded to around 3,200 points today.

Foolish Bottom Line

If we think about it, ignoring market fluctuations and giving ourselves room for error when we invest sounds so simple, that it actually hurts. But as Buffett once said: “Investing is simple, but not easy.”

Psychology plays a very important but often overlooked role in our investing activities. It’s simple to say that we’ll ignore a temporary price collapse. It’s not easy, however, to look at all that red in our brokerage statements and not panic.

But, that’s what we have to do if we want to invest well.

Graham has given us the framework for successful investing for more than 64 years. It’s up to us to use it.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing owns B-Class Shares of Berkshire Hathaway.