The first rule of investment is, don’t lose. And the second rule is don’t forget the first rule. And that’s all the rules there are. I mean, if you buy things for far below what they’re worth and you buy a group of them, you basically don’t lose money. … It’s an intellectual process, a matter of defining your area of competence in terms of valuing businesses, and then within that area of competence finding whatever sells at the cheapest price in relation to value. And there are all kinds of things I’m not competent to value, but there are a few that I am competent to value. – Warren BuffettThis aspect of Buffett’s investment style is what remains of his work and study with Benjamin Graham. After carefully estimating the intrinsic value of a stock, he then only buys it when he finds it trading at a lower price than that.Graham’s value approach was one of buying at a substantial discount to book value. This technique worked wonderfully in the extremely inefficient markets of his day, however the technique has not worked for some time, if you run around buying portfolios of stocks trading at 2/3 of book value you’ll probably go bust in a year or two.This doesn’t deter Buffett though, who has moved on from his early days as a Graham purist when he bought “cigar butt” companies, to the franchise investor he has become today. This transformation is to a great extent due to Buffett’s business partner Charlie Munger who introduced him to what was then a revolutionary concept (to Buffett) of paying a little more than book for a company that is worth a lot more than book.Buying at a substantial discount to intrinsic value does not necessarily mean buying at a low price earnings ratio or high dividend yield, though these may be by-products of a discount to intrinsic value.Single dimensional variables such as price earnings ratios, price to book ratios, dividend yields and price to sales ratios may have some value (the last one does most certainly) but are not anywhere near as powerful as a proper intrinsic value calculation based on discounted owner earnings. In many cases stocks are given low PERs for a perfectly valid reason and many value investors do not do as well as hoped because the market knows these variables well and frequently give stocks low PE ratios for valid and rational reasons.
Buying cheaply has two advantages:
* Stocks bought cheaply compared to true intrinsic value are sheltered from the worst of market volatility because they don’t necessarily have as far to fall.
Although volatility does not concern Buffett, his portfolio has always had a much lower volatility or beta than the market because most of the stocks he buys have very little downside potential, being already sold at extremely cheap prices. If Buffett buys at a 25% discount to intrinsic value, and the company’s profits fall by 10%, his stocks are still below intrinsic value and still cheap, therefore his loss is likely to be very small. * Stocks bought cheaply may become great out performers when the market reappraises their worth, because not only do they recover to the old point of intrinsic value, but they may go much further in line with the growth the company has experienced in the interim. If the stock is bought at 25% below intrinsic value, and intrinsic value increases by 10% over the next couple of years, the stock will need to rise 35% just to fairly price the security. Typically though the market will over-react and overprice the security by a 25% premium to intrinsic value, meaning that the stock will actually rise 60%.
Buffett is definitely a value investor, but a more sophisticated one than those who buy with ratio analysis. These two benefits of value investing done right have been what has given Warren Buffett a history of massive out performance of the stock market, with very low volatility.