Course 506: Great Investors: Warren Buffett
An Approach to Market Prices
In this course
1 Introduction
2 Determining Fair Value
3 Understanding Your Circle of Competence
4 Sustainable Competitive Advantages
5 Partnering with Admirable Managers
6 An Approach to Market Prices
7 Requiring a Margin of Safety
8 Concentrating on Your Best Ideas
9 The Bottom Line

Once Buffett has decided that he is competent to evaluate a company, that the company has sustainable advantages, and that it is run by commendable managers, then he still has to decide whether or not to buy it. This step is the most crucial part of the process so it deserves the most attention.

The decision process seems simple enough: If the market price is below the discounted cash-flow calculation of fair value, then the security is a candidate for purchase. The available securities that offer the greatest discounts to fair value estimates are the ones to buy.

However, what seems simple in theory is difficult in practice. A company's stock price typically drops when investors shun it because of bad news, so a buyer of cheap securities is constantly swimming against the tide of popular sentiment. Even investments that generate excellent long-term returns can perform poorly for years. In fact, Buffett wrote an article in 1979 explaining that stocks were undervalued, yet the undervaluation only worsened for another three years. Most investors find it difficult to buy when it seems that everyone is selling, and difficult to remain steadfast when returns are poor for several consecutive years.

Buffett credits his late friend and mentor, Benjamin Graham, with teaching him the appropriate attitude toward market prices. You may remember Graham's parable in which he said to imagine daily quotations as coming from Mr. Market, your very temperamental partner in a private business. Each day he offers you a price for which he will buy your share of the business, or for which you can buy his share of the business. On some days he is euphoric and offers you a very high price for your share. On other days he is despondent and offers a very low price. Mr. Market doesn't mind if you abuse or ignore him--he'll be back with another price tomorrow.

The most important thing to remember about Mr. Market is that he offers you the potential to make a profit, but he does not offer useful guidance. If an investor can't evaluate his business better than Mr. Market, then the investor doesn't belong in that business. Thus, Buffett invests only in predictable businesses that he understands, and he ignores the judgment of Mr. Market (the daily market price) except to take advantage of Mr. Market's mistakes.

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