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Sunday, February 18, 2007

Pricing value v/s valuing price - Chetan Parikh


In a great book Wall Street on Sale, the author, Timothy P. Vick, writes about the Warren Buffett way.

“To individual investors the world over, Warren Buffett has become the patron saint of due diligence, a man who wrested control of the stock market and proved most known and widely taught financial theories to be ineffectual. Armed with the teachings of Benjamin Graham, he took $100 of his own money, pooled it with $105,000 from family and friends, and over the next 40 years, turned it into a personal fortune of more than $30 billion. Buffett created additional billions in profits for hundreds of investors who entrusted him with their savings. Indeed, no capitalist in this century has figured so prominently in American history as a result of merely trading paper stock certificates. Other great capitalists such as Bill Gates, Sam Walton, and Henry Ford created wealth for society building factories and marketing consumer products. Buffett took what was, for him, the logical next step: He turned the act of passive business ownership into a profit­-making endeavor and an end unto itself.

The enigma that surrounds Buffett he in part has brought on himself, for he shuns publicity and rarely reveals what he buys or sells. But it also partly reflects the public's misunderstanding of his methods and motives. Lesser people have craved more and attained a lot less on Wall Street. Buf­fett seemed to attain more for the sake of showing it was possible. Along the way, his unbelievable track record exploded the popular myth that investing was for crapshooters whose odds of winning were fortuitous at best. Buffett's life story, eccentricities, and string of successes serve as one long mockery of the ticker tape. Yet he has brought integrity to stock pick­ing as no one has. Buffett is among the world's richest people, yet he pays himself a modest $100,000 a year in salary and plans to pass his wealth to charitable trusts after his death. He inhabits the same middle-class home in Omaha, Nebraska, has been known to eat at McDonald's or a local steak­house, plays bridge incessantly, drinks gallons of Cherry Coke each month, and won't waste a shred of paper at his Spartan, understaffed office.

Buffett's life story, eccentricities, and string of successes serve as one long mockery of the ticker tape. Yet he has brought integrity to stock picking as no one has.

In more than four decades of managing money, he's never had a losing year and has defeated the market's returns in all but a handful of years. Dur­ing the 1960s, his investing partnership attained perhaps the best 10-year scorecard of any money manager. He not only beat the returns of major stock indices for 10 consecutive years but by a wide margin. From 1960 to 1969, Buffett posted an annualized return of 28.9 percent for his investors, while the Dow Jones industrial average returned a modest 5.2 percent. An investor who deposited $10,000 in Buffett's limited partnership in 1960 walked away with $126,000 in 1969, when Buffett folded his tent because he could find few stocks trading at reasonable values.

Buffett's longevity and tremendous success stems from four guiding principles: (1) a disdain for losses, (2) his keen ability to keep his trading objective (that is, based on mathematics, not emotion), (3) a honed instinct to recognize undervalued securities, and (4) the recognition that internal growth drives long-term returns. Volumes have been written on Buffett's methods, and hundreds of articles have tried to untangle his synaptic power from infre­quent public quotes. He has left behind, however, a large enough body of material, including two decades of annual reports that he himself wrote, that any investor could pick up his trail and profit handsomely in the market. Buf­fett's variation on Graham can be neatly summed up in 10 points.

1. THE "TAKING STRIKES" CONCEPT

As his legacy to the game of baseball, the Splendid Splinter, Ted Williams, left the world one of the best books ever written by an athlete, The Science of Hitting. Williams's basic thesis was that the strike zone could be carved into minizones that tested, to various degrees, the abilities of both hitter and pitcher. A high and inside strike, for example, tested the batter's weakness against the pitcher's strength. A low and inside pitch might test the batter's strength and the pitcher's weakness. Williams outlined a plan of patience for hitters. They should understand their strengths and limitations and look to drive only those pitches that crossed their strength zones.

Buffett often applies a similar analogy to investing. Following the stock market, he believes, is like standing at the plate and watching thousands of pitches whiz by. Each pitch represents one stock offered at one price at one moment in time. But unlike the batter in the stadium, you are under no obli­gation to lift the bat off your shoulder and swing, for there is no one to judge your trip to the plate. In a 1995 lecture to business students at the University of North Carolina, Buffett briefly outlined this balls-and-strikes concept:

In investments, there's no such thing as a called strike. You can stand there at the plate and the pitcher can throw the ball right down the middle, and if it's General Motors at $47 and you don't know enough to decide on General Motors at $47, you let it go right on by and no one's going to call a strike. The only way you can have a strike is to swing and miss.

Indeed, one of the obvious advantages that you, the individual investor, have over professional money managers is that you are not forced into errors. You are not obligated to beat the S&P 500 this quarter or flip the next hot initial public offering for a profit. You are not responsible for earn­ing a suitable return for thousands of clients, nor is anyone forcing you to dress up your portfolio in advance of an annual report. You don't have to worry about sector rotation, asset allocation, whether Motorola will meet its quarterly earnings targets, or whether you are lagging the performance of competing money managers. Your sole responsibility is to generate a sat­isfactory, long-term return for yourself. Thus, you have the luxury of study­ing 100-plus stocks a month and choosing only one. You can bask in reject­ing Sun Microsystems at $50 and waiting until the shares fall to a reason­able price level before buying. If Sun's stock stays overvalued, you can smile and walk away and focus on any of 10,000 other publicly traded com­panies. You can hang up on brokers month after month until they finally offer a stock you have studied at a decent price. You have the luxury of putting all of your money into bonds—or cash, gold coins, or real estate-­if you cannot find a stock that is attractively priced. Buffett did just that in 1969; he closed his partnership and stayed away from stocks until the mar­ket bottomed in 1974.

The stock market doesn't force you to buy. It just seduces you, as Buf­fett has said. You can walk away from any stock at any price and take com­fort in the fact that you have not risked any cash. But once you discover a stock to your liking, one the market has offered up at a ridiculously low price, swing for the fence. Such opportunities do not come along often and investors should not assume they do. You might be lucky to find 20 golden opportunities throughout your investing lifetime, quality stocks so under­valued they harbor no business risk at all. But dozens of other, slightly less­-attractive opportunities will present themselves, and you should be ready to swing when they arrive.

2. AVOID LOSSES

If you invested all of your assets in fixed-income securities and held them to maturity, you would never suffer a loss. Losses occur when investors take bigger risks hoping for bigger gains. To reduce the chance of losses, you must minimize mistakes. The fewer errors made over your investing career, the better your long-term returns. The advantages you derive from beating the market by a few percentage points a year. Over time, the effects of your success grow immensely due to the power of com­pounding. The same holds true if you can avoid any yearly loss.

When you lose money, even if for as short a time as a year, you greatly erode the terminal value of your portfolio. You consume precious resources that must be replaced. In addition, you waste precious time trying to make up lost ground. Losses also reduce the positive effects of compounding. Consider two portfolios, A and B, both which gain 10 percent a year for 30 years. Portfolio B, however, suffers a 10 percent loss in the fifth year. A $10,000 investment in Portfolio A would return $174,490 by the 30th year. Portfolio B's would return considerably less—only $142,76~because of one poor year (see Figure 1). If Portfolio B sustained two 10 percent losses, say, in the fifth and 15th years, the investor would be left with just$116,810. Avoiding losses, as Buffett strives to do; is paramount to good investing.

FIGURE – 1 The value of avoiding losses.

Investor A*

Investor B**

Year

Yearly Gain

Portfolio

Yearly Gain

Portfolio

0

$10,000

$10,000

1

10%

$11,000

10%

$11,000

2

10%

$12,100

10%

$12,100

3

10%

$13,310

10%

$13,310

4

10%

$14,641

10%

$14,641

5

10%

$16,105

10%

$13,177

10

10%

$25,937

10%

$21,222

15

10%

$41,772

10%

$27,963

20

10%

$67,275

10%

$45,035

25

10%

$108,347

10%

$72,530

30

10%

$174,494

10%

$116,810

How can investors avoid losses? Certainly they can stay above water by selling shares every time a stock threatens to fall below its break-even point. In the long run, however, such a strategy wi11lead to inferior returns because of excessive trading and high commissions. Another way is simply to hold onto the stock until it rallies above your original cost. Such strate­gies are recommended only when you possess confidence in the underlying company. The method I espouse is Benjamin Graham's margin of safety principle: Buy inexpensively to minimize your risk of loss.

3. HOLD A FEW EGGS YOU KNOW WILL HATCH

Collecting stocks for the sake of diversification is foolish to someone like Buffett, who typically owns large stakes in no more than one dozen stocks at anyone time. Investors who keep adding stocks to their portfolios for the sake of protection are in essence practicing a trial-and-error, "Noah's Ark" approach. They may not derive any added benefits beyond having two of everything. Buffett, like many value investors, defines "risk" unlike the textbooks. Academics define risk mathematically, by stock volatility. To them, the sheer act of buying many stocks controls excessive price fluctua­tions. Store up enough stocks from different industries, they argue, and you minimize the possibility that a dreadful decline in one stock will harm your returns. Of course, this method also reduces the effect that a few great stocks have on your returns. The reality is that by holding good, bad, and downright ugly stocks in one nest, what hatches can only be mediocre at best.

Buffett's approach is to concentrate as much money as possible on a handful of undervalued securities and hold them. Figure 2 shows Buf­fett's major holdings since 1977, as revealed by Berkshire Hathaway's annual reports. We can see that over 20 years, Buffett has owned large stakes in several dozen companies, not merely the eight favorite stocks he owned in 1997. On average, he holds each stock for several years, though there have been times when Buffett has sold a large portion, if not all, of his holdings in relatively short order. We can see, too, that Buffett favors cer­tain industries and by inference, shuns others. Consumer products compa­nies have figured prominently in Buffett's portfolio, as have media and publishing companies and ad agencies. From time to time, Buffett has bought large stakes in financial companies-Federal Home Loan Mort­gage, GEICO Insurance, National Student Marketing, PNC Banks, and Wells Fargo-and heavy industries-ALCOA, GATX, Cleveland Cliffs, Exxon, Handy & Harman, Kaiser Aluminum, and R.J. Reynolds. In these instances, Buffett was trying to capitalize on shorter-term industry trends, such as a bottoming of commodities prices or a decline in interest rates.

From Figure 2, we can infer how Buffett diversifies. He focuses Berkshire's portfolio around a small handful of buy-and-hold companies and devotes the rest of the portfolio to companies able to provide shorter-­term (three- to five-year) cyclical gains. To say that Buffett always practices buy-and-hold principles is misleading. While he often may plan to hold a stock forever, circumstances occasionally have prompted Buffett to dump positions, at times more frequently than biographers have portrayed. Take, for example, McDonald's, which Buffett bought in 1996 but sold a year later, or Exxon, purchased in 1984 at around seven times earnings but pre­sumably sold before crude oil prices crashed in early 1986. Buffett pur­chased 772,000 shares of Woolworth in 1979 at a price around six times earnings. He sold the stock before the 1981-1982 recession hit. Later, he publicly swore off retailers. We also can infer that Buffett engages in mar­ket timing. He is most ravenous in poor stock markets, when he loads up on cheap stocks. He listed no fewer than 17 different stock holdings in his1980 annual report. By 1987, when the market reached a state of excessive valuation and subsequently crashed, he listed only three—GEICO, The Washington Post, and Capital Cities/ABC. Rather than plow more money into overvalued stocks, Buffett bought a corporate jet for Berkshire, remarking, "I'd rather buy a good stock than a good jet, but there's nothing that we can see buying even if it went down 10 percent."

4. LOOK FOR "SURE THINGS" TO KEEP YOUR RETURNS POSITIVE

Buffett has made wide use of takeover arbitrage to deliver nearly risk-free returns. In uncertain markets, takeover trades have cushioned him against losses and kept his yearly returns positive. In a takeover arbitrage, an investor buys shares of a company after it has agreed to be acquired and profits from the spread between the market price and the tender-offer price. For example, a company may receive a tender offer for $50 per share, but until the deal settles, its shares may trade for only $46, an 8 percent dis­count. If the deal goes through, you lock in a $4, 8 percent gain. While 8 percent may not sound so hot, the annualized return may be two to three times that, depending on how quickly the companies consummate the transaction. An 8 percent discount, for example, turns into a 36 percent annualized gain if the deal closes in one quarter. String a few of these deals back-to-back and you can counter an otherwise poor year in the market. When playing takeovers, Buffett searches for deals that are almost certain to transpire. If both parties call off their merger or the federal government intervenes to block the transaction, the target company's stock may drop sharply, the major risk an arbitrageur assumes. On occasion, Buffett has scored spectacular success when the stock of the target company soared following the announcement.

5. DON'T LOOK FOR ABSOLUTE VALUES, FOR THEY ARE TOO RARE

The Depression era that profoundly influenced Graham was a faint mem­ory to millions of Americans by the time Buffett was investing full swing. So, too, was World War II. Stability had returned to the American economy and the markets, and the era of the super bargain stocks, ones selling for a P/E of two or for a fraction of their balance sheet cash, had dissolved. Not having seen the full effects of Depression-era market prices, Buffett clung less and less to Graham’s rigid balance-sheet appraisal of companies and leaned more on the writings of Philip Fisher, one of the first to explore the merits of investing in growth companies. After several years of practicing Graham's methods, Buffett rejected what he called Graham's "cigar-butt" approach to investing-picking cheap companies that had one good puff left in them. Buffett never accepted growth methodologies outright, how­ever; too much Graham remained in him. He never let his valuations fall prey to forecasts, nor did he ever rely on a drunken market to validate his investing decisions. To Buffett's great credit, he correctly recognized that growth and value styles were interlocked. "Ben Graham wanted everything to be a quantitative bargain. I want it to be a quantitative bargain in terms of future streams of cash," Buffett said in 1993.3 If a company cannot grow or increase its retained earnings at sufficient rates, it is an unworthy investment to Buffett, no matter how cut-rate the price. It is imperative that companies keep growing to increase intrinsic value. It is equally essential that earnings grow at a rate sufficient to compensate Buf­fett for inflation. This marrying of value and growth investing, premised on a desire to beat inflation and bond returns, is perhaps Buffett's greatest con­tribution to the world of finance.

To Buffett's great credit, he correctly recognized that growth and value styles were interlocked.

Buffett's style continues to blend growth with value, as evident by his purchases in recent years of American Express, Gillette, Wells Fargo Bank, and Coca-Cola. These four buys show he is not afraid to pay a higher PIE ratio for a growth company, as long as the company's long-term earnings offer a degree of certainty. An investor can fall asleep for 15 years, Buffett is wont to say, and awake to find Coca-Cola and Gillette operating in the same lines of business they were before, selling syrup and toiletries. That's how Buffett measures certainty.

6. BUY COMPANIES YOU CAN UNDERSTAND

If you don't know the difference between a router made by Black & Decker and one made by Cisco Systems, sidestep both stocks. When you buy a company whose operations are abstruse, you may as well be sitting in the cockpit of a DC-l 0: You'll land on your feet only if the plane's on autopilot or you're lucky enough to flip the right switches. You may always be tempted to play an exotic, rapidly rising stock in a fast-growing industry, but if you lack even a rudimentary understanding of the company's prod­ucts or services, avoid it, Buffett believes. Your portfolio will not suffer as a result. The sin of regret is never as painful as the sin of investing beyond your ability. Some of the strongest-performing companies in the 1990s were unexciting enterprises in equally ho-hum industries that virtually any­one could have grasped: funeral home operator Service Corp. Interna­tional, drugstore chain Walgreen, discount retailer Home Depot, and motorcycle king Harley-Davidson, to name a few.

I often counsel clients to steer clear of most foreign stocks for this same reason. You should avoid investing overseas unless you understand the eco­nomic, tax, accounting, and political landscapes under which foreign com­panies operate. The less you know about an investment before you buy, the more you are venturing into that perilous territory called gambling. With more than 10,000 publicly traded companies headquartered in the United States, there are few reasons to look past the continental shelf. The United States offers the most diversified roster of companies and industries of any­where, with dozens of niche industries and companies for the picking. Rarely will you find an exceptional foreign stock that offers better appreciation potential than a comparable American stock.

Buffett intentionally shuns many U.S. and foreign companies, namely, those in the technology sector, because of his limited knowledge of the industry. But he has never regretted ignoring the likes of Oracle, Intel, Hewlett-Packard, or Texas Instruments. Asked why he won't buy technol­ogy companies, Buffett told Berkshire Hathaway shareholders in 1998 that he will not try to compete in a field dominated by experts.

The truth is, I don't know [what] Microsoft or Intel will look like in 10 years. And I don't want to play that game where I think the other guy's got an advantage over me. I could spend all my time thinking about technol­ogy for the next year and I'd be the hundredth-of-thousandth-of-the-ten­-thousandth smartest guy in the country looking at these businesses. So that is a seven- or eight-foot bar that I can't clear.

7. LOOK FOR HIGH RETURNS ON EQUITY

I discussed the importance of return on equity (ROE) to a value investor. Buffett obsesses on this standard of performance. On many occasions over the past 20 years, Buffett has stated his preference for com­panies that can generate a minimum 15 percent annual return on equity. By setting such a high hurdle rate, Buffett intentionally limits himself to com­panies experiencing strong and steady earnings growth (recall the link between ROE and earnings growth). A company that pays no dividend and posts consistent ROEs above 15 percent will attain yearly earnings growth in excess of 15 percent. That should translate into long­-term stock-price growth of at least 15 percent a year as well, a rate that far exceeds inflation and bond yields. In calculating ROE, Buffett makes a simple adjustment: He divides yearly operating income (not net income) by shareholder equity. Let's say a company reported $10 million in net income and $15 million in operating income off an equity base of $30 million. Using net income as the numerator, ROE would be 33.3 percent. Using operating income, ROE would be 50 percent. Taking the operating return on equity results in a truer picture of how well management used the capi­tal stock and bond investors provided. Companies can manipulate net income any number of ways by reporting nonrecurring gains or losses.

8. LOOK FOR A MOAT

A business whose products are proprietary, novel, or difficult to replicate by competitors has an impenetrable shield, a "moat" that can allow it to grow unimpeded for years. FlightSafety International, the maker of cockpit simulators, operated without serious competitors for years before Buffett bought the company in 1996. Dairy Queen International, which Buffett bought in 1997, has no coast-to-coast rivals in the soft-serve ice cream business. Walt Disney has no comparable competitors anywhere on earth.

Buffett looks for stocks with defensible franchises, such as Coca-Cola, whose brand name is among the world's most recognized. Coke holds lead­ing market shares in nearly every country in which it sells soft drinks. That the company can increase sales 10 percent to 12 percent a year after 110 years in business is testament to its incredible franchise. Another moat stock Buffett owns is Gillette, whose razor blades and cartridges also hold domi­nant market shares in most countries. "I sleep well knowing that 2 billion men wake up every morning needing to shave," Buffett is fond of saying.

Moats can exist worldwide, like Coca-Cola's, or locally, like your neigh­borhood savings bank or grocery chain. Some of Buffett's best-performing investments have been private businesses, among them See's Candies and the Nebraska Furniture Mart, which hold virtual monopolies in their com­munities. When a business possesses a moat, it has the ability to raise prices without fear of losing market share, a luxury few American businesses have anymore. By contrast, Buffett avoids companies offering commodity like products or services, such as steel manufacturers, automakers, airlines, and retailers. These companies must spend large amounts of their yearly earn­ings upgrading assets or innovating their product lines just to keep pace with other more nimble competitors.

9. DON'T SELL TOO EARLY IF THE COMPANY IS STRONG

If you can picture where a company will be in 15 to 20 years, you can safely count on the enterprise to deliver consistent returns. Because these types of companies are relatively rare, it makes sense to hold onto them once you've bought shares at an attractive price. Buffett made some of his biggest mis­takes when he rushed to take profits and lost sight of the company's longer-­term potential. One of Buffett's first investments was City Service Preferred, which he bought at the tender age of 11 for $38. The stock even­tually rose to $200, but Buffett sold his shares at $40, pocketing what to a child must have seemed like a good profit. In the mid-1960s, Buffett bought 6 percent of Walt Disney's stock for the ridiculously low price of $5 million but sold the entire stake a year later for $6 million. Had he held on, his original investment would have been worth close to $2 billion in 1998.

Virtually every stock you sell will likely trade one day for a lot more money. If you think a company has the potential to sell for much greater values in the future, hoard it like the king's gold. If you are not confident the stock will continue rallying, you should have run from the stock to begin with. Don't own a stock for five minutes if you are not willing to hold it for at least five years.

Virtually every stock you sell will likely trade one day for a lot more money. If you think a company has the potential to sell for much greater values in the future, hoard it like the king's gold.

10. PUT BLINDERS ON AND IGNORE THE MARKET

Here's where Buffett's strategy becomes a hard pill to swallow, because he advocates ignoring daily market movements. He doesn't care whether the Dow Industrials are rallying or declining, or what the latest economic data suggests. He ignores short-term "noise" and assumes that a stock price, over time, will track the company's growth rates. It wouldn't bother Buffett one bit if the stock market closed for two years and he was unable to obtain a quote on any of his businesses. With or without Wall Street, these enter­prises would continue to operate as usual and generate profits that increase their intrinsic value and the value of Buffett's stake. Imagine for a moment that the stock market closed tomorrow. What would be the result? The bro­kerage industry would surely crumble, but not companies. Would General Electric cease to function if no one could trade its shares? Would orders for Intel's microprocessors dry up? Would consumers stop buying Procter & Gamble's detergent? Would Ford have to recall all of its new cars? Of course not. These enterprises probably would go about their business as usual. Rather than operate with an eye toward next quarter's earnings, they could run their plants happily, finally relieved of the pressure to satisfy fund man­agers, arbitrageurs, analysts, and day traders. General Electric, Intel, P&G, and Ford, of course, would still have value. But their value would be based, as it should be, on earnings and cash flow revealed in financial statements, not on whims, rumors, chart patterns, or analysts' mutterings.

SUMMING IT UP IN MR. BUFFETT'S WORDS

Writing in 1987, Warren Buffett said that investors would greatly improve their stock picking if they realized one fact about Wall Street: It exists to serve you, not guide you. Never assume that the prevailing price offered on a company represents a fair price. You are free to ignore every stock that isn't priced to your liking. The passage below, taken from Buffett's annual letter to shareholders, is one of the greatest investing primers ever written.

Whenever Charlie [Berkshire Hathaway director Charlie Munger] and I buy common stocks for Berkshire's insurance companies, we approach the transaction as if we were buying into a private business. We look at the economic prospects of the business, the people in charge of running it, and the price we must pay. We do not have any time or price of sale. Indeed, we are willing to hold a stock indefinitely so long as we expect the business to increase in intrinsic value at a satisfactory rate. When invest­ing, we view ourselves as business analysts-not as market analysts, not as macroeconomic analysts, and not even as security analysts.

Our approach makes an active trading market useful, since it period­ically presents us with mouth-watering opportunities. But by no means is it essential: a prolonged suspension of trading in the securities we hold would not bother us any more than does the lack of daily quotations on World Book or Fechheimer [two companies that Berkshire Hathaway owns]. Eventually, our economic fate will be determined by the economic fate of the business we own, whether our ownership is partial or total.

Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.

Even though the business that the two of you own may have eco­nomic characteristics that are stable, Mr. Market's quotations will be any­thing but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable fac­tors affecting the business. When in that mood, he names a very high buy­-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload his interest on him.

Mr. Market has another endearing characteristic: He doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the bet­ter for you.

But, like Cinderella at the ball, you must heed one warning or every­thing will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are tree to either ignore him or to take advantage of him, but it will be disas­trous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game. As they say in poker, "If you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy."

Ben's Mr. Market allegory may seem out of date in today's investment world, in which most professionals and academicians talk of efficient mar­kets, dynamic hedging and betas. Their interest in such matters is under­standable, since techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising "take two aspirins?"

The value of market esoterica to the consumer of investment advice is a different story. In my opinion, investment success will not be pro­duced by arcane formulae, computer programs or signals flashed by the price behavior of stocks and markets. Rather an investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior 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.

Following Ben's teachings, Charlie and I let our marketable equities tell us by their operating results-not by their daily or even yearly, price quotations-whether our investments are successful. That market may ignore business success for a while, but eventually will confirm it. As Ben said: "In the short run, the market is a voting machine but in the long run it is a weighing machine." The speed at which a business's success is rec­ognized, furthermore, is not that important as long as the company's intrinsic value is increasing at a satisfactory rate. In fact, delayed recog­nition can be an advantage: It may give us the chance to buy more of a good thing at a bargain price.

Sometimes, of course, the market may judge a business to be more valuable than the underlying facts would indicate it is. In such a case, we will sell our holdings. Sometimes, also, we will sell a security that is fairly valued or even undervalued because we require funds for a still more undervalued investment or one we believe we understand better.

We need to emphasize, however, that we do not sell holdings just because they have appreciated or because we have held them for a long time. (Of Wall Street maxims the most foolish may be "You can't go broke taking a profit.") We are quite content to hold any security indefi­nitely, so long as the prospective return on equity capital of the underly­ing business is satisfactory, management is competent and honest, and the market does not over value the business.

In 11 simple paragraphs, Buffett summarized the key elements of success­ful value investing. He boiled down everything that has ever been written about finance and stock-picking-the good, bad, and the downright chi­canery-and condensed it into a few key themes that should lead any investor to success. To briefly restate them:

  1. View yourself as a "business analyst," not as a stock market prog­nosticator. No one has ever foretold the direction of the economy or the stock market with any consistency. Neither will you. If you accept this limitation, you already are well ahead of the game. Hence, any investment decision you make premised on movements in the market or the economy has a higher probability of failure. However, if you narrow your task to that of evaluating businesses, you can't help but score successes in the long run.

  1. Don't be swayed by share-price movements, for they often reflect irrational responses to events. The true measure of success is the rate at which your companies continue to grow. Over the long term, share price follows the growth of the company.

  1. Don't be a price-taker in the stock market. Just because your favorite stock trades for $30 per share doesn't mean the business is worth $30. It may be worth $20; it may be worth $50. You alone must decide whether the offering price is a fair one.

  1. Market participants, on occasion, are patently wrong in assessing the true value of businesses. The prudent investor stands ready to snap up companies thrown out at bargain prices and sell when their value has been grossly overestimated.

  1. Wall Street s mission is to sell you something and to create quantita­tive justifications to induce you to trade. It thrives on maintaining a shroud of secrecy. By positioning investing as a rigorous academic endeavor, the industry tries to hold you hostage to its arcane method­ologies and build a cult of awe around its leading personalities.

  1. No amount of technical or mathematical know-how can substitute for old-fashioned financial-statement analysis. Successful stock investing requires no more than a moderate grounding in mathemat­ics, a working knowledge of basic business principles, a little intu­ition that can be acquired through experience, and the ability to read financial statements-nothing more, nothing less.

  1. Being a value investor sets you apart from, but ahead of the crowd. If everyone subscribed to value investing, few values would exist anymore in the market. The fact that most investors respond irra­tionally to information or fail to value a company before purchasing works to your advantage. From their fickleness, you shall prosper.”