The post Have You Been Sucked Into the Warren Buffett Trap? appeared first on Net Net Hunter

This will probably be the most controversial article on this website.

Warren Buffett is a legend among value investors — and for good reason. His investment record is unmatched by any other investor who existed in the last 100 years. Value investors, understandably, have tried to emulate Buffett’s approach to investing in order to snag a sliver of his returns. This typically means being glued to CNBC in the hopes of catching an interview, pouring over a mountain of books written about him, or combing through Warren Buffett’s annual letters for nuggets of wisdom.

Unfortunately, trying to emulate Warren Buffett has led investors to adopt a less than ideal strategy.

Don’t get me wrong. I like Warren Buffett — a lot. I think he has a lot to teach investors. I appreciate his frank communication style and his generosity as a financial teacher. I just don’t think that his contemporary investment style, one based around buying very profitable large cap companies with sizeable moats at fair prices, is the best strategy for people like you and me. Blindly adopting it after watching TV interviews, reading a couple books about the man, or taking a peek at his past record constitutes falling into the Warren Buffett trap. If you’re sitting on a portfolio of less than $10 million USD then — as those who have signed up to receive free net net stock ideas ultimately know — there are a lot better ways to make money in stocks.

Golden Nuggets From Warren Buffett

Now, I’m not trying to tell you that Warren Buffett is full of crap. Warren Buffett is incredibly intelligent with a far better investment record than I have (and, coincidentally, a lot more money, too) so I’m not trying to say that I know better than Buffett when it comes to investing. That would be silly. But, there is a large body of material out there in the form of interviews, his own articles, as well as his shareholder letters, and all of that has to be made sense of.

Let’s start with the major pieces of advice that you should be taking from Warren Buffett. Buffett came from the Benjamin Graham school of investing and even today embraces most of its philosophy. Graham taught investors for years, for example, that a stock is just a fractional piece of ownership in a business. Its value is derived in large part from that business so a huge driving factor in earned capital gains when investing in stocks is tied to the performance of the underlying business. Warren Buffett still echoes that same principle. In his words:

 

If a business does well, the stock eventually follows.

I totally agree.

This also implies that a stock will fluctuate around it’s intrinsic value, the business value that the stock represents. When taking the two investment principles together, it’s pretty clear that volatility should be seen as a gift, something to take advantage of. This is exactly what Benjamin Graham’s Mr. Market analogy highlights, an analogy Buffet has used many times in the past.

Warren Buffett’s suggestion that you stay within your circle of competence is great. Having well defined boarders is really valuable when it comes to investing and will ultimately lead to better returns. Sticking to what you know means making fewer costly mistakes.

Speaking of mistakes, my favourite piece of advice Warren Buffett ever gave was his suggestion to follow two simple rules: 1. don’t lose money, and 2. never forget rule number one. This piece of advice comes into my own investment strategy in a very powerful way, which I’ll talk about more in a bit.

These are just a few nuggets of gold from Warren Buffett, and all are consistent with the principles that Benjamin Graham originally taught decades earlier.

The Warren Buffett Way

But, while Warren Buffett still embraces the fundamental philosophy of Benjamin Graham, he obviously employs a much different investment strategy than Benjamin Graham argued for years before. In fact, Warren Buffett’s investment style has shifted considerably since the 1950s. Rather than look for classic Benjamin Graham value stocks as he did when he ran his investment partnership, Warren Buffett has turned to finding good businesses at decent prices. His stock selection process has become very simple and now consists of only 4 filters. Charlie Munger, Warren Buffett’s partner in crime, sums it up this way:

 

We have to deal in things we’re capable of understanding, and then, once we’re over that filter, we have to have a business with some intrinsic characteristics that give it a durable competitive advantage, and then, of course, we would vastly prefer a management in place with a lot of integrity and talent, and then, finally, no matter how wonderful it is it’s not worth an infinite price so we have to have a price that makes sense and gives a margin of safety given the natural vicissitudes of life.

I’m convinced that as those on the top of their game develop more skill and experience they are able to pack a lot more of their philosophy, tactics, or strategy, into their explanations, and use increasingly simple language to do so. Despite how simple Charlie Munger’s description is, there’s a lot packed into these principles that would have to be unwound for a thorough assessment of the Warren Buffett & Charlie Munger investment style. This is obviously beyond the scope of this article, but Munger’s simple explanation goes a long way to identifying exactly what the pair do when selecting stocks.

Other soundbites and quotes fill in some of the missing pieces:

 

It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

Buffett has turned to buying exceptional companies over the cheap marginal firms he once bought. The focus is very much on buying high quality businesses at adequate prices — often a price far above what Benjamin Graham would have paid.

 

Our favorite holding period is forever.

 Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.

Warren Buffett also holds his investments for an exceptionally long time — far longer than the bulk of every other “long term” Wall Street investor. While some professional managers talk about holding on to stocks for months or years, Warren Buffett talks about holding onto his investments for decades or for life.

Warren Buffett’s popularity has attracted many new investors to the value investing philosophy. These investors typically get their first experience with value investing through the lens of Warren Buffett’s contemporary investment style. Now long time value practitioners are witnessing an ocean of new value investors who seem to think that the best strategy for success is to buy firms with deep moats at adequate prices and to hold them forever. Typically this means buying medium or large cap companies that have been in the spotlight for years — firms with market capitalizations that reach well beyond a billion dollars.

Unfortunately, this strategy is far from ideal, and could be outright dangerous.

Is Warren Buffett’s Current Strategy Dangerous?

Well, not exactly. It really come down to who is trying to use Warren Buffett’s current strategy.

As simple as the strategy sounds, actually employing it

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