Tuesday, May 1, 2018

Just Looking at the Price is Not Investing - Warren Buffett

I present this article as a commentary on Warren Buffett's interview for CNBC TV titled, "Just Looking at the Price is Not Investing". I have also presented the embedded version of the video on YouTube.



Volatility and Fear in the Stock Markets

Buffett says that if you own an apartment you don't get price quotes every day or week. Suppose you bought an apartment at $20,000 and someone approaches you to buy it, you will not be tempted to sell it at $50,000. Similarly, you will not be worried too much if the price offered is $15,000. This because your apartment is your long-term investment. Therefore he asks you to take a close look at the business when you make an investment.

According to Buffett, the most important factor to you should consider while investing in a stock is the cash it is going to generate from today until judgement day (perpetuity). He adds that this cash flow is not going to change ten percent in two months time. (What Buffett did not say specifically in this interview is that if this cash flow is more than the cost of the investment (price of the stock) you should buy it).

Buffett says, continuing the conversation that anything can happen in the markets. In fact, there is no reason for the markets to remain always, he says. He adds that that is the reason people should not borrow to buy complex instruments (derivatives) that the Wallstreet offers. With these complex instruments, you could lose up to ninety percent of your money in an instant.  Buffett emphasises categorically that these activities amount to gambling and not investing.

Warren Buffett concludes this section of the interview by saying that when you are buying a stock you are buying a piece of the business. Therefore you should look closely at the business. He gives the example of buying a share of McDonald's. He says that when you are looking just at the price of something, you are not investing. Buffett gives the illustration of 'Bitcoin' or any other cryptocurrency you are not looking at an asset that produces anything.

Investing In Pieces of the Business as Against the Whole - Just Looking at the Price is Not Investing

The interviewer observes that Berkshire Hathaway was a net purchaser of stocks of listed companies in the year 2018. She asks whether it is because Warren Buffett could not find deals to buy whole businesses at a reasonable price.

Buffett replies, "You can buy small pieces of business for less than you can buy whole pieces of businesses. He continues, "You get a bargain as an investor compared to what I can get in terms of buying the whole business. Warren Buffett says that if people just think of stocks as pieces of businesses they will much better off than bothering about movements in prices. Buffett is true and it is a revelation for small investors like you and me.

We should understand, appreciate and feel good about buying a few stocks of wonderful companies like Coca-Cola, McDonald's in the US or 'Oil and Natural Gas Corporation' or 'The Great Eastern Shipping Co. Ltd'. When we buy these stocks we are in reality buying a small piece of these wonderful companies.

Just Looking at the Price is Not Investing: Interest Rates

The interviewer moves on to the subject of interest rates next. She says that despite good reports about jobs there is fear that interest rates are going go high. She says that the fear of interest rates firming up has created nervousness. And asks Buffett about his views on the interest rate environment.

Warren Buffet, to her question, elegantly defines the relationship between bonds, interest rates and stocks. He says that bonds have coupons attached to them on which the interest rate is already written. Whereas in the case of stocks the coupon is blank and the investor has to write the return the stocks are likely to provide.

He says that when the 30 years US Government bonds pay 3% per annum and stocks give a 10% return on tangible equity, which US companies always do, clearly the investment decision is in favour of stocks. When the 30 years US Government bond rate, which is the yardstick, exceeds 10% then the equation shifts towards bonds.

When the difference in yield between government bonds and stocks is vast, then the investors' concerns are unfounded.

Just Looking at the Price is Not Investing: Portfolio Mix of Stocks and Bonds

Finally, the interviewer asks Warren Buffett about oft advised portfolio mix of owning bonds and stocks for safety. Buffett replies that some people should not hold stocks at all. He says that some people are emotionally fit to own stocks. He says categorically that many people do dumb things like selling a stock when the price goes down. He points out that if you have bought your apartment for 20,000 dollars, you won't sell it if someone offers 15,000. Buffet emphasises that it is the same with stocks.

He has not answered the interviewers question completely though. Wise investors advise people to hold a certain percentage in bonds. Usually, the proportion of stocks and binds is 50:50. The advise that if the stock markets are depressed to increase the stocks portion to 70% and bonds 30%. When the markets are trading at very high levels the stocks shall be brought down to 30% and bonds shall be increased to 70%. This general advice is not entirely true.

Even when the markets are unreasonably high, you will be able to find a handful of excellent stocks, which are still available at a fair price. You should buy these stocks. It is perfectly all right to not to have a single bond in your portfolio. I have about 50% in fixed deposits with banks today. You may wonder why I don't follow my own advice. The reason for this is that in India the interest rates are quite high. They yield between 7 to 9%. On the contrary, the cash inflows to me as an investor in stocks, by way dividends, in many companies are a poor 2 to 4%. Therefore I own fixed deposits to maintain a healthy stream of passive income in the form of interest.

Conclusion

I conclude by saying that just looking at the price is not investing. When you have already invested in stocks of good companies after thorough research and at a fair value you should not bother about price fluctuations.

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