Three Basic Ideas

(Continuing on the wonderful compilation of Warren Buffett's sayings done by Bud Labitan called "The Warren Buffett Business Factors" but unfortunately the link I had recorded is broken.)

Three basic ideas of Intelligent Investing

1. That you should look at stocks as part Ownership of a business,

2. That you should look at market fluctuations in terms of his "Mr. Market" example and make them your friend rather than your enemy by essentially profiting from folly rather than participating in it, and finally,

3. The three most important words in investing are "Margin of safety" - which Ben talked about in his last chapter of "The Intelligent Investor" always building a 15,000 pound bridge if you're going to be driving 10,000 pound trucks across it.

I think those three ideas 100 years from now will still be regarded as the three cornerstones of sound investment. And that's what Ben was all about. He wasn't about brilliant investing. He wasn't about fads or fashion. He was about sound investing. And what's nice is that sound investing can make you very wealthy if you're not in too big a hurry. And it never makes you poor - which is even better. So I think that it comes down to those ideas - although they sound so simple and commonplace that it kind of seems like a waste to go to school and get a Ph.D. in Economics and have it all come back to that. It's a little like spending eight years in divinity school and having somebody tell you that the ten commandments were all that counted. There is a certain natural tendency to overlook anything that simple and important. But those are the important ideas. And they will still be the important ideas 100 years from now. And we will owe them to Ben.

In Berkshire's investments, Charlie and I have employed the principles taught by Dave Dodd and Ben Graham. I think the best book on investing ever written is "The Intelligent Investor" by Ben Graham. Ben wrote "Investment is most intelligent when it is most businesslike." I learned from Ben that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values. Ben identified this "margin of safety" in bargain purchasing as the cornerstone of intelligent investing. He wrote: "Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety." Years after reading that, I still think those are the right three words. And, the failure of investors to heed this simple message caused them staggering losses.

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Smart investing requires 3 basic ideas, the three basic ideas of Intelligent Investing.

Buffett makes it sound so easy and I do agree very much it is very easy but more often than not, it is us, the average investors, that makes investing so very difficult and complicated for ourselves!

1. Investing in the stock market requires one to use the part ownership perspective when one invests in a stock.

Ah, ze Businesslike Investing. Think about it again. This is what's intelligent investing or perhaps I should call it as commonsense investing all about!

Think about it again. Who would be insane to want to own a lousy business? For example, if you see a company's profit margin declining each single quarter, using commonsense thinking, doesn't this decline in profit margin suggests that perhaps intense competition could be eating into the company's profit? Or perhaps the management isn't capable to be delivering profits back to the shareholders? Remember as the minority shareholder or investor, your 'share' of profits is derived from how much the company declares its earnings per share. And worse still, the management is being paid by the company and not you. So if the profit or the profit margin is declining isn't it a sign of a lousy business? What else is there to argue?

Or perhaps let's use the trade receivables issues. Trade receivables is what other people owe to the company. Last nite, I was reading about this listed company called Avangarde, who plans to hire professional debt collectors . That company is in shambles. 140 million is being owed to the company and because of the company's inability to collect its debts, it is said that their fy 2002 net loss totals more than 30 million. Remember this 140 million represents the trade receivables. And when they cannot collect, they have to make provisions and allowances for these doubtful debts. And when the provisions are too big, it simply translates to losses! I do remember some salesman talk, "A sale is not a sale unless the money is collected." Think about it. When you see a company's trade receivables balloons out of proportion, you know very well that there is something deeply very wrong with the company and the management. From an ownership perspective, in such a scenario, would you ever want to go to a business-partnership with someone who cannot collect their sales? And on the extreme side, what if this prospective partner is in cahoots with that trade debtor? What if your partner tells that debtor, "here take these goods, we will settle the issue privately and let my silly partner bear the cost!" How? See how important it is not to discount this issue?

So from a business perspective, would you want to own a struggling lousy business? Or would it make more sense to own an excellent business?

2. Mr.Market. See this blog posting: Warren Buffett Business Factors: Mr.Market

3. Margin of Safety.

One of the better comments I have read about this margin of safety was posted in the Wallstraits forum, which I had compiled it under this blog posting :Ze Compilation

The margin of safety must be sufficient.

I learnt the hard way that the margin of safety can only be sufficient when there are multiple criteria for investment.

An excellent profit margin, an efficient management, stupendous growth potential, a good dividend policy and a low price are individually insufficient to justify an investment decision.

They should all be present to some degree, but more importantly, strength in one area cannot offset weakness in another.

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This was posted under a posting thread themed Investment Mistakes. And I find it so educational (and of course very profitable) to learn from other people's mistakes.

The very key word for me is the second sentence, "individually insufficient" to justify an investment decision.

Take for example, if you see a company reporting some stellar net profit growth. That might trigger us to want to invest in it, right? However, upon our study of the company, what if we note that despite this stellar net profit growth is achieved by what they call the engineering of profits? The company borrows and borrows money to achieve an artificial turnover and net profit growth. Sacrificed in the company's bid to achieved more profits is the net profit margin. The company borrows and borrows to buy more and more machine to churn out more and more sales. However, in order to achieve this more sales, the company has to sell cheaper. Hence the lower margins. Now all this fine and dandy but what if trouble happens? For example, what if there is rise in production costs? Or perhaps would the lower sales induce an intense sales marketing war? Or what if the product runs out of favor? Or what if as they say "Not laku" anymore? How then? What about the millions spend or rather the millions borrowed to engineer this sales growth? And sadly in the end, the investor might be cursing that their margin of safety investment strategy was insufficient and because of this lack of margin of safety, it causes them staggering losses in their rather poor investment.

Let me remind myself this too: The Margin of Safety must be sufficient and it simply cannot be compromised.

Or how about this? Say there is this fantastic company. Excellent profit margins, great profit growth, great balance sheet but the company's management/owners integrity and reputation is questionable. Now if this seemingly wonderful stock sells at a seemingly low price, do you reckon that it is wise to invest in it? Simply put, would you be willing to sacrifice the issue of trust for the sake of being a part owner in this seemingly wonderful business? How? Without trust, can one ever safely ass-u-me that one would be adequately and justly compensated for taking the risk to being a part owner in the business? Is it wise to do so? What if this owners cheats you? Not possible? Not possible that these owners embark on a corporate exercise that only enriches they, themselves and not you, the minority shareholder? How does one evaluate such risk? Or how do you evaluate a crooked company?

So forget this not:

An excellent profit margin, an efficient management, stupendous growth potential, a good dividend policy and a low price are individually insufficient to justify an investment decision.