An Essential Buffett 2 Step Strategy (Part 2)

Let’s continue from where we left off from Part 1… Determine the Value of the Business.

Let me ask you, when you normally shop for something, be it bag, shoes, groceries…. a rational you will most likely buy them when they are on sale, or when they are more expensive than other times/places? You would buy them when on sale wouldn’t you? If it is more expensive than usual, you the intelligent and rational shopper will likely pass.  Bottom line is you will be price-sensitive while knowing it’s value.

When investing, you should buy shares the same way!

Step #2… Buy at Attractive Prices

Focus on businesses that are understandable, have enduring economics, and are fun by shareholder-oriented managers. All those tenets are important, Buffett says, but by themselves will not guarantee investment success. For that, he must first buy at a sensible price, and then the company must perform to his business expectations. The second activity is not always easy to control, but the first is. If the price isn’t satisfactory, he passes.

Buffett’s basic goal is to identify businesses that earn above-average returns and then to purchase these businesses at prices below their indicated value. Graham taught Buffett the importance of buying a stock only when the difference between its price and its value represents a margin of safety. Today, this is still his guiding principle, even though, as we have seen, his partner Charlie Munger has encouraged him toward occasionally paying more for outstanding companies.

The margin of safety principle assists Buffett in two ways. First, it protects him from downside price risk. If he calculates that the value of a business is only slightly higher than its per-share price, he will not buy the stock; he reasons that if the company’s intrinsic value were to dip even slightly, the stock price would eventually drop too–perhaps below the amount he paid for it. But if the margin between price and value is large enough, the risk of declining value is less. If Buffett is able to purchase a company at 75% of its intrinsic value (a 25% discount) and the value subsequently declines by 10%, his original purchase price will still yield an adequate return.

The margin of safety also provides opportunities for extraordinary stock returns. If Buffett correctly identifies a company with above-average economic returns, the value of its stock over the long term will steadily march upward. If a company consistently earns 15% on equity, its share price will appreciate more each year than that of a company that earns 10% on equity. Additionally, if Buffett, by using the margin of safety, is able to buy this outstanding business at a significant discount to its intrinsic value, Berkshire will earn an extra bonus when the market corrects the price of the business. ‘The market, like the Lord, helps those who help themselves,’ says Buffett. ‘But unlike the Lord, the market does not forgive those who know not what they do.’

I’ll leave you with a witty quote from Buffett (he has loads of them which I just love!):

Dec. 10, 2001: Warren Buffett on the stock market
“To refer to a personal taste of mine, I’m going to buy hamburgers the rest of my life. When hamburgers go down in price, we sing the ‘Hallelujah Chorus’ in the Buffett household. When hamburgers go up in price, we weep. For most people, it’s the same with everything in life they will be buying — except stocks. When stocks go down and you can get more for your money, people don’t like them anymore.”

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