PT III: The wisdom of Warren
I wasn’t completely satisfied yesterday where I left the post and wanted to present a follow up and talk a little bit more philosophy than the requirements for valuation. I think providing some insights into the master’s thought process that rather than tell us HOW to find and value wonderful companies, it tells us WHY we should be so picky and not fear the waiting.
Right now the market is hugely overbought, there are companies trading at massive multiples to earnings, which should lead us to ask, why? It seems like a FOMO (fear of missing out) moment, where everyone sees their friends making money and they fear not making money either. Or people who get notices from a service telling them to buy a stock, artificially inflate it and then after making 100% return, sell and someone gets left holding the bag. These are not wholly indicative of the market as a whole, but it does fit a large percentage.
Through the process of valuation of companies with all of the wonderful qualities we look for I find fewer and fewer that are at a place where I can safely buy without the concern of losing money even if the market dips. My watchlist is fairly huge (that is wonderful companies which just aren’t on sale right now) and my buy list can be counted on one hand. That’s crazy, and while I can blame Coronavirus for screwing with the economy and weakening some companies which were wonderful companies, it’s probably honestly a sign that the company was not as strong as I thought. I could blame the fear of missing out or Coronavirus for making some very great companies such as work from home technology or online retailers price tag way out of the safe zone, but that is part of the movement of the market too. People should make money and I can’t blame them for buying a stock that goes up, but the problem is that it is based on greed and fear. Greed is obvious because these stocks are skyrocketing, but fear of missing out seems just as important. Investors I know watch CNBC in the morning and reacting to the news of which company has a new drug looking good for Coronavirus vaccination or treatment, or large online retailers whose quarterly results are great or have announced a merger with another company. However, this can be dangerous, drug companies are often one failed round of testing from a selloff and online retailers will eventually not be the only option for shopping anymore and their price being so far above earnings that eventually the price will have to come back to an underlying value.
This is where philosophy fits into the market, and why Warren has survived and thrived through bad and good periods of the market. He advocates the principle of buy on fear and sell on greed, which often gets scoffed at as “we all know to buy low and sell high”, but does not hit the crux of the philosophy. We wait on an event to bring the price down to the value, this can be anything from a problem with the food at a restaurant or an oil tanker or rig spilling millions of gallons of oil into the ocean. These are events, we consider them to be events when it is something that will provoke a reaction in the market, but is temporary in nature. We don’t want an event that changes the overall business, Luckin Coffee is a great example recently. Luckin Coffee was an up and coming coffee company from China that was starting to look at grabbing some big market share. That was until it came out that the CFO and founder were cooking the books. It was such a big deal and so bad that they had to step down at the board’s insistence and they were de-listed in the US. That is a change in the company, not an event. So we look for events that bring price to value (determined in a couple of different ways that center on the cash flow of the business) as Warren has, or identifying a company that is looked over by the rest of the investing world. In Warren’s day it was easier to find a Sees Candy to buy at $25 million and years later be receiving $65 million checks every year from them with little change to the underlying business, but with advent of the internet and access to the information the pros get it is harder to find the diamonds in the rough.
The flip side to the coin of buy on fear, which is using the emotions of the other investors in the market as they sell off from events lowering the price to our safe zone to buy wonderful companies at a reasonable price, is to sell on greed. Warren has another saying (shocking I know, but don’t worry, he has a ton of them and a lot of those are really great for the individual investor) which is pigs get fat and hogs get slaughtered. This is a message to us saying to make a good profit, but don’t try to time the market and get greedy. The most frequently quoted and aimed for rate of return yearly is 26%, which if you average year over year people will fight each other to give you their money to invest. There are very few investors who have returns consistently over time that are anywhere near this number, but it is possible with enough work. If you are chasing consistent 100% returns, you will lose quite often and if you succeed it makes it harder to walk away from which likely will lead to very poor returns over time. So, we want to watch the market and know when to get in and out of positions in order to maximize returns with only 15% gain, because that is likely the top range of our skill level at this time. I showed in a previous posting how a 15% compounded yearly rate of return will make you rich and give you the freedom from the corporate world to pursue your dreams and build wealth for your family. So let’s chase the achievable goals and not try to call the top of the market and get slaughtered with the other hogs chasing the top.
So what does this have to do with title you ask? I’m coming to it now, when we wait on those perfect opportunities to invest it can take time and will often occur during a market down turn, but that provides the most amazing opportunities for investing. If the time comes and the majority of your money is in the sinking market or companies that may not be as high quality, you can recognize that there is an opportunity but you may only have a tiny amount of liquidity to buy these companies which is the equivalent of holding out a thimble to catch the gold falling all around you. On the other side if you have been patient and waiting in cash when you recognize the gold falling from the sky, then you will have a war chest to spend which is the equivalent of holding out a wash-bucket to catch the gold. Warren also says when these events to occur to “back the truck up” in order to load up on all the wonderful companies on sale. This is the concept behind Deep Value Investing, I can throw a rock and hit a good company in the market that is going up currently, but I predict that we will see a number of these companies either fail or come crashing back to earth in the next few years. Mostly because many of these companies have no durable competitive advantage over their rivals or new startups and have been oversold on the market and could have their value artificially inflated. This means that even results in the short term if not managed properly can cause major problems for an industry in the long term, look at the debacle of 2008 and the banking sector to see how this happens or the dot com bubble of 2000.
Those who don’t learn from history are doomed to repeat it and those who stay the course and practice patience will walk away with a wash-bucket of gold when people are around them are losing big. This is the patience of a Buffett and why I try to control my FOMO on a daily basis when I see the news or look at my accounts and realize there is a lot of money left on the table right now, but believing that there may be wisdom in waiting in a market that challenges history. My predictions may well be wrong and things have certainly progressed further in the midst of crisis than I ever believed they could, but I have that nagging Wiley Coyote feeling that the shadow growing isn’t a cloud, but the ACME instant rock that we planted at the top of canyon falling. So, I hope you will look at this philosophy, search more information and make your own decisions about the market. I won’t quote the Wilshire GDP or other statistics at you, but know we are at some historical highs that should have all of us looking closely. Anyway, hopefully I will be able to put out another post by next week. Until then, chasing brontosaurus through the brush.