Tuesday, April 29, 2008

Where Many Investors Trip Up

Whether you realize it or not, many investors often commit mistakes that regularly go unnoticed. Or worse, the mistake is made under the false assumption that the activity is actually correct. Such common traps include:

1. Investing for capital appreciation when instead you should be investing for capital preservation. Investing in this manner is like crossing the street after only looking straight ahead. The destination might be clear, but without looking left and right, the consequences can be perilous.

2. Interpreting market volatility as a destroyer of opportunity when it is instead a creator of opportunity. If your approach is sound then volatility allows you to buy that which was cheap yesterday cheaper today.

And most important of all: spending time thinking about when to sell a security when all your time should be spent learning when to buy a security. This is a mistake that many investors commit without ever realizing it.

Many people believe that knowing when to buy is much simpler and easier to do than when to sell. However, the real reward in investing comes from making smart buying decisions. Selling is simply the activity that rewards your disciplined buying approach. Far too many investors exaggerate the selling process. In doing this, they subconsciously approach the investment process backwards. In my most recent letter to partners, I discussed the fallacy in "learning" when to sell an asset:

"...you only need to do a few things right to be a successful investor. Knowing when to sell a security is not one of them. Money is made when the asset is bought not when it's sold. Learning when to sell is a task that far too many investors spend far too much time attempting to perfect. In his 50+ years as an investor, Warren Buffett has realized losses on an absurdly low percentage of his investments (less than 5%). Buffett spends little time worrying about when he should sell his investments and instead on focuses on buying assets cheaply. This buying process should be at the center of an investor's focus. You can never go broke by taking profits. If you maintain a disciplined approach to the price you pay for an asset, the selling process will take care of itself. Echoing Shelby Davis, 'you just don't know it at the time.'"

Your profits (or losses) are made the minute you buy an asset. You just won't "see" it until you sell. If you concentrate your efforts on buying businesses selling at a discount to intrinsic value, the odds are favorable that when you need your money, you will sell at a higher price. Understand of course that intrinsic value can be impaired if the fundamentals of the business deteriorate. This is possible with any investment, but much less likely with superior businesses with successful long-term operating performance.

The common mistake is made when investors confuse buying a business and buying a stock. When buying something cheap, investors often take that to mean buying the stock at the bottom. This is flawed thinking. You can still make money even if you buy at top--as long as the intrinsic value is substantially higher.

Also, investors assume that if they sell at a profit only to see the share price advance further, then they made a mistake by selling too soon. But that too reflects the wrong perspective. First of all, anytime you sell an investment at a gain, you have succeeded. I learned at an early age that you will not lose money by selling something for more than you paid for it. So, if that's the name of the game, then mastering the buy side is how you win the game. Warren Buffett once remarked that "investing is simple, but not easy." It's simple in that all you need to do is find a handful of great businesses selling at reasonable prices and let time do its thing.

Yet investing is not easy because most investors have a hard time being patient. Mohnish Pabrai once told me that two things occur to him after he makes an investment: When he buys, the stock usually dives, and after he sells, the stock rockets. Yet in the almost nine years that he's been running the Pabrai Investment Funds, he's boasting an annualized return above 20% -- after fees.

All investors make mistakes. But if you do your work, chances are you won't make many big mistakes. A couple of huge mistakes can wipe you out for good. Concentrate your efforts on a few very simple lessons and you tilt the odds of outperforming most.

Wednesday, April 16, 2008

Buffett Talks Business

We all know Buffett is good..but why is he so good?

Simply put, he keeps things simple and logical. While most other investors are busy trying the "crack the code" with some marevlous analytical break through, Buffett simply breaks everything down to its most basic economic fact.

As an illustration, consider Buffett's discourse on brand value, specifically as it realtes to Coca-Cola. The following comments were made by Buffett at the 1993 shareholders meeting and can be found in Andy Kilpatrick's newest edition Of Permanent Value.

Buffett: Will developments in the generic brand area hurt Coca-Cola? That’s a terribly important question.

“Generic brands have been with us a long time. But lately they’ve attracted a great deal of attention—partly because they’re doing better and in particular because of Philip Morris’s actions a few weeks ago—when, in reaction to the threat and the inroads of generics, they cut the price dramatically on Marlboro.

“I wouldn’t say Marlboro is the most valuable brand name in the world. Coca-Cola is more valuable—and I think that’s been proven by subsequent events. But Marlboro earned more money than any brand name in the world.

“And all of a sudden, Philip Morris took some actions which dramatically reduced the earnings of that brand and changed the pricing dynamic that had existed in the cigarette business for many decades. And since then, Philip Morris has had $16 billion lopped off its market value and RJR’s suffered accordingly.

“It’s a terribly interesting case study and it illustrates one of the dangers of generic competition. Philip Morris cigarettes got to where they were selling for $2.00 a pack. The average cigarette consumer uses something close to ten packs a week. Meanwhile, the generic was at about $1 or thereabouts. So you really have a $500 a year differential in cost per year to a ten-pack-a-week smoker. And that is a big annual cost differential. You better have something that people think is dramatically better than the generic for the average consumer to shell out an extra $500 a year. It’s happening in other areas, too—whether it’s corn flakes or diapers or a lot of things...
“In our case, I think the Gillette brand name, for example, is far better protected against generic competition than the main product of Philip Morris—although there always has been generic competition in blades and there always will be.

“The average male purchases something like 30 blades a year. He pays 70 cents each if he buys the best—which is the Sensor. That’s $21 a year. The best he can do if he wants something that leaves him Band-Aids on his face and an uncomfortable experience costs him $10 a year. So you’re talking $11 for a 365-day experience...

“I think there’s a generic threat of some sort in any industry where the leaders are earning high returns on equity. It just stands to reason that that’s going to encourage competition.

“And the threat may be accelerating in many industries. But I think that brand names with the right ingredients are enormously valuable. Sometimes infrastructure is a problem for the generics. The worldwide infrastructure for Coca-Cola, for example, is very impressive and very hard for a generic provider to duplicate.

“But if somebody wants to sell a generic box of chocolates in California against See’s Chocolates, that’s obviously somewhat of a threat. And I just hope that they take them home on Valentine’s Day and say, ‘Here, Honey, I took the low bid.’ ”

“Wal-Mart’s selling Sam’s Cola. And Wal-Mart is a very, very potent force. One thing that’s helpful is that they were selling it as cheap as $4 a case here. And I don’t believe that’s sustainable. That’s 162/3 cents a can.

“It’s been a while since I looked at aluminum—and it’s down. But I think the can is close to a six-cent item by itself. The can is far more expensive than the ingredients... Distribution costs, trucking, stocking and all that sort of thing have to be fairly similar. In a 12-ounce can, there’s 1.3 ounces of sugar—which at the domestic price, would be around 13/4 cents per can. And that’s got to be the same whether it’s Sam’s Cola or Coca-Cola.

“The Coca-Cola Company sells about 700 million 8-ounce servings—largely of Coca-Cola, but also of other soft drinks—worldwide every day. If you take 700 million and multiply it by 365 days, you come up with 250 billion or so 8-ounce servings of Coke or its products in the world each year.
“The Coca-Cola Company made about $21/2 billion pretax last year. That’s one penny per serving. One penny per serving does not leave a huge umbrella. The generic is not going to buy the can any cheaper. And they’re not going to buy the sugar any cheaper and so on. Their trucks aren’t going to be any cheaper.”

So while everyone is busy looking at P/E Ratios and making forecasts into the future, Buffett simply looks at the business from a businessman's point of view. Ands that all you've got to do folks to succeed in this game.

True to form: 'I'm a better investor because I am a businessman and a better businessman because I am an investor.'