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Wednesday, April 9, 2008

7 TIPS TO KNOW WHAT YOU OWN:: Buffett and Graham both recommend a stock market investor view stocks as businesses, and limit investments to businesses you truly understand...

#1: Invest Rationally, Not Emotionally

Rational investing is one of the main ideas Buffett got from Graham. Stock market investing is best where it is most rational. Remember to think of stocks as businesses, and buy them like you were buying the whole business-- with careful consideration and research. Mr. Market is irrational, swinging from manic irrational exuberance to depression, from greed to fear, investing with emotion. Mr. Buffett is rational, investing intelligently and always based on value. Instead of heavily traded, new economy, sexy businesses, this super investor looks for ignored, old-economy, and boring enterprises.

#2: Focus on Domestic Investments

In terms of international investing, Warren suggests that it's hard to know the political, currency, market, and cultural risks of companies that are based in countries other than the one in which you're living and investing. For example, to the students at the University of North Carolina in Chapel Hill in 1995 Warren said:

We love the kinds of companies that can do well in international markets, obviously, particularly where they're largely untapped. Would we buy Coca-Cola if, instead of being located in Atlanta, the company were located in London or Amsterdam or someplace else? The answer of course is yes. Would I like it quite as well? The answer is a tiny notch less, because there might be nuances in corporate governance factors or tax factors or attitude towards capitalists, or anything else that I might not understand quite as well, even in England, as I might in the United States. If I can't make money in a $5 trillion market right here in the United States, it may be a little bit of wishful thinking to think that all I have to do is get a few thousand miles away, and I'll start showing off my stuff.

#3: Define Your Circle of Competence

What are you capable of understanding? A successful active investor looks at most investments and says, "It's outside my circle of competence." Know what you don't know and be honest with yourself.

The world's most successful investor often gives this advice: "Draw a circle around the businesses you understand and then eliminate those that fail to qualify on the basis of value, good management, and limited exposure to hard times. It's not how large, but how well defined the circle is, particularly at the perimeter. Don't compare yourself to someone else's larger circle with a fuzzy edge."

In the 1995 annual meeting of Berkshire Hathaway, Warren described how he came to be an outstanding investor:

I would take one industry at a time and develop some expertise in a half a dozen companies in that industry. I would not take the conventional wisdom now about any industries as meaning a damn thing. I would try to think it through. If I were looking at an insurance company or a paper company, I would put myself in the frame of mind that I just inherited the company and it was the only asset my family was ever going to own.

What would I do with it? What am I thinking about? What am I worried about? Who are my competitors? Who are my customers? Go out and talk to them. Find out the strengths and weaknesses of this particular company versus the other ones in the same industry. If you have done that, you may understand the business better than the management.

Warren is extremely thorough at evaluating companies. For example, one of Warren's managers, who sold his business in its entirety to Berkshire for $1.5 billion, said that he and Warren met for only an hour and a half to structure the deal. But the manager realized during that time that Warren Buffett knew more about his business than he did-- and this manager had founded the company!

Warren commented on how his "know what you own" philosophy applies to all stocks, not only the old-economy stocks in which he himself invests:

Our principles are valid when applied to technology stocks, but we don't know how to do it. If we are going to lose money, we want to be able to get up here next year and explain how we did it. I'm sure Bill Gates would apply the same principles. He understands technology the way I understand Coca-Cola or Gillette. I'm sure he looks for the same margin of safety. I'm sure he would approach it like he was owning a business, not just a stock. So our principles can work for any technology. We just aren't the ones to do it. If we can't find things within our circle of competence, we don't expand the circle. We wait.

#4: Know a Lot about a Little

Even Buffett recognizes a limit on what you can know. For example, when speaking to students of his alma mater, Columbia University, a few years ago, he said, "Anyone who tells me they can value... all the stocks on the board must have a very inflated idea of their own ability, because it's not that easy. But if you spend your time focusing on some industries, you'll learn a lot about valuation."

Being able to value companies properly is the key to Buffett Wealth. The only way to do that is to focus on what you know and own.

#5: Forget Missed Opportunities

Even the world's greatest investor has missed out on some golden investing opportunities, including pharmaceuticals, cellular, cable, software, and telecom. Being part of every fantastic investment is not possible, and one can get very wealthy by focusing on opportunities ahead instead of missed pitches behind.

#6: Read and Research

By reading five times more than everyone else, you will naturally recognize and welcome opportunities as they show themselves to you. To be a successful investor and build the kind of wealth that Warren Buffett has, you must be an investigative journalist. Bob Woodward, who works for the Washington Post and of Watergate fame, once asked Warren Buffett how he analyzed stocks. Warren said, "Investing is like reporting. I told Woodward to imagine he had been assigned an in-depth article about his own newspaper. He'd ask a lot of questions and dig up a lot of facts. He'd know the Washington Post, and that's all there is to it." In other words, you should be curious.  

#7: Be Book and Street Smart

One of the great things about the stock market is that it knows no race, religion, age, gender, education, or country. It is meritocracy at its best. An Asian immigrant living in Canada without a high school diploma can achieve Buffett Wealth. Investing is naturally diverse and holds no prejudices. It embraces all, preferring irrational behavior (because Wall Street makes more money off them) but rewarding intelligent investors.

Warren has benefited from his higher education with a master's degree in economics (the equivalent of an MBA today) from an Ivy League school. He supports and recommends good quality public education and universities, although he does suggest that it's a waste of time to get a PhD in economics. He said, "It's like spending eight years in divinity school and later finding out that all you needed to know is the Ten Commandments." But you need to know what you're looking for. Know what kind of investor you are.

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