Warren Buffett 3 Rules of Investing

Warren Buffett learned investment in ‘Columbia Business School’.

In that school Benjamin Graham was the teacher of Warren Buffett.

Those were the days of early 1950’s when Warren Buffett learned investment under Benjamin Graham.

Back then, Warren Buffett was only 21 years of age. Buffett was young, and in Benjamin Graham he found a perfect investment Guru.

Lets see the top 3 rules of investing that Warren Buffett learned from Benjamin Graham in Columbia Business School.

These 3 rules of investing are such powerful rules that it has power to transform even a common man into Warren Buffett.

#1. Take Right Investment Decisions…

What should drive ones investment decisions?

At least the market should not drive ones investment decisions, right? This is a very important lesson.

We all know that the market is volatile. So within a short period of time it can both peak and bottom.

Hence, if we start taking investment decision based on market movements, it will be a lot of stress.

So what we must do ideally?

Well the answer is easy, do nothing. Surprised?

Ok, but this is better than taking too many panic decisions.

Do you know why there are more traders in stock market than investors? Traders love to be always busy, involved and tensed.

On the other hand, investors are relaxed, focused and always calm.

Look around your work place, you will find many people who like to pose as if they are busy.

Some may even be busy. People like to keep doing something or the other all day.

But what’s more important in work is “goal focused, efficient woking”.

A software programmer doing job of an office boy all day is good work? No.

So coming back to our topic, how to take right investment decisions?

First step is, do nothing. It is not good to invest money all the time.

Let your savings accumulate. Do not just invest it, simply because they are piling up.

So what you must do when you are doing nothing?

Learn to do stock research.

This activity may drain you initially, but in long run it will prove to be “the best skill you gathered in lifetime”.

Warren Buffett does this all day.

He keeps reading companies financial reports to analyse if their stocks are good buy or not.

Low price may not always mean a ‘good buy’.

Combination of strong fundamentals & low price mean a good buy.

But what price is a ‘low price’?

When a stocks market price is less than its ‘intrinsic value’, it said to be undervalued.

Only undervalued stocks can be tagged as low-priced.

But how to know stocks intrinsic value?

This is where Warren Buffett proves to be the master. He knows best how to estimate the intrinsic value of stocks.

#2. Never ignore the intrinsic value…

A stock market investors decision should be driven by the intrinsic value.

But the problem is, most people buy and sell stocks without estimating its intrinsic value.

What is intrinsic value?

What we see in price charts is the stocks market value.

This market value of stocks says nothing about the stock, apart from the fact that what we must spend to buy it.

But does it say, is this the right price to pay for this stock? No, it doesn’t answer this question.

This question can only get answered if one knows the stocks intrinsic value.

When intrinsic value per share is more than the stocks market price, the stock is undervalued.

If the formula is so simple, why people do not follow it?

The difficulty lies in estimating the stocks intrinsic value.

People like Warren Buffett has spend all their life, learning this unique skill.

Today Warren Buffett is the world’s most successful investor only because he knows how to estimate stocks intrinsic value.

What makes intrinsic value estimation so difficult?

There are less people in this world who can do all the following at a time:

  1. Read the financial reports
  2. Interpret the financial reports
  3. Convert the interpretation into intrinsic value.

Theoretically, several procedures and formula’s are available that can help people to convert a financial report data into a meaningful number called intrinsic value.

But not many people can read financial reports. Very few can actually interpret the numbers. Even fewer know the procedures and formula’s that can estimate intrinsic value of stocks.

It is my wild guess that, probably only 1 in 1,000 in this world can even attempt to estimate intrinsic value of stocks.

Even those people who know how to read, interpret and convert, has another limitation.

Having ability to calculate the intrinsic value based on numbers is good.

But to become a Warren Buffett, one must know “how the business is done”.

Yes, Warren Buffett buy stocks of only those companies whose nature of business he can understand.

This is one reason why he is still tentative to buy technology stocks.

This is very important.

To estimate the intrinsic value of a company like Warren Buffett one must:

  1. Read
  2. Interpret &
  3. Convert – financial reports and also
  4. Understand its Business

In fact the point number 4 is so important that, even Warren Buffett never ignores it, irrespective of the fact that his skill related to 1,2 and 3 is already exemplary.

Warren Buffett has does not prefer to buy technology stocks. He says, he cannot understand their business model. Wow…

#3. Understand the business, before buying its stocks

Buy stocks as if you are buying the whole business.

Lets read a story:

Suppose you have a small tyre repair shop adjacent to your office. Would you like to buy it from its owner? Possibly No.

There could be several reasons for the “No”.

But one major reason could be related to the “understanding of this business”.

It is easy to understand the nature of this business, right?

A tyre repair shop mends the flat tyres of automobiles. People having issues with their tyres approach the shop, their problems gets resolved, and in turn they pay.

The type of work, cash flow, skill required, type of customers, etc everything is known.

So should you go ahead and buy this business? At least you know how it is done!

The problem with this business is its future growth prospects. Our automobiles are quickly shifting to tubeless and more sophisticated tyres.

Compared to our olden days, these days we go to a tyre repair shop less frequently.

A tyre repair shop’s business is understandable, but it has very weak future growth prospects.

So the story ends with a conclusion that you will not buy this business.

What was the idea behind telling this story?

Knowledge/awareness of the business is essential before buying its stocks.

It is the deep understanding of a business that may give you an edge over other investors.

Warren Buffett is so successful because not only he buys good stocks, but the knowledge of his stocks underlying business makes his purchases even more profitable. How?

Lets read another story:

Suppose there are two investor’s Mr. X and Mr. Warren Buffett.

Mr.X is an IIT and IIMA alumuni. He also had special training in companies valuation.

Mr. X estimates the intrinsic value of Company called “ABZ Corp.” as $10 Million.

Hence Mr. X offered $6.7 Million to the owner of ABZ Corp for the takeover.

Though Mr.X’s calculation are mathematically correct, but he had little know-how of how ABZ Corp functions.

Warren Buffett had this edge.

He did his research and exactly know how ABZ Corp was running its business.

Being aware of this fact, Warren Buffett estimated the intrinsic value of ABZ Corp as $12 Million.

Hence Buffett offered $8.0 Million to the owner of ABZ Corp for the takeover.

What is your guess, the owner of ABZ Corp will accept whose offer?

Of course, the owner will accept Warren Buffett’s offer, as it is on the higher side ($8.0 million over $6.7 million).

Though, at this moment of time, it may look like that Warren Buffett has overpaid for the ABZ Corp. But over a period of time this investment will pay Warren Buffett very handsomely.

So the idea is, the more a investor knows about how the business is done, more accurate will be his/her intrinsic value estimation.

Conclusion…

Warren Buffett’s 3 rules of investing are simple to understand.

If one can start putting these 3 rules to practice, success is guaranteed.

These are the ultimate 3 rules of stock investing.

These 3 rules has the capacity to change ones thought process about stock investing.

As a result, the investor will start to buy better stocks for great long term returns.

How he/she can buy better stocks?

These are stocks of such companies which are fundamental power houses.

What does it mean?

Consider this, you bought 1,000 stocks of Apple Inc yesterday.

Today for some reason, the stock market closed for next 1 year.

Does these 1,000 stock will becomes a trash? Not at all.

Even if stocks market is closed, the business of Apple Inc is still running.

The company will be driving ‘sales’, and also will make loads of ‘profits’.

What shareholders should be more interest is in companies profits, or stock market operations?

Even if there is no stock market, companies like Apple Inc can still make money for its shareholders in form of dividends alone.

Higher dividends will come from higher profits.

But in order for companies to make higher profits each year, its business fundamentals should be very strong.

Hence investor must learn how to analyse companies fundamentals and estimate its intrinsic value.

The above listed Warren Buffett 3 rules of investing helps stock investors to do just that.

Have a happy investing.


Disclaimer: All blog posts of getmoneyrich.com are for information only. No blog posts should be considered as an investment advice or as a recommendation. The user must self-analyze all securities before investing in one.

3 Comments on "Warren Buffett 3 Rules of Investing"

  1. (Your statement in article) When a stocks ‘intrinsic value’ is less than its market price, it said to be undervalued.(i read in google)An undervalued stock is defined as a stock that is selling at a price significantly below what is assumed to be its intrinsic value. For example, if a stock is selling for $50, but it is worth $100 based on predictable future cash flows, then it is an undervalued stock.

  2. Serenity Stocks | June 1, 2015 at 9:33 pm | Reply

    Benjamin Graham – also known as The Dean of Wall Street and The Father of Value Investing – was a scholar and financial analyst who mentored legendary investors such as Warren Buffett, William J. Ruane, Irving Kahn and Walter J. Schloss.

    Warren Buffett once gave a speech at Columbia Business School explaining how Graham’s record of creating exceptional investors (such as Buffett himself) is unquestionable, and how Graham’s principles are everlasting. The speech is now known as “The Superinvestors of Graham-and-Doddsville”.

    Buffett describes Graham’s book – The Intelligent Investor – as “by far the best book about investing ever written” (in its preface).

    Graham’s first recommended strategy – for casual investors – was to invest in Index stocks.
    For more serious investors, Graham recommended three different categories of stocks – Defensive, Enterprising and NCAV – and 17 qualitative and quantitative rules for identifying them.
    For advanced investors, Graham described various special situations or “workouts”.

    The first requires almost no analysis, and is easily accomplished today with a good S&P500 Index fund.
    The last requires more than the average level of ability and experience. Such stocks are also not amenable to impartial algorithmic analysis, and require a case-specific approach.

    But Defensive, Enterprising and NCAV stocks can be reliably detected by today’s data-mining software, and offer a great avenue for accurate automated analysis and profitable investment.

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