The Makings of a Financial Legend

Who's this financial legend I'm talking about? It has to be the world's 2nd richest person, Mr Warren Buffet himself, who made all his riches through prudent investments. After reading The New Buffettology by Mary Buffet and David Clark, I'm enlightened on a new world of investing where great returns can be expected with minimal risk.

If that is so, why do people always say investing is risky and henceforth the common logic of greater risks beget greater returns? Well, there is nothing wrong with common logic, except the common people who make up the market often do not use common logic. (Seems like a paradox right?) It has the same principle as to why price often is not set at where demand meets supply in the short run. In the short run, people are often myopic and have strong emotions such as fear or greed working for them that blind them to their logic. For example, in a bull market people often rush to buy stocks where p/e ratios have reached a ridiculous 50 or more just because others do the same too. On the other hand, in a bear market people tuck away all their money in banks and become poorer each day.

Warren Buffet is a value investor who employs a strategy called selective contrarian. As a value investor, he buys stocks at low prices and sell them high. However, the word selective distinguishes him from most other investors in that he only invests in companies that offer a durable competitive product or service, which in other words mean that the company's products or services can survive for 50 years down the road and still enjoy a monopoly in the market. Examples of such companies are like Coca-Cola, Macdonalds and Yum Brands. (which control KFC, Pizza Hut and Taco Bell) In a bear market, the stocks of these companies are often grossly undervalued and Warren buys them like a maniac. He knows that the stock value of these companies will certainly bounce back to their original level or even higher because the underlying fundamentals of the company are still strong. A bear market often does not affect such a company's earnings too significantly since its products still enjoy a monopoly position in the market, especially if its products or services are necessities. Therefore, the stock prices of these companies will definitely rise because in the long term the market will reflect the true economic value of a company. When it comes to bull market, it is time for investors like Warren to sell these stocks to investors at crazy prices. With careful analysis and a thorough understanding of the industry, market and operations of these companies, there is truly little risk in making investments on these companies.

Another important thing that most investors tend to neglect is the price of stocks. Some people feel that the dividends of good companies are more than enough to justify their investments. However, if the prices of these stocks are very high you may get an initial rate of return that pales far in comparison with secure investment vehicles like US Treasury bonds with a guaranteed return of 5-6%. Therefore, it is completely illogical to neglect the prices of what you are buying. Another way to determine whether the stock is a good buy besides initial rate of return is calculating the future price of the stock. A good way to project the future price of these companies' stocks will be first to determine the future earning power of a company using its compounded average earnings growth rate and multiply by its average p/e ratio for the past ten years. (By the way, Warren considers investments with a ROI aka return on investment of less than 12% totally unattractive and his portfolio averages on 22% ROI) However, we have to take note that projecting the future price of a company's stocks for 10 years is insane in most situations as many events in the general economy, industry or the company itself can severely distort a company's stock prices and its economic fundamentals. But in the case of Warren Buffet, he only considers companies with a strong durable competitive advantage that he believes can weather through most of the ups and downs of a volatile market. So far, his strategy has worked for the past 40 years which grew his company from $105,000 to $30 billion. With his success in mind, it is up to you to decide whether making investments is really that risky afterall. (P.S It is not the investment that is risky, it it the investor himself)