This Is What You Need To Know To Be A Successful Investor

May 16, 2018

This Is What You Need To Know To Be A Successful Investor

Warren Buffett has stated that all you need to know for profitable long term investing is in chapters 8 and 20 of Benjamin Graham’s The Intelligent Investor.

Chapter 8 is titled “The Investor and Market Fluctuations,” which is something we are all always intrigued by. The key is to prepare both financially and psychologically for market fluctuations.

Market Fluctuations As A Guide To Investment Decisions – Timing Vs. Pricing

Graham distinguishes between two ways of taking advantage of market fluctuations: you can time the market or you can price it. Timing assumes you predict where the stock market will go next, while pricing makes you look for stocks trading below their fair value. 

Graham is straightforward about market timing and thinks its absurd to think that the general public can ever make money out of market forecasts and technical analysis as the popularity of a market strategy cancels its benefits and long term advantage, if there is any.

Can You Buy Low & Sell High?

We are all attracted by market cycles. Looking at past stock charts makes you wish you sold in 2007 and bought more in 2009, but it all looks easy in hindsight. If we look at the S&P 500 in the last 10 years, one would have been extremely happy if they sold in 2011 especially as the market dropped again soon after and the stock market doubled from the 2009 bottom. However, since 2011, stocks have doubled again and this shows how difficult it is to buy low and sell high.

Figure 1: S&P 500 over the last 10 years. Source: Google.

So, Graham is against making any investment decision by looking at price movements. The only thing one can do is to be prepared for stocks to fluctuate. Graham states how most of our holdings will advance 50% or more from their low point and decline 33% or more from their high point within the next 5 years.

Such huge medium term jumps make at least one thing easy: daily, weekly, or even monthly stock price moves won’t make you any richer or poorer. Further, everyone of us needs significant will not to follow the crowd which is something extremely difficult to do in this market when the S&P 500 is again approaching record highs. If you must do something, Graham suggest rebalancing between bonds and stocks depending on valuation to at least partially counter the crowd.

Business Valuation Vs. Stock Market Valuation

The key to making investing easy is to look at yourself as a silent partner in a private business. In such a case, your returns are completely dependent on the profits of the enterprise where the change in book value and dividends tells you your returns.

I must say that from a personal perspective, all of my past investment successes came when I focused on the business and the underlying earnings. This makes investing so easy as you don’t care much about what’s going on with the stock.

However, given all the entertainment surrounding investing, it’s much more difficult to focus on the business than it is on the price.

Graham discusses how the more a business is doing well, the more risky it becomes as the market is willing to pay whatever premium when things go well.

Figure 2: I know times are different, but AMZN lost 90% after the dot-com bubble. Source: Google.

Graham’s point is that at some point in time, growth stalls and the stock drops which makes great businesses extremely risky.

Graham’s rules for investing are the following:

  • Buy at a maximum of 33% over book value.
  • Buy at a satisfactory ratio of earnings to price.
  • Buy into a financially strong company (low debt).
  • Expect earnings to be maintained over the years.

Buying good businesses at or below book value will allow you to sleep comfortably and forget about market vagaries. What I would add here, something that wasn’t that big of a deal in Graham’s time is goodwill and intangible assets. Please remove those from book value calculations as goodwill just shows by how much the management was willing to overpay for an acquisition.

If you think that it’s impossible to find companies trading close to book value, a company we recently discussed that is trading at 1.09 to book value is Kraft Heinz. Graham discusses how A&P wildly fluctuated in price even though earnings were relatively stable and has two messages for us:

  1. The stock market often goes wrong.
  2. Graham discusses how an investor should not watch a company like a hawk, but give it a good hard look from time to time as companies change over time.

Introducing Mr. Market 

Graham finishes the chapter by discussing Mr. Market as a crazy person that offers you a quote on your stake in a business. Graham’s point is that you own the option to buy or to sell and that you should do that only when it is advantageous to you.

Conclusion – Acquire Businesses At Suitable Prices

Graham’s message is simple:

  • Take advantage of low price levels and high price levels.
  • Buy when you have money, but be careful what you buy.
  • Don’t worry about market fluctuations as you can’t influence them.
  • Avoid buying when the market has extremely high valuations. Look for special situations then.
  • Never buy or sell something due to market moves.
  • Find good management running the business.
  • Be a business owner.

If you can follow the above, you have nothing to worry about.