[#throwback] Investing 101: Introduction to (Value) Investing

This was an article I wrote when I was in university 6 years ago for the investing club (I am getting old…). I have learnt a lot more since then, but the core ideas in the article still stayed true. Some of the examples are outdated:

  • for BHP the mining boom has turned into a bust and is undergoing its mini-revival. The stock price of BHP has stayed flat (it is at $23.67 as of 10/3/17). You would have done better buying their South32 spinoff…at the right price of course (Forager Funds  did a great write-up on it 2 years ago).
  • Warren Buffett has bought IBM, airplane stocks and Apple (another testimony of how much of a learning machine he is!)

So without further ado… here it is!

Investing 101: Introduction to (Value) Investing

During this summer holiday, I got the chance to read “The Essays of Warren Buffett”, edited and compiled by Lawrence Cunningham. The philosophies of Buffett have been thoroughly examined and studied by investors all over the world, largely because of the amount of wealth he acquired. He was the richest person in the world in 2008, the only one who made it through wealth management. He still is considered the greatest investor ever. His record stands at 20.3% compounded annually for over 44 years. Imagine this, if you can emulate his record, $1000 with interest re-invested over the 44 years will be currently worth $3,401,634.15. His arguments are simple, commonsensical and overwhelmingly persuasive. Therefore, I believe that an outline of his philosophies as well as other related subjects will provide a more than adequate introduction to investing.

Warren Buffett was at one time a university student just like the rest of us. Although he had prior investing experience through self study, it was not until his postgraduate years that he formed a concrete opinion about how to invest. He sought his professor and idol, Ben Graham and embraced his view on the market and margin of safety. However, it was not until he met his future partner, Charlie Munger that he became as successful as he is right now. Munger introduced him to the idea of Phil Fisher, that great businesses are the ones worth owning. Prior to this, Buffett stuck to the word definition of value investing and only owned cigar-butt companies (companies which have assets greater than its market value.) After this, his most famed acquisitions of GEICO, Coca Cola, etc ensued.

An essential thing to know before embarking on this journey, (a journey that ALL of you will take because of compulsory superannuation) is the difference between investing and speculating. To take Graham’s definition “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” As simple as the definition sounds, people too often make investments that are actually speculative. I too have done this, much to my shame, even at one stage considering roulette to be an adequate vehicle of investment (it is NOT an investment for weekend warriors aspiring to get money off the casino, though since the casino has a small edge, for the casino, it may be somewhat an investment). The key phrase to note in that definition is “thorough analysis promises…” In establishing this position, let’s move on to his key investment concepts.

Mr Market

One of Graham’s most profound insights which he imparted to Buffett was his view of the market. His analogy of the market as a manic-depressive person who quotes you prices which at times can be absurd compared to its value is golden. Just like when you tend to buy when things are on discount, the same could be said for the 08’s GFC, it was a massive sale for shares.  If you bought BHP during all this, let’s say you bought it at $25/share (its low was $20, but who can pick the bottom of the market), right now you would have nearly doubled your money. (BHP closed at $45.19 on 20/1/11) The trick here is to have a sufficient margin of safety.

Margin of Safety

The concept of margin of safety is a simple one. It basically says “not to purchase a security unless the price being paid is substantially lower than the value being delivered” (Essays of Warren Buffett). In a simple example, you wouldn’t buy a share in a company which only produces film cameras even if it has a price-earnings (P/E) ratio[1] of 3 (this means that based on the current share price, it will take 3 years of the last 12 months earnings per share to recoup the purchase price), because the market is so saturated with digital cameras such that prices keep on decreasing and quality keeps on increasing. In fixed income securities such as bonds, the total value of the company needs to be substantially higher than the amount of debt issued to provide a sufficient margin of safety.

In the previous example, BHP’s P/E ratio was only 8.76.  A P/E ratio of 8.76 for the world’s largest diversified resource group is for the most part unsustainably cheap, especially in times of the resource boom[2]. This was a good indication that the share was undervalued and a significant margin of safety existed.

Margin of safety checks the downside of your investment, for even the best investors will make mistakes. The key is to minimize those mistakes and margin of safety, if applied correctly, will provide a sufficient cushion. While margin of safety largely relies on your subjective appetite for risk, it is still imperative that you apply it when you invest.

Great Businesses

Owning great businesses complements the principle of margin of safety, since having sufficient ‘moats’ increases a business’s value. Why is it that owning a great business is so important? To quote Ben Graham, it is because “in the short run, the market is a voting machine. In the long run, it’s a weighing machine.”This means that the market might ignore good businesses for a while, but it cannot continually ignore it if it keeps on posting strong results year after year. Hence, businesses with substance that has long term characteristics, such as good management and good long term prospects are desirable.

Circle of Competence

Circle of competence means clearly drawing out industries and companies where you can confidently value and sticking to those companies. We need to objectively analyse our own circle of competence, for during university we obtain technical education on all different kind of things. Students doing engineering will have greater technical competence on engineering firm than commerce or medical students, and vice versa. However, since we are young this is the time to actively pursue to enlarging our circles.

Warren Buffett, for all his success does not invest in technology companies for he cannot confidently predict the field in 10 years time. He only sticks to businesses which have simple yet enduring economics, such as insurance, confectionary, beverages, etc. This shows that you don’t need to have a large circle, but the key is to know the boundaries of your circle and sticking to it.

There are a lot of ways to be a successful investor, and I have just lightly touched on one method applied by Warren Buffett. This is just an introduction to an ever expanding subject and you should never stop learning if you want to master investing. If this article interests you, the next logical step is to read Buffett’s letter to shareholders of Berkshire Hathaway.

[1] P/E ratio is a valuation ratio of a company’s current share price compared to its per-share earnings <http://www.investopedia.com/terms/p/price-earningsratio.asp>

[2] The historical P/E ratio for the ASX 200 has been around 12-13.

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