Warren Buffett’s 3 Cornerstones of Sound Investing

Warren Buffett is worth over $60 billion. He knows a thing or two about investing.

True geniuses tend to make things simpler, not more confusing. Buffett is no exception.

Buffett simplifies investing down to the following:

“All there is to investing is picking good stocks at good times and staying with them as long as they remain good companies.”

That doesn’t sound overly complicated – because it isn’t. Click here to see 17 of Warren Buffett’s best quotes analyzed.

Buffett says there are 3 things that make a successful investment:

1. Good stocks (strong competitive advantage)

2. Good times (low prices)

3. Stay with them as long as they remain good investments (let them compound your wealth)

You don’t have to be a genius to follow this plan…

“Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ”
– Warren Buffett

Warren Buffett’s mentor was Benjamin Graham – the father of value investing. Three of Graham’s ideas greatly impressed Buffett. He went on to say that:

“(He) believes those ideas, 100 years from now, will be regarded as the three cornerstones of sound investing.”

Warren Buffett’s 3 cornerstones of sound investing are:

1. Look at stocks as small pieces of a business

2. Look at market fluctuations as your friend rather than your enemy

3. Margin of safety

This article takes a deeper look into each of these 3 investing cornerstones.

Look At Stocks as Small Pieces of a Business

For many (if not most) individual investors, the stock market is a large virtual casino.

If you pick the right 1, 2, 3, or 4 digit ticker symbol, you could double or triple your money! If you pick the wrong one, you could lose it all.

It’s easy to see why…

Stock quotes are updated in (nearly) real time, giving markets the same frenzied tempo as you see on a spinning roulette wheel in Las Vegas Casino.

You can pull up lists of the top performing stocks every day to see the ‘big winners’ and ‘big losers’

If only you invested in the big winners every day… You’d be a billionaire in no time!

This has led to the prevalence of penny stocks. A stock could be worth $0.01 today, and go to $1.00 tomorrow – giving you 100x returns in a day! Of course, this rarely (if ever) happens. Penny stock sites like to hype up your brain with the (largely false) idea of big returns that are easy to get.

Informed investors know better.

Traders with a gambling mentality trade very frequently. Who stands to gain from rapid trading?

Wall Street firms in general, and discount brokerages in particular.

The truth is that discount brokerages are worth billions because investors trade so frequently. The less you trade, the more money remains in your account (where it belongs) to compound, and the less money goes to financial institutions. Click here to learn more about Wall Street and investing fees.

The less you trade the better your investments will do.  This is not conjecture, it was proven by analyzing thousands of individual accounts at a discount brokerage over a period of years.

It can be difficult to get out of the gambler mindset – because gambling is addictive. It’s also one of the most important things you can do to preserve and grow your wealth.

The stock market isn’t a casino – far from it. Rather, the stock market is a place where people with excess capital (investors) go to purchase pieces of businesses.

Thinking of a stock as a small piece of a business dispels the gambler myth about the market.

When you buy a stock (even just 1 share), you are buying fractional ownership of a business.

It’s even easier to remain committed to your stocks when you can actually see or use their products.

That’s because a link between the digital numbers in your investment account and the real world business is established.

This makes it obvious how wrong the idea that the stock market is a giant casino really is.

If you own shares of PepsiCo, Inc. (NYSE:PEP), you know you are profiting every time you see someone drinking a Pepsi or eating a bag of Lay’s potato chips.

Similarly, if you own McDonald’s Corporation (NYSE:MCD)‘s shares, you benefit every time someone eats at McDonald’s.

While it’s true we don’t get tiny checks every time someone drinks a Pepsi or eats a Big Mac, the real earnings from these purchases do pass through to the business – and the business passes that value along to shareholders in one of two ways:

1. If earnings rise, the share price will (eventually) rise

2. Through dividends

That’s one of the many reasons I’m such an advocate of Dividend Growth Investing; it creates a link between rising company value and rising dividend income.

When McDonald’s makes more money, it pays a larger dividend. This makes the connection between the business and your investment very clear.

McDonald’s Corporation (NYSE:MCD) (and every other business) can only pay rising dividends if they make more money every year (or nearly every year).

Dividend growth investing places the emphasis on the business. If a PepsiCo, Inc. (NYSE:PEP) or McDonald’s Corporation (NYSE:MCD) stops growing, it will be unable to pay rising dividends in a few year – there is no escaping the cold hard reality that dividends come from earnings. To pay increasing dividends, you must have increasing earnings.

To have increasing earnings for decades, a business must have a strong and durable competitive advantage.

Dividend growth investors don’t look to gamble on ‘the next big thing’. Instead, we look for businesses that have the ability to pay increasing dividends.

This puts the investor’s focus right where Warren Buffett says it should be – on the business.

There is a select group of stocks that have paid increasing dividends for 25+ consecutive years in a row. This group is called the Dividend Aristocrats. Click here to see all 50 Dividend Aristocrats.

To be a Dividend Aristocrat a business must have a strong competitive advantage – how else could it pay increasing dividends for 25+ years? It should come as no surprise that the Dividend Aristocrats index has substantially outperformed the market over the last decade.

Source:  S&P Dividend Aristocrats Fact Sheet

If investors looked at dividend increases rather than stock prices, investors in general would be far better off.

Stock prices are distractions that can deter you from the goal of investing in great businesses with favorable growth prospects.

It’s important to view stock prices (and market fluctuations) in the correct way.

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.

Margin of Safety

Warren Buffett’s third cornerstone of sound investing is to invest with a margin of safety.

The margin of safety is the discount between your calculated intrinsic value of a stock and the current market price of a stock.

If you believe shares of a company are worth $100, but they are only trading for $70, then you have a 30% margin of safety. You could be wrong on your intrinsic value calculation by up to 30% and still break even.

The margin of safety concept is extremely important in an uncertain world. Valuing a business is very difficult – there are many variables and moving parts to even simple businesses that make knowing the true exact intrinsic value impossible.

That’s why the margin of safety is so important – because intrinsic value calculations are not precise.

Before going any further, the intrinsic value of any asset is the sum of its future cash flows discounted back to present value with an appropriate discount rate.

Unless you can see the future with crystal clarity, you can’t come up with an exact intrinsic value.

This only necessitates having a margin of safety. In an imprecise world, a buffer against errors is needed.

The larger your margin of safety, the better. It would be foolish to buy a business you think is worth $100 for $98. There’s no room for error. If you are off in your calculations by just a few dollars in the wrong direction then you’ve overpaid.

The deeper the discount to intrinsic value a stock is trading, the more likely it is to be a profitable investment. Said another way, the deeper the discount to intrinsic value, the more things that can go wrong in an investment for it to still be profitable.

Interestingly, stocks tend to trade for their highest margin of safety (deepest discount to intrinsic value) after negative events have already occurred.

This is beneficial for investors because it brings to light problems that may have been difficult to recognize beforehand, and gives you a bigger room-for-error if future problems hamper a business.

Not every investment requires the same margin of safety. You would need a tremendous margin of safety to invest in a high-risk biopharma startup. On the other hand, investing in a business that has proven itself by paying rising dividends over decades – perhaps one of the 50 Dividend Aristocrats – you need less of a margin of safety because future cash flows are more secure.

The more secure future cash flows are, the lower a margin of safety is needed.

The market partially prices this in already. High quality businesses tend to have lower stock price standard deviations; they (on average, historically) fall less during recessions – meaning you get a smaller margin of safety versus riskier stocks.

Adding a margin of safety to your investing arsenal will help to avoid mediocre investments. It will also help to reduce your risk of buying overpriced securities.

Finding an appropriate margin of safety for an individual business is an art, not science. I know that The Coca-Cola Co (NYSE:KO) needs a smaller margin of safety than Twitter Inc (NYSE:TWTR), but exactly how much is hard to say. With Twitter’s precarious business position and presence in a rapidly changing industry, I would need a very large margin of safety before considering an investment in the company.

On the other hand, an investment in Coca-Cola requires a much smaller margin of safety because the company operates in the slow-changing low-tech beverage industry and has proven for over a century that it can reliably grow its business through developing new beverage brands and through continuous international expansion.

Many successful investors use the margin of safety concept.

Seth Klarman – the billionaire value hedge fund manager of Baupost Group –titled his bookMargin of Safety. That shows how critical the concept is to him.

“A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world.”
– Seth Klarman

Warren Buffett describes the concept of Margin of Safety as follows:

“Leave yourself an enormous margin of safety. You build a bridge that a 30,000 pound truck can go across and then you drive a 10,000 pound truck across it. That is the way I like to go across bridges.”

Buffett, Klarman, and Benjamin Graham have all employed the margin of safety concept effectively – and build fortunes, which shows how important the concept is to successful investing.

Final Thoughts

Two out of three of Warren Buffett’s sound investing cornerstones are psychological. Thinking of stocks as small pieces of businesses and viewing market fluctuations as your friend are not hard-and-fast investing rules. They focus on the mindset of the investor.

Investor mindset is the most critical aspect of investing. Without sound investing principles, your investment performance will suffer as you switch from this investing fad to that investing fad.

With sound principles, you can invest in great businesses for the long-run.

Warren Buffett is arguably the greatest investor of all time. He has simplified and distilled Benjamin Graham’s message – and added to it. You can see Warren Buffett’s 20 highest yielding stocks here.

Together, Warren Buffett’s 3 cornerstones of sound investing urge investors to think about stocks as businesses, not get fooled by market prices, and to invest in undervalued securities. There is little doubt these rules will stand the test of time – just as they have sense Benjamin Graham first discussed them.

Disclosure: None