So why is it on my mind today?
My old roommate messaged me today telling me how he’s going to start investing in stocks of some sort. He even set up a new blog where he’s going to chronicle his investing adventures (and misadventures). He’s never invested even a penny in the stock market, so it should be good. I’m doing a feature on his blog in a week, so stay tuned for that!
A few years back I do remember learning a little about Warren Buffet, and his investment strategies. I always told myself that if I started investing, I would learn everything I could about how he invests. Which brought me to this article today on Fool.com called Warren Buffett’s Best Advice Ever:
“While Buffett had been dominating for decades, his talent wasn’t truly apparent to the world until he gave a 1984 speech at Columbia University titled “The Superinvestors of Graham-and-Doddsville.”
The lengthy speech can be found in its entirety here (opens PDF file), but I’ll give you the Cliffs Notes version.
Dumb luck, pure skill, and flipping coins
Buffett begins by imagining a nationwide coin-flipping contest. Everyone in the country participates and calls the flip of a coin. Call correctly and move on to the next round, guess wrong and you’re out.
After 20 days, about 215 lucky flippers will have correctly called 20 consecutive flips. They gloat in success, yet the nature of coin-flipping tells us they’re just lucky. It’s a game of random chance.
But what if all 215 flippers lived in the same town? What if they all hailed from the same school? The same fraternity? Then we’d get excited. The laws of probability suggest 215 winners after 20 days. But those same laws tell us that if all 215 belonged to an associated group, that almost certainly wouldn’t be the product of random chance. These 215 flippers clearly would know something we don’t.
Meet nine “lucky” flippers
The real flippers in Buffett speech are nine “superinvestors” — himself included. All nine crushed the market averages over multiyear periods by between 8% and 22% per year.
In a world with millions of investors, such returns can occur by sheer luck — just like the 215 coin-flippers appeared at first glance. But all nine superinvestors hailed from the investment school of Benjamin Graham and David Dodd — Columbia professors now known as the fathers of value investing. That meant something big. It meant that their success wasn’t the product of luck. It almost had to be attributable to the only common link they shared: the investing philosophy learned from Graham and Dodd. The “intellectual origin,” as Buffett put it.
What set Graham and Dodd’s philosophy apart? That’s where the title of this article comes in. Explaining it was simply the best advice Buffett ever gave.
Here it is
Buffett states the superinvestors’ core values quite succinctly…”
The common intellectual theme of the investors from Graham-and-Doddsville is this: they search for discrepancies between the value of a business and the price of small pieces of that business in the market. Essentially, they exploit those discrepancies without the efficient market theorist’s concern as to whether the stocks are bought on Monday or Thursday, or whether it is January or July, etc …
It’s very important to understand that this group has assumed far less risk than average …While they differ greatly in style, these investors are, mentally, always buying the business, not buying the stock.
It’s that simple
Most investors aren’t superinvestors. To them, there’s little distinction between price and value. A cratering stock means risk, while a soaring stock somehow indicates strength and safety — all with little regard to other, more deeply rooted factors. This is akin to assuming that all attractive people make great spouses.
But a more philosophical view shows how crazy this is. Risk appears when market value equals or exceeds the long-term value of a company’s discounted cash flows — its intrinsic value. It then diminishes in proportion to how far market price drops below intrinsic value. Really simple. The relationship between price and risk is often the opposite of what it’s comfortable to assume.
Here’s an example: Was Google (Nasdaq: GOOG ) riskier in 2007, when optimism was on fire and shares exploded, or in late 2008, after shares crashed and bottomed out at around 12 times forward earnings? The answer is easy. Google was enormously risky in 2007, when the market assumed it was a surefire bet, and steadily approaching riskless territory in late 2008, when market volatility made investing look suicidal. Same goes for companies such as Alcoa (NYSE: AA ) and Dow Chemical (NYSE: DOW ) . Investing risk was lowest when the performance and volatility of their shares looked bleakest. That was when the gap between price and intrinsic value was widest. That’s when you want to invest.”