Tuesday, March 6, 2012

Buffett: Three Chapters Investors Should Read

Over the years, Warren Buffett has been pretty clear that he thinks there are three chapters investors should read and understand.

Those three chapters are 8 and 20 of The Intelligent Investor and chapter 12 of The General Theory of Employment, Interest, and Money.

The Intelligent Investor

The General Theory of Employment, Interest, and Money

In a November 2011 interview with Business Wire CEO Cathy Baron Tamraz, Buffett said the following about the chapters:

"If you understand chapters 8 and 20 of The Intelligent Investor (Benjamin Graham, 1949) and chapter 12 of the General Theory (John Maynard Keynes, 1936), you don't need to read anything else and you can turn off your TV," Buffett said.

Some excerpts from the two chapters in The Intelligent Investor.

The Intelligent Investor - Chapter 8
"Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.

If you are a prudent investor or a sensible businessman, will you let Mr. Market's daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.

The true investor is in that very position when he owns a listed common stock. He can take advantage of the daily market price or leave it alone, as dictated by his own judgment and inclination. He must take cognizance of important price movements, for otherwise his judgment will have nothing to work on. Conceivably they may give him a warning signal which he will do well to heed—this in plain English means that he is to sell his shares because the price has gone down, foreboding worse things to come. In our view such signals are misleading at least as often as they are helpful. Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies."

The Intelligent Investor - Chapter 20
"In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, 'This too will pass'. Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY."

The above is how Graham began the chapter. Later he added...

"The margin-of-safety idea becomes much more evident when we apply it to the field of undervalued or bargain securities. We have here, by definition, a favorable difference between price on the one hand and indicated or appraised value on the other. That difference is the safety margin. It is available for absorbing the effect of miscalculations or worse than average luck. The buyer of bargain issues places particular emphasis on the ability of the investment to withstand adverse developments. For in most such cases he has no real enthusiasm about the company's prospects. True, if the prospects are definitely bad the investor will prefer to avoid the security no matter how low the price. But the field of undervalued issues is drawn from the many concerns—perhaps a majority of the total—for which the future appears neither distinctly promising nor distinctly unpromising. If these are bought on a bargain basis, even a moderate decline in the earning power need not prevent the investment from showing satisfactory results. The margin of safety will then have served its proper purpose."

If you've been following Buffett for a while these ideas are certainly familiar but the full chapters are still worth checking out.

I'll follow this post up with an excerpt from chapter 12 of The General Theory of Employment, Interest, and Money.

Adam

Related post:
Buffett: Three Chapters Investors Should Read - Part II
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