If you’re planning a picnic next Saturday, the first thing you would do is check the weather forecast. If the weather forecast for Saturday is mainly sunny and 0% chance of rain, you’d feel comfortable going ahead with your plans.
What if it's now Wednesday morning and the weather forecast for Saturday has changed to variable cloudiness with a 20% probability of rain, what would you do? You'd start to feel a bit uneasy but would probably still keep your plans while keeping your fingers crossed.
Now it's Friday night and the weather forecast for Saturday (gasp) has changed again; now the probability of rain is 80%! You spend a few minutes uttering profanities at the weather channel but eventually, you still need to make a decision.
Do you go for it, and risk having a lousy time, not to mention hearing all the complaints from friends and family or do you wait for a better day? Most people would make the right decision and reschedule their picnic. That’s just common sense based on the high probability of rain.
Somehow, when it comes to investing, many individual investors just don’t use common sense or to be more accurate, don’t understand probabilities when making investment decisions.
Smart investors understand that success in investing comes down to a matter of probabilities; all their investment decisions are made with the probability of success stacked heavily on their side.
That's why legendary value investors like Benjamin Graham, John Templeton and Warren Buffett only invest in companies that have these characteristics:
What if it's now Wednesday morning and the weather forecast for Saturday has changed to variable cloudiness with a 20% probability of rain, what would you do? You'd start to feel a bit uneasy but would probably still keep your plans while keeping your fingers crossed.
Do you go for it, and risk having a lousy time, not to mention hearing all the complaints from friends and family or do you wait for a better day? Most people would make the right decision and reschedule their picnic. That’s just common sense based on the high probability of rain.
Somehow, when it comes to investing, many individual investors just don’t use common sense or to be more accurate, don’t understand probabilities when making investment decisions.
Smart investors understand that success in investing comes down to a matter of probabilities; all their investment decisions are made with the probability of success stacked heavily on their side.
That's why legendary value investors like Benjamin Graham, John Templeton and Warren Buffett only invest in companies that have these characteristics:
- A business they understand very well
- A wide moat (a durable competitive advantage)
- A strong balance sheet with low debt
- A stock price selling at a large discount to their intrinsic value
Companies that have the above characteristics are very likely to do well over time; as their earnings keep rising, their stock price will also go higher rewarding shareholders.
It's obvious that successful investors understand probabilities and this helps them make good investment decisions.
However, to make this point even more clear, let’s invert this. What would it take to have the probabilities stacked against you? The probabilities are not on your side when you invest in a company that has:
It's obvious that successful investors understand probabilities and this helps them make good investment decisions.
However, to make this point even more clear, let’s invert this. What would it take to have the probabilities stacked against you? The probabilities are not on your side when you invest in a company that has:
- A business you know very little about (i.e. you bought the stock because you know someone who made money on the stock).
- No competitive advantage (i.e. you bought the stock because of takeover rumours).
- A weak balance sheet with high debt (i.e. you bought the stock based on technical charts or opinions from the mainstream media).
- An overvalued stock price (i.e. you bought the stock because its price has been hammered recently and you thought you were getting a bargain).
Excellent article, thanks! Buffett shies away from companies that do or have to do R&D, what is reason for this? Granted, there are risks but arent' the payoffs bigger with highly innovative companies? Isn't it difficult for young investors like me, who have affinity with technology companies, to follow Buffett's advice of focusing on (rather unsexy) companies like Coca Cola or Wrigley's? Thanks.
ReplyDeleteGood question. The reason Buffett shies away from companies that do a lot of R&D is because capital must be deployed every year to create new products in order to keep increasing earnings.
ReplyDeleteAs such, he cannot reasonably predict the cash flow these companies will generate over time. Earnings predictibility is very important to him; he wants to know where these companies will be 10 years from now or more. On the other hand, companies like Nike or Coca Cola don't have to spend a lot of money on R&D and just have to keep their brands alive with celebrity/athlete endorsements and advertising.
That being said, Buffett does not advise investors to only focus on unsexy companies like Coca Cola or Wrigley's. Instead, he advises them to focus on companies within their circle of competence, which means companies they understand very well. Buffett just doesn't understand technology companies enough to feel comfortable investing in them, even in his buddy Bill Gates' Microsoft.