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Thursday, 5 June 2008

Reminders from Omaha

By Paul A. Larson

I was fortunate enough to be able to travel to Nebraska again this year to attend the "Woodstock for Capitalists," otherwise known as the Berkshire Hathaway (brk.b.B) annual shareholders meeting. It was an enjoyable time, and a great way to remain grounded in the sound principles of investing in stocks.

Warren Buffett's and Charlie Munger's takes on current events seemed to garner a lot of the attention from the crowd and press, including Morningstar. (See my previous article Buffett and Munger Hold Court for more on current events.) Yet, after sitting and listening to the famous pair talk for six hours, I was struck by how much of what they were saying really hadn't changed a whole lot from year to year. And in my opinion, these unchanged insights are what held some of the greatest wisdom. Following is some of the timeless advice Buffett and Munger shared with investors in attendance.

Think Like a Business Owner
Don't view stocks as merely things that you trade among other investors. Keep in mind what a stock really is: an ownership stake in a business. You should aim to buy fantastic businesses, and hold them for a long period of time, as they grow and generate cash.

Let the Market Serve You, Not Instruct You
In other words, don't let the tail wag the dog. I take this to mean that we should focus on and anchor to the intrinsic value, or future cash-flow-generating ability, of the businesses we own, not the daily pricing being shouted by the market and the press. In other words, don't fall prey to the behavioral pitfall known as availability bias, which is paying great attention to readily available, easy-to-digest, but unimportant information (daily stock prices), while ignoring more-rare, harder-to-understand, yet much more important information (relating business value).

The market will serve us when it overreacts--like it periodically does--and puts prices out of alignment with intrinsic value. But if you don't have an estimate for a company's intrinsic value and are solely focused on price, you won't know when the market is really serving you.

Always Have a Margin of Safety
I was glad to hear the second step of my simple two-step strategy for selecting stocks for the portfolios is still a cornerstone of Buffett's thinking. Buffett gave an example of when he bought PetroChina (NYSE:PTR - News). At the time he bought, he thought the firm's value was about $100 billion, but the market capitalization at the time was just $35 billion. This provided an adequate margin of safety, even if he was off in his assessment of the firm's value by 25% or more. In contrast, if the market capitalization of the firm had been $90 billion, compared with his $100 billion fair value estimate, it would have been too close a call.

When looking at the future (which is inherently uncertain) and making estimates, it's of little use to carry things out three decimal places. Aim for the obvious. As the pair joked in Omaha, if you see a man with a wide girth walking down the street, you donâEuro�t need to know whether he is 300 pounds or 350 pounds to know he is fat.

Focus on the Right Things
Buffett said that only two really important classes are taught in business school: how to value a business and how to think about the market. When investing in stocks, basic math and accounting knowledge are required, but advanced math is of little to no help.

Don't Do Anything Regardless of Price
I will reiterate that it's important to understand the difference between price and value.

Professionals Should Concentrate Their Bets, Amateurs Diversify
This dovetails nicely with the Kelly Criterion, which IâEuro™ve been using in managing the Tortoise and Hare model portfolios. In a nutshell, Kelly says the greater an investor's edge (confidence and knowledge of a situation) in a stock, the greater the proportion of a portfolio that stock should be, all else equal. It also makes perfect sense to me that the amount of diversification needed in a portfolio should correlate to an investor's skill level. For those unwilling or unable to do the hard work of following individual companies, Buffett again said that a low-cost, wide-market index fund is a perfectly acceptable option.

Longtime Morningstar StockInvestor subscribers will concur that I've mentioned all of these things multiple times in the past; however, I think it's critical to remember these core principles and strategies. I was certainly reminded of that during my annual pilgrimage to Omaha.

A version of this article originally appeared in the May issue of StockInvestor.

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