ValueInvesting:GrahamBuffettapproachtosuccefffulstock marketinvesting

Dr. Tejinder Singh Rawal Chartered Accountant India [email protected] 1.Introduction:

The investor is concerned with human phenomena, which are necessarily complex phenomena. Human beings are seldom rational in their thinking The biggest damage that academicians have made is to quantify the field of investment with complex mathematics, which has made this field of psychology look like a branch of mathematics. Intricate mathematical equations have been created to measure the cause and effect relationships, where such relationships are only spurious. The point I want to make here is that investment, in spite of the look of exactitude that it has got, still continues to be a semi-science, a semi-art, and a study of human psychology. This should not dishearten you. On the other hand, this non-linier thinking of human beings, sometimes collectively, opens a window of opportunity for an intelligent investor. If you can identify the window as it opens you can be sure of your success in market operations. 1.1Valueinvestingiseasytocomprehend,butdifficulttoapply: The principles discussed in this paper are simple to understand. Warren Buffett says it best by saying the fact that value investing is so simple makes people reluctant to teach it. If youve gone and gotten a Ph.D. and spent years learning how to do all kinds of tough things mathematically, to have to come back to this---its like studying for the priesthood and finding out that the ten commandments were all that you ever needed. "Success in investing doesn't correlate with I.Q., once you're above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing. says Warren Buffett i . However, remember that while these principles are easy to understand, they do require a considerable degree of hard work. Value investing would only remove mystery from the investing process, not the hard work. 1.2Differentplayershavedifferentmotives: Different players enter the market with different time-frame, and with different intentions. Some look for quick bucks, and would cash on the market momentum, totally ignoring the market and stock fundamentals, while for some it is a casino, where they would make or lose money as if by a flip of coin, these people usually day-trade, as they look for quick results. Then there is a small, albeit committed tribe of value investors, who would invest only when they find that a share is being traded at a price below its intrinsic value. Value investors believe that more often than not, there would be a divergence between the real value of a share, and its quoted price. The wining strategies lies in finding the true net worth of a share, and buy a share only if there is, what the father of value investing Benjamin Graham referred to as, the Margin of Safety in the deal.

There is one statistic that has remained constant in investment since records were kept and that is the ratio of winners to losers has remained constant over time. On reflection this would seem a startling fact, but despite the massive advance in economic forecasting methods and supply of information, the ratio remains the same. The chief reason is that the basic human nature has not changed. Advances in science have only made the matter worse: it has created more day traders, and momentum players. ii

2.Efficientmarket?Noway!

Because a considerable part of the stock market is comprised of investors belonging to diverse schools of thought many a time the market tends to react irrationally to economic news, even if that news has no real effect on the technical value of securities itself. The problem is accentuated by the fact that the stock market comprises a large amount of speculative analysts, or pencil pushers, who have no substantial money or financial interest in the market, but make market predictions and suggestions regardless. Over the short-term, stocks and other securities can be battered or buoyed by any number of fast market-changing events, turning the stock market in a generally dangerous and difficult to predict environment for those people whose lack of financial investment skills and time does not permit reading the technical signs of the market. Therefore, the stock market can be swayed tremendously in either direction by press releases, rumours and mass panic. Contrary to what many assume such speculation is essential for the market. Let us think of a wheat contract being launched today. If all the farmers want to sell at the highest possible price, and all the buyers want to buy at the lowest possible price, then no deals will take place. We need to have people who are willing to conjecture that if they are paying a farmer a high price today, they'll get higher price in future, thus giving them a profit. They are taking on the risk and are either making or losing money. They are adding liquidity to the contract to ensure efficient price discovery and are hence critical to the exchange. This is why these people are needed in the market or else contracts would never be liquid and the system would be inefficient. In short, as Buffett once said, it is good that market consists of speculators, traders and other short sighted players; if all were to follow a consistent investment policy, market would lose its charm. 2.1EfficientMarketHypothesis In the collective mind the intellectual aptitudes of the individuals, and in consequence their individuality, are weakened. The heterogeneous is swamped by the homogeneous, and the unconscious qualities obtain the upper hand. This very fact that crowds possess in common ordinary qualities explains why they can never accomplish acts demanding a high degree of intelligence. The crowd is always intellectually inferior to the isolated individual. This is in sharp contrast to the belief in Efficient Market Hypothesis (EMH), which states that the collective force of the market is wise enough to iron out all aberrations, and the price the market pays is the best quote possible. This theory presumes that the collective decision of people, who may not be individually competent, is a very reasoned and intelligent decision. In practice more damage has been done in the market by EMH than by any other theory.

3.GreaterFooltheory: It is possible to make money by buying securities, whether

overvalued or not, and later selling them at a profit because there will always be someone (a bigger or greater fool) who is willing to pay the higher price. When acting in accordance with the greater fool theory, an investor buys questionable securities without

any regard to their quality, but with the hope of quickly selling them off to another investor (the greater fool), who might also be hoping to flip them quickly. Unwitting investors purchase the stock in droves, creating high demand and pumping up the price. If you are lucky, you will pass on the stocks to a greater fool, the greater fool may offload it to a still greater fool. Very soon the ultimate fool will be found out, and when the music stops. the man who will be holding the shares at high price for which there is no buyer.!

Doeshigherriskmeanhigherreturns? Graham disagreed with the usual

postulated risk-return relationship, that is, to earn a higher return an investor must accept higher risk. To the contrary, he felt that the more intelligent effort one put into investing, the better the bargains bought. And the better the bargains, the lower the risk. Thus intelligent investing provides high yields and low risk. Finance academicians often fail to appreciate this point. The equity market is considered as the most risky class. The fact is that, equity can be the safest class of assets if investment is made with a sufficient degree of Margin of Safety. Equity shareholders are the providers of the risk capital to the economy, but if you can identify value, and buy stocks at a price which is considerably lower than value, you have reduced the risk element to a great extent.

5.

ValueInvesting: Value investing is an effective investment strategy, designed by

Benjamin Graham, which has such successful investors like Warren Buffett, Peter Lynch, Sir John Templeton, and Phil Fisher, as its ardent followers. Simply stated, Value Investing implies a study of the fundamentals of a company to arrive at its intrinsic value. A value investor keeps watching the market keenly, and would wait for the divergence between the market price of shares and their intrinsic value. He grabs the shares which he finds has a considerable divergence between the two numbers, and waits patiently for the market to realise the divergence. The key aspects of Value Investing are discussed below:

5.1 Investforthelongterm. When Keynes said, in the long run we are all dead; he was certainly not referring to the stock market. The success in stock market largely depends upon your ability to stay invested for a long period. When Buffett buys a stock, his favorite holding period, he has famously said, is forever. He has confessed that he makes more money by snoring than by working. Before buying a stock, he asks himself: Would I want to own this business for 10 years? He doesnt slavishly follow the stock ratings in Value Line or Standard & Poors. Those ratings are for only one year, not 10 years. And he stalwartly resists the vast conspiracy out there to get investors to buy, buy, buy, and to sell, sell, sell. iii It is human nature to think things will continue as they are at any point in time. The herd mentality tends to have people crying the sky is the limit or screaming the sky is falling. 5.2 Donottimethemarket. A Value Investor does not try to predict the direction the market is going to take. You should not wait for the market to rise or fall before you decide to invest. Since as a long-term investor you will be focussing on the value of individual share, rather than the frenzy of the market, market direction should not be a cause of concern, as

long as you are sure that the investment you are making is attractive, and has a sufficient margin of safety built into it. As a long-term investor, you should not hold your cash, waiting for the market to fall, so that you can invest when the prices are low. You should know the time value of money, which means that the early you invest the higher will be your return. Moreover, if you invest regularly, you are able to take advantage of dollar averaging, which takes care of market fluctuations. 5.2.1 TheHemline,theSuperBowlandothersuperstitions: Market timers have a wide range of tools available at their disposal. Many of them are apparently spurious; others may give an impression of an exact science. Some people consider macroeconomic variables like interest rates and GDP growth- to predict that you must buy shares when interest rates are low. While low interest does lead to higher economic growth, it may fail to lead to higher share prices if the growth was less than what was anticipated by the market. Even if the correlation existed in isolation, the operation of other factors simultaneously may cancel the effect of the positive correlation. Some people would use the feel good indicators (opinion of the experts on CNBC, speech of the Finance Minister, and RBI Governor), while some rely on the opinion of cocktail party chatters! I even came across an economic model trying to predict the stock market direction on the basis of the prevailing trend in the hemline of womens skirts!( Believe me, there is a theory called Hemline Effect Theory to be found in Financial management). The argument is that, rising hemline denotes boldness and fashion consciousness that comes from confidence that you get from a buoyant economy, and is an indicator of a stronger market, while increasing length of the skirts denotes a conservative and cautious approach. What could be sillier than thinking the length of skirts has anything to do with stocks? Sounds more like an excuse traders in Wall Street's mostly boys' club came up with to look at women's legs. 5.3 Buylowsellhigh: Easy as it may seem it is difficult to put in practice. Here is the advice from the most successful investor in the world, Warren Buffett: A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves. But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the "hamburgers" they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices. iv 5.3.1MarginofSafety A value investor always looks for stocks available at a throwaway price, thus buying at a margin of safety. This concept central to the discipline of value was pioneered by the father of value investing, Benjamin Graham. Warren Buffett explains the concept of Margin of Safety in the following words "If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you'd need. If you're driving a truck across a bridge that says it holds 10,000 pounds and you've got a 9,800 pound vehicle, if the bridge is 6 inches above the

crevice it covers, you may feel okay, but if it's over the Grand Canyon, you may feel you want a little larger margin of safety..." v . Margin of safety being the difference between the price and the value, it gives you a cushion. With a high margin of safety, you pay, so to say, $50 for a $100 note. Buying in that situation heavily stacks the odds in your favour. On the other hand buying a stock without adequate margin of safety, or zero margin of safety exposes you to great risk, and makes your investment no better than a bet or a gamble. This would be so even if the company you have invested is a blue chip company. The underlying company would do well but the investor would still burn his fingers. A bull market is a party time for everybody. Everyone makes money whether he follows technical analysis, or fundamental analysis, or indulges in pure speculation, or consults an astrologer for the investment strategy. The tide takes everyone along. It's only when the tide goes out that you learn who's been swimming naked. 5.3.2 Mr.Market: Graham would explain this concept in his lectures by telling the parable of a fictitious Mr. Market. Mr. Market is a whimsical partner in your business. He keeps approaching you every day, and keeps quoting the prices of shares you own or intend to buy (With the live quotations ticking on your computer screen, Mr. Market actually keeps quoting prices every moment). Even if the company may have a very stable business, unfortunately the quotations of Mr. Market are anything but stable. He has severe emotional problems; at times he becomes euphoric and can see only favourable factors affecting company. In that mood, he quotes a very high price. At times, his mood is very depressed, and he is pessimistic about the shares. He quotes a ridiculously low figure when in a bad mood, thinking that the sky is going to fall. The more manic-depressive his behaviour is, the better it is for you since you can find a great bargain. One good thing about Mr. Market is that he does not mind being ignored. His job is to quote the prices, to buy or not to buy is purely your decision. If he shows up one day in a very foolish mood, you would do well to take advantage of him, but it could be disastrous for you if you succumb to his influence. In order to strike the right deal, you should be better in the art of valuation than Mr. Market. If you cant understand the business better than Mr. Market, please dont play the game. You should have the ability to know when he makes a stupid move and you should be able to capitalize on that. 5.3.3 NetCurrentAssetValue(NCAV) Graham always looked for companies, which were so battered and neglected that they were sold even below their net working capital. How do you find stocks with a margin of safety? In part, they are found by avoiding stocks, which are unlikely to possess this margin. Popular stocks are avoided since they are likely to be fully priced, and growth stocks are avoided since they tend to be popular and since they tend to perform poorly in bad markets. And you follow rules pertaining to low price/earnings ratios, low price/book value ratios, etc., which are designed to exclude stocks without a margin of safety. He created a Net Current Asset Value (NCAV) model to find such bargains. Calculate the net working capital of the company, which is the excess of current assets over current liabilities. Subtract from this all the debts whether short term or long term. Divide the resultant figure by the number of issued shares of the company. If this per share value is less than the current market price of the share, you have a margin of safety. And, you are getting the whole of fixed assets free of cost. Graham looked for shares that offered at least 1/3rd

margin of safety. While it may not be possible to find many shares meeting criteria of this high margin of safety, there are certainly some shares which pass through this screen.

5.4 Doyourhomework. As a value investor you should know the fundamental value of the share you are buying. Remember that PE ratio is not the acid test of investment. Low PE ratio does not on its own make a particular company worthy of investment, and high PE , per se, does not make a share less attractive. Other factors like the quality of management, breakup value of the share, debt-equity ratio, interest coverage ratio are equally important. 5.5 Donotinvestinpennystocks. Penny stocks and junk scripts look attractive to the investor when the indices are rising, since the price of these shares usually rise faster than the rise in prices of other shares. However, then the market falls, the investor is left with junk, which has no value. As a matter of principle, you should invest in stock of the only such companies whose fundamentals are known to you. Do not depend on tips, however reliable the source of tip may be. Most of the tips are generated by people with vested interest. Even when the source of the tip is genuine, the time frame the issuer has in mind may be different. If you are tempted to act on a tip, study facts before you decide to go ahead. 5.6 Do not panic. This is very important. More money is made in stock market by remaining inactive. It is foolish for a long-term investor to be excited or subdued by the market ticker. CNBC channel is for the short-term traders and day-traders, do not let the opinions expressed there affect your investment decision. If you are confident your investment is fundamentally strong, every fall should give you an opportunity to buy rather than sell. 5.7 Do not invest in the company and sector whose business you do not understand. If you can understand a business and you find value there, invest. Do not be tempted to invest in industry about which you do not have much idea. While there is so much money to be made in technology shares, yet if you do not understand the business, it is better you do not go into it. My personal investment philosophy is to invest in the business, which I would be comfortable running on my own. 5.7.1 BuffettsCircleofCompetence: The three factors that make an outstanding investment are : the depth of knowledge low valuation and high quality . The depth of knowledge about the company is an important criterion because without knowledge about the company you are investing in, you may end up valuing the company at a figure much higher than its intrinsic valuation. The process of valuation is bound to be faulty in respect of the companies whose business model you do not understand. To put it in other words: Do not invest in companies that are not within your Circle of Competence. The concept of a circle of competence was presented by Phillip Fisher in his book, Common Stocks and Uncommon Profits. Warren Buffett was much inspired by this idea and he always stayed within his own circle of competence. He never ventured into buying a business he did not understand, preferring simple businesses over complex businesses, however exciting the latter might have looked to him. He remarked, We try to stick with businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change were not smart enough to predict future cash flows.

Circle of Competence is defined by your ability to understand a companys products and operating context. Circles of competence are as varied as the investors who must define them. All investors must grapple with the challenge of using current and past information to gauge future business performance. vi

Warren Buffett explains this concept very aptly in the following words: We try to stick with businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change were not smart enough to predict future cash flows. Incidentally that shortcoming doesnt bother us. Buffett says further thus: We select our marketable equity securities in much the same way we would evaluate a business for acquisition in its entirety. We want the business to be (1) one that we can understand, (2) with favourable long-term prospects, (3) operated by honest and competent people, and (4) available at a very attractive price. We ordinarily make no attempt to buy equities for anticipated favourable stock price behaviour in the short term. In fact, if their business experience continues to satisfy us, we welcome lower market prices of stocks we own as an opportunity to acquire even more of a good thing at a better price. Addressing the shareholders of Berkshire Hathaway, Buffeett elaborates on his investment style, Our experience has been that pro-rata portions of truly outstanding businesses sometimes sell in the securities markets at very large discounts from the prices they would command in negotiated transactions involving entire companies. Consequently, bargains in business ownership, which simply are not available directly through corporate acquisition, can be obtained indirectly through stock ownership. When prices are appropriate, we are willing to take very large positions in selected companies, not with any intention of taking control and not foreseeing sell-out or merger, but with the expectation that excellent business results by corporations will translate over the long term into correspondingly excellent market value and dividend results for owners, minority as well as majority. vii 5.8 Doyourownresearch. Security analysis is not as difficult as it may seem. You do not have to be a qualified analyst to do the analysis. When I say that more money is made by being inactive in the market, I certainly do not mean that you should invest and forget. On the other hand, you should keep reviewing the performance of the company you have invested in. If there is a fundamental change in the situation of your company, which has altered the premise based on which you had bought the shares, decide if the change warrants a change in your portfolio. 5.9 Derivativesandleveragedinstruments,astrictNO: Because derivatives offer the possibility of large rewards, many individuals have the strong desire to invest in derivatives. However while the rewards are large, the risk is larger, and if you compute the risk reward ratio, derivatives are not meant for you unless you are using it for hedging. An investor in derivatives often assumes a great deal of risk, and therefore investments in derivatives must be made with caution, especially for the small investor. One should keep in

mind that one purpose of derivatives is as a form of insurance, to move risk from someone who cannot afford a major loss to someone who could absorb the loss, or is able to hedge against the risk by buying some other derivative. Since derivatives can be traded at a very thin margin, there is always a danger that someone would lose so much money that they would be unable to pay for their losses. This might cause chain reactions, which could create an economic crisis. In 2002, legendary investor Warren Buffett commented in Berkshire Hathaway's annual report that he regarded them as 'financial weapons of mass destruction', an allusion to the phrase 'weapons of mass destruction' relating to physical weapons which had wide currency at the time. We shall keep revisiting these and other principles over and over again till you are able to imbibe them well into your subconscious. The principles we discuss in this book have been perfected by masters and are time-tested technique for long-term investment in the market. While this is not the only way one can invest, this method is more scientific and if applied consistently, it would make the process of investment a less risky proposition with higher margin of safety. 6. Successininvestmentisamatteroftemperaments:

Investment requires consistent application of these principles. It requires you to be defensive when it comes to protecting your capital and offensive when you come across the right ball to hit. Warren Buffett likes to say that the number one rule of making money is not to lose money and the second rule is to remember the first rule. To this I may add my further thought: In investing the key is to avoid doing something really stupid. Thus investment is more about avoiding stupid mistakes. On the street there are hundreds of examples of people with no B school background consistently beating the B school guys. It is not randomness that is the reason; but that some people have an ability to control their temperament better than others and are not swayed by the herd mentality is what makes them successful players. Investment success requires far more than intelligence, good analytical abilities, proprietary sources of information, and so forth. Equally important is the ability to overcome the natural human tendencies to be extremely irrational when it comes to money. Warren Buffett agrees, commenting that, "Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ... Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing." 7. TheCrayonTest: Never invest in any idea you can't illustrate with a crayon, was the conclusion that legendry investor Peter Lynch drew when he conducted a very interesting experiment with primary school students. A class of seventh graders at an American primary school were asked to do their own research and dig up stocks for a paper portfolio. Lynch invited them to a pizza dinner where they were asked to illustrate their portfolio with simple drawings representing each stock. Lynch just loved this because it illustrates the principle that you should only invest in what you understand, the kids portfolio consisted of toy manufacturers, makers of baseball swap cards, stationery, clothing manufacturers and outlets, Playboy Enterprises (a couple of boys chose that one!), Coke, and similar stocks. While biotechs and dotcoms were conspicuously absent in their portfolio, their portfolio returned a whopping 69.6% against a background of a 26.08% gain in the S&P500 ! This only goes on to prove that if you develop childlike inquisitiveness in stock selection, you will never go wrong in stock selection. As Lynch put it, During a lifetime of buying cars or cameras, you

develop a sense of whats good and whats bad, what sells and what doesnt . . . and the most important part is, you know it before Wall Street knows it. viii 8. TheLastword:ValueInvestingdelivers!

A suggestion is sometimes made by the protagonists of Efficient Market Hypothesis that investors like Warren Buffett have been monkeys on a typewriter who have successfully produced Iliad; and thanks to the operation of the principle of randomness, and they should not be trusted to produce similar outcome in future. Efficient market hypothesis (EMH), formulated by Eugene Fama in 1970 suggests that, at any given time, prices fully reflect all available information on a particular stock and/or market. Thus, according to the EMH, no investor has an advantage in predicting a return on a stock price since no one has access to information not already available to everyone else. Thus, no trading strategy will have an expected long-run positive return in other words, that prices follow a random walk ix . Whatever success some investors have made in the stock market is attributed to lady luck: active intervention did not help. In short, you cannot beat the market. Warren Buffett himself provides an explanation to this. He says that while the law of probability indeed can make him, and many others like him, a successful investor. If there were 50 people who have always been right; you would tend to believe that these 50 people have been lucky. But if all of them hail from the same village, then the situation changes considerably. Out of the total world population if 50 most successful investors belong to the same school of thought, there is a considerable twist in the story: it is not randomness but something else that is making them rich and successful. The fact that they all have in common is that they all are value investors. They are the people who buy when shares are available at a discount and wait with patience for others to acquire fancy for the shares that they have bought.

9.

Bibliography
1. The Intelligent Investor: The Definitive Book On Value Investing, Revised Edition by Benjamin Graham, Jason Zweig 2. Security Analysis by Benjamin Graham 3. The Interpretation of Financial Statements by Benjamin Graham, Spencer B. Meredith 4. The Essays of Warren Buffett : Lessons for Corporate America by Warren E. Buffett 5. How to Think Like Benjamin Graham and Invest Like Warren Buffett by Lawrence A. Cunningham 6. The Rediscovered Benjamin Graham : Selected Writings of the Wall Street Legend by Janet Lowe 7. Common Stocks and Uncommon Profits and Other Writings by Philip A. Fisher, Kenneth L. Fisher 8. Benjamin Graham on Value Investing: Lessons from the Dean of Wall Street by Janet Lowe 9. Beating the Street by Peter Lynch and John Rothchild 10. One Up On Wall Street : How To Use What You Already Know To Make Money In The Market by Peter Lynch and John Rothchild

11. Benjamin Graham on Value Investing: Lessons from the Dean of Wall Street by Janet Lowe 12. Damn Right! Behind the Scenes with Berkshire Hathaway Billionaire Charlie Munger by Janet Lowe 13. Value Investing Made Easy by Janet Lowe

10.

Appendices
BUFFETTS12INVESTINGPRINCIPLES

Appendix1

1. Dont gamble. 2. Buy securities as cheaply as you can. Set up a margin of safety. 3. Buy what you know. Remain within your circle of competence. 4. Do your homework. Try to learn everything important about a company. That will help give you confidence. 5. Be a contrarianwhen its called for. 6. Buy wonderful companies, inevitables. 7. Invest in companies run by people you admire. 8. Buy to hold and buy and hold. Dont be a gunslinger. 9. Be businesslike. Dont let sentiment cloud your judgment. 10. Learn from your mistakes. 11. Avoid the common mistakes that others make. 12. Dont overdiversify. Use a rifle, not a shotgun. More words of wisdom from Warren Buffett You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right. We do not view the company itself as the ultimate owner of our business assets but instead view the company as a conduit through which our shareholders own assets. When Berkshire buys common stock, we approach the transaction as if we were buying into a private business. Wide diversification is only required when investors do not understand what they are doing. Accounting consequences do not influence our operating or capital-allocation decisions. When acquisition costs are similar, we much prefer to purchase $2 of earnings that is not reportable by us under standard accounting principles than to purchase $1 of earnings that is reportable. Never invest in a business you cannot understand. Unless you can watch your stock holding decline by 50% without becoming panicstricken, you should not be in the stock market. Why not invest your assets in the companies you really like? As Mae West said, "Too much of a good thing can be wonderful". The critical investment factor is determining the intrinsic value of a business and paying a fair or bargain price. Risk can be greatly reduced by concentrating on only a few holdings. Stop trying to predict the direction of the stock market, the economy, interest rates, or elections.

Many stock options in the corporate world have worked in exactly that fashion: they have gained in value simply because management retained earnings, not because it did well with the capital in its hands. Buy companies with strong histories of profitability and with a dominant business franchise. Be fearful when others are greedy and greedy only when others are fearful. It is optimism that is the enemy of the rational buyer. As far as you are concerned, the stock market does not exist. Ignore it. The ability to say "no" is a tremendous advantage for an investor. Much success can be attributed to inactivity. Most investors cannot resist the temptation to constantly buy and sell. Lethargy, bordering on sloth should remain the cornerstone of an investment style. An investor should act as though he had a lifetime decision card with just twenty punches on it. Wild swings in share prices have more to do with the "lemming- like" behaviour of institutional investors than with the aggregate returns of the company they own. As a group, lemmings have a rotten image, but no individual lemming has ever received bad press. An investor needs to do very few things right as long as he or she avoids big mistakes. "Turn-arounds" seldom turn. Is management rational? Is management candid with the shareholders? Does management resist the institutional imperative? Do not take yearly results too seriously. Instead, focus on four or five-year averages. Focus on return on equity, not earnings per share. Calculate "owner earnings" to get a true reflection of value. Look for companies with high profit margins. Growth and value investing are joined at the hip. The advice "you never go broke taking a profit" is foolish. It is more important to say "no" to an opportunity, than to say "yes". Always invest for the long term. Does the business have favourable long term prospects? It is not necessary to do extraordinary things to get extraordinary results. Remember that the stock market is manic-depressive. Buy a business, don't rent stocks. Does the business have a consistent operating history? An investor should ordinarily hold a small piece of an outstanding business with the same tenacity that an owner would exhibit if he owned all of that business

Appendix2 WordsofWisdomfromGrahamsInvestmentphilosophy x 1. A stock is not just a ticker symbol or an electronic blip; it is an ownership interest in an actual business, with an underlying value that does not depend on its share price. 2. The market is a pendulum that forever swings between unsustainable optimism (which makes stocks too expensive) and unjustified pessimism (which makes them too cheap). The intelligent investor is a realist who sells to optimists and buys from pessimists.

3. The future value of every investment is a function of its present price. The higher the price you pay, the lower your return will be. 4. No matter how careful you are, the one risk no investor can ever eliminate is the risk of being wrong. Only by insisting on what Graham called the margin of safety never overpaying, no matter how exciting an investment seems to becan you minimize your odds of error.
i

In an interview with Anthony Bianco of Business Week Online, http://www.businessweek.com/1999/99_27/b3636006.htm ii Warren Buffett in THE INTELLIGENT INVESTOR A BOOK O F PRACTI CAL C O U N S E L FOURTH REVISED EDITION BENJAMIN GRAHAM Updated with New Commentary by Jason Zweig Page 9 iii J.K. LASSERS PICK STOCKS LIKE WARREN BUFFETT Warren Boroson John Wiley & Sons P 97 iv Letter to the shareholders of Shareholders of Berkshire Hathaway 1997 v 1997 Berkshire Hathaway Annual Meeting. vi HOW TO THINK LIKE BENJAMIN GRAHAM AND INVEST LIKE WARREN BUFFETT Lawrence A. Cunningham McGraw-Hill P.XIII vii Letters to the shareholders of Berkshire Hathaway, 1977 viii Peter Lynch with John Rothchild, One Up on Wall Street (Penguin, 1989), p. 23. ix LeRoy, 1989; Malkiel, 1990 x THE INTELLIGENT INVESTOR A BOOK O F PRACTI CAL C O U N S E L FOURTH REVISED EDITION BENJAMIN GRAHAM Updated with New Commentary by Jason Zweig Page xii