Listen to this article
Many investors would improve their performance by imitating Warren Buffett, the greatest investor of the modern era.
It does not follow, however, that every precept Buffett articulates should be copied mindlessly. Some of his strategies depend on context, making literal application of all his ideas inappropriate.
For example, Buffett buys a stock in the hope of holding it “forever”. This is in contrast to the hyperactive overtrading of the typical investor. While most investors would do well to lengthen holding periods, that does not mean they should copy Buffett’s goal of holding a stock forever.
Context is everything. Buffett’s goal of owning a stock forever is partially
a result of constraints that are unique to him. It makes sense to think in terms of permanent ownership when managing an enormous amount of capital. It can even make sense to maintain positions in moderately overvalued companies when managing an enormous amount of capital. But capital constraints do not affect the majority of investors.
The analytical process for buying and selling stocks should be symmetrical. The proper process requires an investor to answer two questions before buying: “What does it cost?” and “What is it worth?”
If value exceeds price by a wide margin, the investor should consider buying.
The proper decision-making process for selling mirrors the process for buying. It requires answers to the two questions. When the price of a stock approaches value, an investor should consider selling.
Most skilled, value-centric money managers will sell a stock before the price rises all the way up to value. That is because the opportunity cost of holding out for the last dollar of value is high. It is better to sell a stock at 90 cents on the dollar if you have the opportunity to plough the proceeds back into another stock at 50 cents on the dollar.
Another Buffett strategy that should not be copied automatically is the notion of buying only quality companies. Buffett has alluded many times to picking up “cigarette butts” (low-quality companies) early in his investing career and the resulting problems he encountered.
The quality-only strategy works well for Buffett, but that does not mean other investors should copy it.
While high-quality businesses are rare, it is fair to say that businesses that can retain high-quality status over the long term are even rarer.
It is a mistake to underestimate Buffett’s talent for differentiating between high-quality businesses that will endure and those that will not. Just because Buffett can make this distinction does not mean the average investor can do so.
Since a large percentage of investors chase the same strategy of investing in the highest-quality companies, it is easy to overpay.
Many investors will identify a quality company, and there the decision- making process stops. They rely on personal anecdotal experience to facilitate the buy decision.
Call it the “I like this product so I’ll buy the stock” approach to investing. They buy stocks without answering the question “What is it worth?” and end up with a portfolio of high-quality but overvalued companies.
The best way to approach the quality variable is to understand that quality change is more important than quality itself.
Let us assume we can accurately rate the quality of companies on a scale of one to 10, with one being the lowest and 10 being
the highest. Most groups
would fall somewhere in
the middle of this ranking. A bare handful would
be at the high end and the
The investor who can identify companies migrating to higher levels in the quality chain has an advantage over one trying to buy only the highest-quality companies.
For example, an investor who can identify a company poised to move from a
four ranking (slightly
below average) to a six ranking (slightly above) will profit more than an investor who can only identify companies with static nine or 10 rankings (the highest quality).
The quality change concept can be extended to say, generally, that potential investing profit correlates to the magnitude of change. All things being equal, an investor who identifies a company poised to move from a three to
a seven ranking will profit more than an investor who identifies a company moving from a four to
a six ranking.
The room of investors seeking the highest-quality stocks is filled to overflowing. Reward is limited because it is popular to invest in these companies and prices are bid to high levels.
Risk is arguably higher
as well. That is due to the potential change in quality. The companies that are ranked 10 can move in only one direction – down.
It is easy to overestimate the durability of quality. In the ultra-competitive world of business, disruption, not stability, is the norm.
The writer is a portfolio manager for Alsin Capital and the Turnaround Fund. firstname.lastname@example.org