Warren Buffet on Market Fluctuations

It is a pleasure to read Warren Buffet’s letters to his shareholders; these letters contain information about how the company is doing and his ideas about economy and investing principles in general. They are a wealth of knowledge and Buffet is a very witty writer so they make fun reading too.

In his 1997 letter he takes an interesting analogy to explain common investor reaction to market fluctuations and we are going to take a look at that here.

Buffet asks that if you plan to eat hamburgers throughout your life, but are not a hamburger producer then will you hope for higher or lower prices?

Similarly if you are going to buy cars frequently but are not a car manufacturer, will you prefer higher or lower prices?

Most investors will find the answer to the two questions above very easy, they know that they will definitely prefer lower prices.

However this same outlook is somehow not applied, when it comes to investing. Take a look for yourself by answering the next question.

If you are going to be a net saver for the next five years, will you hope for higher or lower stock prices?

Most investors get this one wrong; it is very hard to find an investor who doesn’t get depressed when stock prices go down. Despite the fact that they will be net buyers of securities for many years to come investors get really jittery when stock markets go down. The natural investor reaction is to be depressed when stock prices are depressed and be elated when stock prices are on a high. Even if it means that they are going to buy the same stocks at a higher price now. Or to continue the earlier example, people rejoice when the price of the hamburgers they are going to purchase goes up and get depressed when the price of the hamburgers they are going to purchase goes down.

In times when the markets are down there are plenty of bargains for investors and they shouldn’t panic but instead make long term investments in good companies with solid fundamentals that have performed well and are available at bargain prices.

Penny Stocks

The name penny stock can be somewhat misleading to those who aren't familiar with the stock market. The name tends to express that there isn't very much money involved. This is true because they often trade at less than $5, but they are very high risk investments.

That means you don't have very good odds in your favor of earning any return on them. These types of stocks are best left for those who have money they can afford to lose. Many people do invest in them though because should they get a return on them it is usually quite substantial.

It is very important to understand that the information out there about penny stocks can be manipulated. They are often involved with fraud, false reports, and information that show them to be liquid in nature when they really aren't. There are less shareholders and so there isn't going to be the liquidity with penny stocks as you will find with many other types of investments.

In fact, that is often the case so new investors should steer clear of them. Even those with a great deal of expertise in the market can't predict what will happen with them most of the time. It is important to carefully consider the pros and cons of penny stocks before you move forward with investing in them.

Repo and Reverse Repo

Repurchase agreements are commonly referred to in the market as repos. This type of agreement involves someone owning a security that hasn't yet matured. They can still use that security though as a type of collateral with a lender. They will be able to get the money they need now. They also agree to buy that security back at the cost of it plus interest. The rate of interest is variable and so it will depend on the market at that time.

This same concept is often referred to as a reverse repo when you are talking about the involvement of the entity that offers the funds. These are the lenders who willfully agree to buy them at this time and then resell them for face value plus interest at a later date. The terms are the same but a repo is from the view of the borrower while the reverse repo is from the view of the lender involved in the same transaction.

A repo and reverse repo are often associated with a type of secured loan. They are basically a way to have collateral that the lender can access should the recipient default as to the terms of the loan agreement. It significantly reduces the amount of risk that the lender has to carry. As a result they are often more willing to provide the borrower with the funds that they have requested.

Buffet's words of Wisdom – Three primary causes of terrible returns for investors

Every year Warren Buffet writes a letter to his shareholders in which he discusses the year gone by and his views and opinions about the businesses they are in, economy and investing as a whole. This letter contains pearls of wisdom from the great investor.

In the 2004 letter, Buffet briefly touched upon three primary causes because of which investors make mediocre returns from investing in the stock markets.

Buffet starts by saying that over the past 35 years American business has delivered terrific results and an investor's return from owning the S&P Index would have been 11.2% compounded annually. To put this growth into perspective $100 invested in 1960 would have translated into $4,108 at the end of 35 years at this CAGR.

So all an investor needed to do was to buy the S & P index fund and sit back and enjoy. However this has not been the case and most investors have experiences which are nightmarish.

Buffet attributes the following three reasons for this experience:

1. High Costs. Trading frequently and getting in and out of stocks increase the brokerage costs for investors and eats into their profits. Another reason for high costs is paying excessive amounts for investment management.
   
   
2. Portfolio decisions based on tips. Many investors have the habit of investing into the markets based on tips rather than thoughtful analysis. This leads to buying stocks because of fads and getting into businesses that investors do not really understand. Very often investors do not do any analysis of the profits and revenues of the company and jump into stocks based on tips. These tips fizzle out quickly and turn into losses more frequently than is good for any investor's health.
   
   
3. Start and stop approach to investing. This means not investing consistently and timing an entry or exit into the market which investors usually get wrong.

So investors end up buying stocks long after they have already advanced quite a bit. And in the same manner end up selling stocks long after a decline has already taken place or long period of stagnation has existed.

Buffet cautions that investors should keep in mind that excitement and expenses are enemies of investors and if an investor wants to time the market then they should try to be fearful when others are greedy and greedy only when others are fearful.

Warren Buffet and the fable of Aesop

 In his annual letter to shareholders for the year 2000, Buffet wrote that the principle for valuing an asset for financial gain was established by Aesop in 600 BC and it remains largely unchanged since then. The fabl's moral: a bird in hand is better than two in the bush.

You have to go through Buffet's explanation several times before it starts making sense but once it does it hits you that the thing is absurdly simple and insightful.

A bird in hand is the risk free rate of interest that you would get if you bought government securities. So the returns that you are expecting from your investments should be much more lucrative than the risk free rate of interest that you can earn. And to find out whether it is lucrative enough or not you have to look in the bush and answer these three questions:

1. Are there any birds are in the bush?
2. When will the birds emerge and how many would there be?
3. Put simply would the business ever generate positive cash flows?

When it does generate positive cash flows, would the discounted cash flows be greater than what has been spent in the initial years to be profitable and lucrative?

Buffet stresses upon the fact that ultimately it is the cash generation ability of a business that will decide its true worth. Other factors like P/E Multiple, book value, dividend yield etc. are at best just clues as to how much the business is worth.

I find this particularly interesting because I use P/E multiple quite a bit in deciding whether a stock is selling at a reasonable price or not. However the fallacy is quite obvious, a company which is struggling will have a comparatively lower p/e but that does not make it lucrative. On the other hand a company which has performed sturdily over the years and promises to do the same in the future would have a higher p/e but that doesn't make it expensive either.

Projecting cash flows for a business isn't an easy thing to do however it is not a very difficult thing to do either. What an investor needs according to Buffet is a general understanding of business economics and a sense of independent thinking which can help the investor to reach a ˜well founded positive conclusion".

The projected cash flows should be a range rather than a fixed number so that you get an estimate of the most pessimistic view to the most optimistic. This would help in ironing out any errors in forecasts that may have been made. In industries where technology changes rapidly or in the case of new businesses even getting a range of estimates become difficult and hence Buffet's advise of investing in businesses that an investor understands.

The concepts that Buffet discusses are quite simple and insightful and though it takes some time to digest and go through them, the simplicity and thoughtfulness really makes sense in the end.

Value Investing

The concept of value investing was established by Benjamin Graham and David Dodd who were both Columbia professors. At its core, value investing means buying into securities whose price is lower than their "underlying value". There are various measures to judge the underlying value and primary among them are P/E ratio, price to book ratio, book value, intrinsic value etc.

Value investors look for stocks that are trading at less than what they are actually worth and then buy into such stocks. Typically these situations arise when the market over reacts to a piece of bad news, there is a general down turn in the market or a particular stock gets beaten down more than it deserves and other such situations.

The key, is to understand that valuing a stock is always an inexact science and you need to factor in some margin for error or what has been famously described as Benjamin Graham as margin of safety in whatever price you have given to a security.

Growth Investing

Growth investing is the name given to the kind of investment where the investor buys a stock because the company is in a high growth industry. Such companies are expected to grow at a high rate for the next few years and are generally characterized by a high P/E multiple.

This type of investing became popular in the dotcom era. After the dotcom burst though growth investing ceased to be as sexy as before, but the concept is still widely used by analysts. Typically investments in emerging markets, technology stocks and smaller companies are used as vehicles for growth investing.

What investors need to keep in mind is that the P/E multiple is a means to judge the "price" of a stock and by definition most of the "growth stocks" have high earnings multiples.

Therefore the risk on your investment also becomes that much more. However that doesn't mean that the stocks with high P/E will always be lemons. A lot of investors have made good money on stocks like Apple and Google which typically trade at a higher P/E due to their growth rates. What it means is that if a company doesn't shine as it was promised to; the fall could be quite steep.