Warren Buffett’s 3 Cornerstones of Sound Investing

Loot at Market Fluctuations as Your Friend

Warren Buffett’s second cornerstone of sound investing is to look at market fluctuations as your friend rather than your enemy.

In every other aspect of life, when someone offers you a lower price on something, that is seen as a positive. If you want to buy socks, and they are on sale for 50% off, no one is going to panic and demand to pay full price.

“Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down”
– Warren Buffett

The Warren Buffett quote above captures this sentiment.

For some reason, many people have the exact opposite mentality when it comes to the stock market.

If ‘high quality merchandise’ (a great business) sees its price decline, individual investors often panic and sell (or at the very least, don’t buy).

It doesn’t make sense. In recessions, the stock prices of nearly all businesses fall in unison – regardless of fundamental performance. This doesn’t mean the intrinsic value of your holdings has diminished.

Is the value of The Coca-Cola Co (NYSE:KO) stock diminished today because of the Great Recession (or the great depression for that matter)? I don’t think so.

All falling prices mean is that people are willing to pay you a lower price today than yesterday to part with your ownership in a business – but you don’t have to take that offer.

Instead, you can capitalize on price declines and purchase great businesses trading at bargain prices.

This lesson is best encapsulated in the ‘Mr. Market’ parable by Benjamin Graham in The Intelligent Investor:

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. Sometime 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 proposed 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 wise to form your own ideas of the value of your holdings, based on full reports from the company about is operations and financial position.

The beauty of the ‘Mr. Market’ parable is that it personifies ‘the market’. This personification helps to show the fallacy in buying or selling based on market prices rather than on your own judgement of the value of the business.

That’s how to take advantage of market prices – to look at them as options to buy or sell, not obligations.

Having the option to buy or sell at different prices over time is beneficial for the patient investor. This is how market fluctuations become your friend rather than your enemy.

You have the opportunity to benefit from market fluctuations by purchasing great businesses when they go on sale, and only selling them when they become very overvalued. The 8 Rules of Dividend Investing are designed to help investors take advantage of market fluctuations and build a portfolio of high quality dividend growth stocks.

Benjamin Graham and Warren Buffett make it sound very easy to profit from market folly rather than participate in it – and it very well may be to them.

For the rest of us investing mortals, it can be difficult to go against the crowd. When stock prices are falling, people tend to succumb to the zeitgeist and give in to the fear of the times rather than keep a calm head.

Developing a contrarian approach to market prices (during bull markets) will prepare you to handle – and profit from – bear markets.

When the market is rising, I don’t have the same excitement that many investors do. The more the market rises (in excess of earnings growth), the less undervalued businesses are around. You get less ‘bang for your buck’ when markets are overvalued.

Bear markets create the perfect entry point to profit from the coming bull market. When markets are undervalued, you can invest your capital at more favorable long-term return rates. Recessions create bargains – as the fairly recent Great Recession showed.

It’s important to note that profiting from market fluctuations is different fromtiming the market. Buying stock in a business when it gets cheap and expecting prices to eventually rise as long as the business continues growing is very different from trying to predict the dates the market will rise and fall.

Buying undervalued businesses could not be more different than attempting to forecast market prices over the next year (or month).

Making market fluctuations your friend rather than your enemy gives you the opportunity to buy great businesses with a margin of safety.