Classroom Learning by Teaching Investment Principles Not Finance Formulas
Terry Brown was a student of Dr. Koch in his Investment and Finance Case Studies class at Dalton State College. In May 2022, Mr. Brown is graduating with a degree in Applied Economics and Finance. His LinkedIn profile is: https://www.linkedin.com/in/terry-brown-finance
Warren Buffett Essays
By Terry Brown
By and large, reading The Essays of Warren Buffett for Dr. Koch, Finance Case Studies class has reshaped many of my assumptions about investing that I had formed through my education in traditional academic finance theory. Whereas I was once a strict proponent of Modern Finance Theory, the Efficient Market, beta-analysis, and other tools of the trade, I have now come to realize that, while these tools can prove helpful, they are grossly limited in scope. Indeed, while many finance students are brought up through our universities being spoon-fed academic finance, they are also being stunted in their education by being deprived of any teachings in value investing. Buffett himself, a student of Columbia University, learned how to contextualize and subvert the strictly academic approach. His professors, Benjamin Graham and David Dodd, played an integral role in Buffett’s understanding of the intrinsic value of securities. This book has helped to cement my knowledge of the principles as well. Buffett’s explanations of the “cigar butt” approach, basket-watching, the virtues of volatility, and the trifecta of investing have left a lasting impression on me.
“If you buy a stock at a sufficiently low price, there may be some hiccup… that gives you a chance to unload at a decent profit, even though the long-term performance… may be terrible” (Buffett 119). Buffett then goes on to make the analogy of finding a cigarette butt lying on the ground. You can pick it up, and sure enough, there may be a couple of puffs left, but ultimately you are smoking garbage. The idea that you should not just buy a stock for the sake of making a quick buck is not often addressed in academic finance. We are often encouraged to squeeze every last dollar out of every investment possible. And while the goal is undoubtedly to make the most profit possible, Buffett’s explanation of “cigar butt” investing is more a warning about the inherent risk associated with taking on investments in securities that have very little or no underlying value. Academic finance often lacks this contextualization; where money can be made, it should be made. Many academic texts will tell you that a low-priced security presents negligible risk and should be taken on for whatever profit can be made, but as Buffett explains, “unless you are a liquidator, [it is] foolish… no sooner is one problem solved than another appears,” (Buffett 119). This is the so-called “cockroach theory”—there is never just one cockroach in the kitchen. Buffett explains that these “cigar butt” businesses often take longer to turn around than one might anticipate. First-level thinking indicates that there is a guaranteed profit to be made on these low-priced securities. Still, when one considers the time investment required for many of these businesses to present that profit opportunity, much of it has been eaten away by time-decay. The opportunity cost of having invested in a sounder business, with better fundamentals and more significant earning potential, even at a higher price, is too great to consider only the cigar butts.
Academic finance also preaches the gospel of diversification. Every finance textbook I have ever laid my hands on has had several chapters dedicated to portfolio diversification. The idea is that one can reduce the unsystematic risk associated with a portfolio by taking positions in several different companies or industries with varying correlations to the overall market. While this is great in theory, it dramatically limits profit potential. “Reconfiguring a portfolio… to accommodate the desired beta-risk profile defeats long-term investment success.” (Buffett 14). A more concentrated portfolio, while theoretically riskier, may actually present less risk than initially assumed if the holder of these securities knows them well and manages them skillfully. While traditional academic theory warns against placing all of your eggs in one basket, Buffett quotes Mark Twain in saying that you should actually put all your eggs in one basket, “and watch that basket!” (Buffett 14). This ties into the idea of maintaining investments in your “circle of competence”, one arm of the trifecta of investing. So long as you know your basket of stocks well and you manage them dutifully, the beta-risk variable is less prominent in your evaluation of the genuine portfolio risk. Buffett says that you “may be better off not knowing” (Buffett 93) beta or understanding the efficient markets or modern portfolio theory. Buffett admonishes strict adherents to these academic principles and warns that limiting oneself to making judgments based solely on the mathematical formulas in finance textbooks will ultimately diminish whatever long-term returns may have been possible with a more concentrated portfolio.
Furthermore, by comprising your portfolio with stocks in your circle of competence, that is to say, in industries where you have a particular level of familiarity or expertise, then you give yourself a great advantage in anticipating how these businesses will respond to changing market conditions. You also have greater insight into the day-to-day operations and the business’s actual potential. Additionally, by focusing on a concentrated portfolio, you can reduce the fatigue that would be inevitable as you try to keep up with the latest news on a much broader basket. You can limit your scope to industries that you are familiar with and focus more on what is relevant to that basket. No analyst can be expected to be competent in all areas. No analyst is expected to have an all-encompassing circle of competence. Buffett advises that the “size of the circle is not very important, knowing its boundaries… is vital” (Buffett 93). Much of Buffett’s advice is just as applicable in other areas of life as it is in stock analysis. Here he is touting the virtue of self- awareness. “Know thyself.” While you cannot be an expert in every subject, you can have a comprehensive understanding of many. However, most importantly, you must know your limitations and address them accordingly.
In addition to the principle of using your circle of competence to mitigate risk in opposition to only using diversification to minimize beta-risk, there is the idea that beta-risk is inherently good for the investor. This is the second arm of the trifecta of investing, what Benjamin Graham referred to as “Mr. Market.” This character, Mr. Market, is a personification of the volatility and irregularities associated with a market patronized by a mix of rational and irrational investors. He is described as being temperamental and ever-obliging. He commonly represents investors who make emotional investing decisions based on surface-level data. Investors who react poorly to the twenty-four-hour news cycle also fall under his scope. When investors make these decisions in mass, the market certainly experiences heightened levels of volatility. Consequently, this presents heightened levels of risk. However, Buffett states that “a wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses” (Buffett 76). These are the sorts of opportunities that the value investor should be looking for. In contrast to cigar butt businesses, these are businesses with actual underlying value. These are not businesses for which you would have to wait several years to see a nominal return. Buffett emphasizes that these are “solid” businesses that are irrationally priced. Value investing is all about determining the true value of these businesses and seizing the opportunity to buy them at a discount when the rest of the market is acting erratically. Indeed, “the more manic-depressive Mr. Market is, the greater the opportunities available to the investor” (Buffet 76). Ultimately, sound investing is about finding the right businesses at the right prices. It is about finding businesses with a market price lower than their intrinsic value, thereby achieving a margin of safety for the investment.
The third arm of the trifecta of investing is this margin of safety. Buffett describes it as the “cornerstone of investment success” (Buffett 87). Simply put, the margin of safety represents the dollar-for-dollar profit potential in the difference between the currently listed market price and the intrinsic value of a business. Accordingly, the margin of safety and Mr. Market are inextricably tied. As Mr. Market behaves more erratically, as investors begin making irrational buying and selling decisions, the resulting volatility is much more likely to plummet the market prices of otherwise sound businesses. For an intelligent investor with adequate analytical skills, determining the intrinsic value of these businesses in opposition to the market price may uncover prime opportunities to purchase these securities at a significant discount. Identifying these idiosyncrasies in the market price and intrinsic value becomes all the easier when these businesses fall within your circle of competence. Identifying these opportunities becomes much more commonplace when you know the businesses in your basket well. However, the idea behind value investing is not just to reap every measly dollar available. It is about identifying businesses with real value. Buffett’s argument is that “…if we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying” (Buffett 87). It is important to find opportunities for larger margins in the event that your analysis is wrong. These are not simple arbitrage opportunities but rather the result of irrational mispricing. Therefore, the valuation models implemented on securities subject to the whims of Mr. Market present the risk that Mr. Market will continue to behave irrationally. While you can calculate the intrinsic value of the stock with all available information, the market is comprised of investors who may altogether ignore this information or misinterpret it. This is why having large margins is paramount to success. Eventually, the stock price will return to its intrinsic value, but it is necessary to factor in the time investment that may be necessary. Larger margins ensure that the returns will be adequate to account for the risk undertaken.
Reading this book has been critical to rounding out my education as a finance student. As an aspiring financial analyst, it is of the utmost importance that I digest the teachings of one of the most successful investors in modern history. Warren Buffett’s principles of value investing, in combination with or in defiance of the Chicago School principles, have cemented his legacy as the Oracle of Omaha. Learning analysis from a value investment approach has given me an advantage over students of the traditional academic philosophy as I now know how to analyze financial data in all its contexts and in relation to the impact that the psychology of irrational investors has on the market.
References
“If you buy a stock at a sufficiently low price, there may be some hiccup… that gives you a chance to unload at a decent profit, even though the long-term performance… may be
terrible” (Buffett 119)
“unless you are a liquidator, [it is] foolish… no sooner is one problem solved than another appears,” (Buffett 119)
“Reconfiguring a portfolio… to accommodate the desired beta-risk profile defeats long- term investment success.” (Buffett 14)
“and watch that basket!” (Buffett 14)
Buffett says that you “may be better off not knowing” (Buffett 93)
Buffett advises that the “size of the circle is not very important, knowing its boundaries… is vital” (Buffett 93)
Buffett states that “a wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses” (Buffett 76)
Buffett describes it as the “cornerstone of investment success” (Buffett 87)
Buffett’s argument is that “…if we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying” (Buffett 87)
