Mary Buffett - The Buffettology Workbook: Value Investing The Warren Buffett Way

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Copyright 2001 by Mary Buffett and David Clark

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This publication contains the opinions and ideas of its authors. It is not a recommendation to purchase or sell the securities of any of the companies or investments herein discussed. It is sold with the understanding that the authors and publisher are not engaged in rendering legal, accounting, investment or other professional services. Laws vary from state to state and federal laws may apply to particular transaction, and if the reader requires expert financial or other assistance or legal advice, a competent professional should be consulted. Neither the authors nor the publisher can guarantee the accuracy of the information contained herein.

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The Buffettology Workbook is designed to teach you the investment methodologies of Warren Buffett. Warren has never been the type of investor who plays the stock market. In fact, over the last forty years, he has made a point of dodging every popular investment mania to sweep Wall Street. Be it the Internet revolution or the biotech bonanza, he sat out all the big plays, never making, as he himself admits, one thin dime off any of them. Yet, in those years, as countless treasure-laden Wall Street ships slipped by, Warren managed to turn an initial investment of $105,000 into a fortune exceeding $30 billion, solely by investing in the stock market. His investment feat is unparalleled in the history of Wall Street.

How did Warren Buffett become a multibillionaire, King of the Street, without making any money off any of the big Wall Street plays? Its an interesting question.

The answer may not be obvious but it is simple: Warren Buffett got super rich not by playing the stock market (you heard me right, he doesnt play the stock market) but by playing the people and institutions that play the stock market. Warren is the ultimate exploiter of the folly that results from other investors short-sightedness. The people and institutions that play the stock market in search of quick profits will at some point (we can assure you) commit acts of short-sightedness that ultimately collapse into investment foolishness. When they do, Warren is there waiting, patiently, to take advantage of them. It sounds predatory, doesnt it? It is.

Warren is able to do this better than anyone else because he discovered something that very few people appreciate, that approximately 95% of the people and investment institutions that make up the stock market are what he calls short-term motivated. They respond to short-term stimulithey buy on good news and sell on bad.

The good news can be as complex as a prospective buyout looming on the horizon or as simple as a quarterly increase in earnings or a quickly rising stock price. The bad news can be anything from a major industry recession to simply missing a quarterly earnings projection by a few cents.

Warren realized that an enthusiastic stock price, when coupled with good news about a company, was often enough to help push the price of a companys shares into the stratosphere. This is commonly referred to as the good news phenomenon. He also saw that the opposite happened when the situation was reversed. A pessimistic price, when coupled with negative news about a company, will send its stock into a tailspin. This is, of course, the bad news phenomenon.

Warren discovered that in both situations the underlying long-term economic value of the companys business is often totally ignored. The short-term mentality of the stock market sometimes grossly overvalues a company, just as it sometimes grossly undervalues a company.

Warren also observed that, over time, it is the long-term economic value of a business that levels the playing field and ultimately causes the stock market to properly value the company relative to its long-term worth as a business enterprise. Warren has found that businesses that the stock market has overvalued are eventually revalued downward, making their shareholders poorer. This means that many a fashionable investment ends up in the dumps, costing its shareholders their fortunes, rather than earning them a bonanza. He also discovered that many overlooked and undervalued businesses are eventually revalued upward, making their shareholders richer. Which means a current stock market pariah can often end up tomorrows shining star.

The aspect of this treasure hunt that intrigues Warren, and where he made the majority of his money, is when the short-term market mentality grossly undervalues a great business. He has determined that the stock market will sometimes overreact to bad news about a great business and rush to sell its stock, making it a bargain buy for the few who value the stock based on its predictable long-term economics. (Remember, the vast majority of people and institutions, like mutual fund managers, sell on bad news.) When this happens to a stock that Warren is watching, he goes into market and buys as many shares as he can, knowing that over time, the long-term economics of the business will eventually correct the negative situation and return the stocks price to more profitable ground.

Warren, unlike the vast majority of the market, loves to buy on bad news. He shops when the stocks are unpopular and the prices are cheapwhen short-term doom and gloom blinds Wall Streets eyes to the predictable long-term economic value of a great business.

Speculating in good news bull markets is something that Warren leaves to the other guys. Its not his game. He never owned Yahoo!, Lucent Technologies, CMGI, or any of the other high-flying high-tech companies that were all the rage of the Internet bubble. Warrens game is to avoid popular stocks, wait for short-term bad news to drive down the price of some fantastic business, then jump on it with a ton of cash, buying as many shares as he can.

The Buffettology Workbook is designed to teach you tools that will give you the kind of conviction that Warren has to charge ahead where others fear to tread. Well take you step by step through the methodology and financial equations Warren uses, not only to determine what companies to invest in, but also when to invest in them. Simply knowing what types of companies have excellent long-term economics working in their favor is not enough. You also have to know how to determine the right price to pay for them. Pay too high a price and it doesnt matter how great an economic engine the company has working for you, your investment return is forever moored to the dock of poor results. Pay a low enough price for the right business and you too can sail away with the riches of King Solomon, just as Warren has.