Buffett’s primary investment principles were solidified early in life, thanks to his mentor Ben Graham. Though Buffett evolved his thinking somewhat over the years, incorporating ideas about more qualitative investing from business partner Charlie Munger and growth investing pioneer Philip Fisher (we’ll get into this further later on), once he’d formed his philosophical foundation, he never wavered from it.
Buffett would encounter trying periods for his intellectual strength and psychological fortitude in just about every decade he’s been investing in. He’s been seen as “out of step” (his own words in a 1967 letter to his partners) or past his prime, time and time again.1 Pundits have derided his opposition to technology investments, declaring him washed up, his style of investing no longer successful.
Before he was the well-known Buffett of magazine covers and book titles (ahem), he faced pricey, irrational markets that left him little choice but to wait with cash burning a hole in his proverbial pocket. Through it all, through the criticism, through the frustration of seeing good companies simply selling for too high a price, Buffett stayed true to himself, certain in his beliefs. He did not abandon his Graham-based ideology, and he did not doubt that the way he was investing was the best and most sensible way to go about things.
In a televised November 2009 CNBC interview Buffett participated in (along with Bill Gates) at Columbia University, he said, “Having sound principles takes you through everything. And the bedrock principles that really I learned from Graham and Dodd, I haven’t had to do anything with them. They take me through good periods, they take me through bad periods. In the end, I don’t worry about them because I know they work.”2
The Buffett partnership began in 1956, and he quickly and easily found undervalued places to invest his partners’ money. However, as the 1960s progressed, dubbed the “Go-Go” years by market hotshots making fast, easy money, Buffett found himself frustrated, with too much money to invest and too few opportunities to do so. Indeed, in 1966 he closed his partnership to new investors.
At the time, predating another tech bubble that would see Buffett’s logic questioned, investors were snapping up technology and electronics companies without pausing to ask exactly what these companies did or how they made money.
Buffett refused to participate in the madness, telling his partners in the aforementioned 1967 letter to them, “When the game is no longer being played your way, it is only human to say the new approach is all wrong, bound to lead to trouble, etc. I have been scornful of such behavior by others in the past. I have also seen the penalties incurred by those who evaluate conditions as they were—not as they are. Essentially, I am out of step with present conditions. On one point, however, I am clear. I will not abandon a previous approach whose logic I understand even though it may mean forgoing large, and apparently easy, profits to embrace an approach which I don’t fully understand, have not practiced successfully and which, possibly, could lead to substantial permanent loss of capital.”3 (It should be pointed out, however, that thanks to his earlier purchases, the partnership performed very well in the 1960s. He closed the partnership in 1969, having given his lucky partners a 32 percent average annual return before fees.)
From this point early in his career, Buffett had to be strong and not bend to mob rule. Sure, he could have followed all the other “investors” (Buffett likely wouldn’t agree with that characterization of them) into the market, hopping into stocks that he didn’t understand but were nevertheless going up because everyone else was in a frenzy, but that is not who he is or how he operates. He believes in being systematic and having a set approach, a framework, and once you know who you are as an investor and what you’re looking for, you stick to it. Changing with every market whim and speculative wind that blows through Wall Street is not the way to build wealth over the long term.
Buffett would be tested again in the early 1970s, as mutual fund managers poured money into a group of big companies known as the “Nifty Fifty.” The fact that everyone was doing it was not enough reason for Buffett to join them, and he set out on his own, snapping up cheap shares of companies other investors were ignoring. The stock market swooned in 1973–74, and despite his current investments losing value, Buffett was excited about the chance to pick up companies he believed in for ever-lower prices. The more dismal the stock market became, the happier it made Buffett.
The 1960s and the 1970s were, together, periods that exemplified one of Buffett’s most famous sayings: “Be fearful when others are greedy, and greedy when others are fearful.” In the 1960s, there had been euphoria and greed galore, and Buffett patiently waited on the sidelines, hesitant to join the sure-to-end party. Then, as the market collapsed in the mid-1970s, and most investors were all filled up with fear, Buffett was greedily adding to his favorite positions and initiating new ones.
When interviewed by Forbes magazine in 1974, and asked how he felt about the stock market at that particular time, Buffett said, “Like an oversexed guy in a harem. This is the time to start investing.” (OK, so clearly Buffett does have some traces of testosterone.) He added, “Now is the time to invest and get rich.”4 This attitude and ability to remain cool in the face of panic and market declines is a trait that separates Buffett; it’s also something you’ve got to learn to develop in order to be a better investor.
Speaking of Buffett and his remarkable temperament, Roger Lowenstein, author of Buffett: The Making of an American Capitalist, and more recently, The End of Wall Street, said in an interview published on Fool.com, “How many times have we heard he’s through? We heard that in the dot.com era and we heard it in the mortgage era again. Just bubble after bubble, he stands on the sidelines and lets other people take what seem to be easy gains until they come crashing down. It sounds easy in retrospect, but it just takes an awful lot of self-confidence.”5
Lowenstein also said, “The key to his temperament is that he is comfortable following his own instincts and judgment and ignoring (when he disagrees with it) that of the consensus. This has enabled him to avoid many, many investment fads and perils over the course of his career, from the Go-Go stocks of the ’60s to the Nifty Fifty of the early ’70s, to the dot.coms of the late ’90s and the mortgage bubble of recent years.”6
It can be incredibly scary to go against what other investors are doing. To be contrarian is so difficult. The conviction in your own analysis and beliefs is paramount. Otherwise, you might as well give in, give up, and resign yourself to a future following the so-called herd, investing in what everyone else is, destined to do only as well as they do.
DON'T WAVER FROM YOUR CONVICTIONS
Let’s not fool ourselves. Overcoming this tendency is ridiculously hard. Recent research even shows that when we conform, the areas of our brain that are activated are the same ones associated with pleasure.8 So, truly, piling in behind other investors, and having them pile in behind us, actually, literally feels really good. But remember, as Buffett has said, “Approval . . . is not the goal of investing.”9
Instead, a carefully calculated weighing of the facts, and of your analysis of the company’s future prospects, is called for. When everyone in the market believes something’s true, ask yourself what they’re missing. Question the conclusions of pundits. Don’t assume that they know more than you do, or know something you don’t. The best place to look for promising investments is often the very place most investors have turned their backs on. Look where others aren’t looking.
When Buffett was just a young graduate student and visited the Washington, D.C., headquarters of GEICO in person and ended up investing three-quarters of his portfolio in the company, he did so based on his own analysis of the company. He didn’t listen to anyone else. Even his mentor Ben Graham would have believed he was overpaying, and yet Buffett so trusted himself that he forged ahead.10 He didn’t let self-doubt take over.
Developing this ability to control your emotions takes time and work. For Buffett, it seems to be innate, though he’s had to endure ridicule time and again for missing out on big market movements. The dramatic late 1990s–early 2000 rise in the market at large, and in technology and Internet companies in particular, was one such time.
In 1999 alone, the Dow Jones Industrial Average rose 25 percent, while the tech-heavy Nasdaq rocketed ahead a remarkable 86 percent. Meanwhile, Buffett sat on the sidelines, certain that the market’s rise was founded on nothing more than unicorns, rainbows, and that little puppy dog sock puppet from Pets.com. He most certainly did not purchase shares of Internet companies for Berkshire, leaving the easy money to everyone else, and he was questioned for it. Buffett endured doubts about his investing abilities and method for several years during this period. Berkshire’s stock price suffered, too, giving even more ammunition to the media proclaiming Buffett’s best days behind him. The criticism was loud and unrelenting.
It’s not easy being misunderstood, or worse, mocked, but the Oracle stood strong. Talking in an interview about that time, Buffett said, “You can’t do well in investing unless you think independently. And the truth is, you are neither right nor wrong because people agree with you. You’re right because your facts and reasoning are right. In the end, that’s what counts.”11
And, of course, in the end Buffett was right. Investing hadn’t changed overnight. Value still mattered. The way to build wealth over the long term wasn’t, in fact, found by throwing money at anything and everything ending in a “.com.” But it was most likely trying for Buffett to hear and absorb the blows. It will be trying for you, too, at times, but if you’ve developed your investing philosophy appropriately, you’ve got to also develop the self-confidence—and thick skin—to stick with it.
STAY TRUE TO YOURSELF
Buffett has demonstrated his ability to withstand peer pressure at other times, too. During the market’s 22.6 percent one-day crash in October 1987, Buffett didn’t bow to fear and run away from stocks. The same goes for the period in late 2001 and early 2002 when news of the massive accounting fraud at Enron and other companies broke, creating investors’ distrust in management and reported financial results. Suddenly every public company and executive was suspect. Buffett looked at the conditions created by all that nervousness and took advantage of it. He’s said, “Cash combined with courage in a crisis is priceless.”13
More recently, and as we talked about earlier, Buffett again showed his courage in the panic-ridden fall of 2008 as the market, and seemingly the world, tumbled around him. He became the reassuring voice in the dark night that investors needed, publishing his New York Times editorial to encourage others to be brave and take a stand as he was.14 Buffett would follow through on his words, too, investing in Goldman Sachs and General Electric at this time, although it must be said that he did negotiate very favorable deals when he made these two investments, setting them up as preferred stock deals that ensured Berkshire a certain return. Most investors couldn’t have gotten the deals on these companies that Buffett did (indeed it’s hard to imagine anyone but Buffett exacting the terms he did), but that doesn’t diminish the fact that he was acting as a model of investment temperament at the time.
It’s possible to practice being “greedy when others are fearful and fearful when others are greedy” both when the market as a whole is in decline, and at the individual company level. Buffett has done it both ways, targeting companies that are temporarily down because investors misunderstand or doubt their future earning potential (as he did when he picked up shares of the Washington Post in the 1970s with a generous margin of safety) or jumping into the market and snapping up shares of many desirable businesses when everyone else seems to have run off, leaving cheap stocks scattered about like abandoned toys.
Another way that Buffett asserts his independence and won’t bow to peer pressure is his stance on dividends and stock splits. Aside from one $0.10 per share dividend paid by Berkshire way back in 1967 (Buffett joked “I must have been in the bathroom” when the decision was made to pay a dividend) ,15 Buffett has denied paying anything out to Berkshire stockholders. The reason’s simple: He believes that Berkshire shareholders are better served by him hanging on to the money and investing it back into Berkshire’s stable of wholly owned and partially owned companies versus paying them out a dividend. There are also tax implications with paying dividends, both at the company level and at the individual shareholder level, but that’s not Buffett’s primary concern.
To Buffett, the way a business chooses to allocate its capital is the most important thing. If you can efficiently and effectively allocate your capital into profitable new lines of business or in improving existing business lines, then you shouldn’t be paying a dividend. But that’s a big if. If a business is mature and not growing rapidly, and management’s ability to allocate capital is constrained, shareholders deserve to have that money paid out to them to compensate for the likely lack of growth in the stock price.
In Berkshire’s case, though, we can agree that Buffett is a master capital allocator, and it’s a pretty safe bet that he can do more with the excess money generated by the company’s insurance operations than his shareholders could. He is, after all, Warren Buffett. Nevertheless, certain investors and segments of the market crave dividends for income and have been disappointed with Buffett’s stance. It’s logical, though, and is fully consistent with his beliefs.
Of course, there is always the possibility that Berkshire’s immense size will truly catch up with it and create a situation where paying out a dividend actually does make more sense than retaining all the earnings, but so far, that hasn’t happened. Buffett’s been warning about the drag Berkshire’s size has on its results for years, and at some point that could make his current stand on dividends more difficult to rationally defend. We’ll see.
Buffett has also long held the belief that stock splits are pointless and a waste of time, money, and energy. In a stock split, the overall amount your shares are worth doesn’t change, but the number of shares you own does. So, for instance, if you owned 5 shares at $4 each of Big Al’s Corndog Emporium and the company splits its stock 2-for-1, you’d then own 10 shares at $2 per share. Either way, your investment is worth $20 (and those darn dogs are so delicious it’s likely to keep going up).
Companies split their stock for all sorts of reasons, none of which are particularly compelling to Buffett. Some say it’s to help create more “liquidity” and make it easier for more investors to purchase the company’s shares. This has certainly been an argument presented as a reason Buffett should split the “A” shares of Berkshire Hathaway. Trading at a price of around or above $100,000 for one share (!) of stock, Berkshire is out of the reasonable price range for many investors.
Buffett, though, doesn’t believe splitting Berkshire’s stock would have any positive effect on the company or its owners and indeed, could even create a group of shareholders that he deems undesirable. Buffett wants Berkshire to have long-term-focused shareholders (he refers to them as “partners”), and he wants Berkshire’s price to reflect the company’s intrinsic value as closely as possible. Splitting the stock would create the potential for irrational stock movements caused by new speculative shareholders focused on the short term.
However, Buffett’s hand was forced on the stock split issue in the mid-1990s. Investment houses, wise to the fact that more people wanted to own a piece of Berkshire Hathaway than could afford one, planned to buy shares of Berkshire and divvy them up, selling them as smaller units to the public, and charging fat fees for the privilege. To avoid what he saw as an expensive and unfair way to profit from Berkshire’s success at the expense of small investors, Buffett created a second class of Berkshire shares in 1996, the “B” shares, which were valued at 1/30 of an “A” share and had voting rights of 1/200 of an “A” share.
The Berkshire “B” shares, however, were actually split 50-to-1 in early 2010, to help shareholders of Burlington Northern, which Berkshire announced it intended to purchase in full at the end of 2009. Burlington shareholders could choose either cash or Berkshire stock, so by making the share price lower for them, Buffett made it easier for them to choose the stock versus the cash (and avoid any nasty tax implications). This move also opened the door for Berkshire to replace Burlington Northern in the S&P 500 (can you believe it wasn’t already in there?).
You have to believe, though, that Buffett’s thinking on the silliness of stock splits hasn’t changed. Unusual circumstances forced him to both create the B shares back in the 1990s and then split them more recently. His desire to have long-term shareholders/partners remains as real today as ever. He did what he did with the B shares because he was looking out for the best interests of small, individual investors, not because he suddenly decided everyone was right about stock splits.
Reputation is a significant matter for Buffett, which is another reason he is unlikely to bend to peer pressure. If there’s a risk it could sully his reputation, Buffett won’t have any part of it. He once famously told his oldest son, “It takes twenty years to build a reputation and five minutes to ruin it. If you think about that you’ll do things differently.”16
Buffett believes in something he’s dubbed the “Inner Scorecard.”17 Essentially, it’s a framework for living your life according to your own rules and your own beliefs, and not acting according to whether or not other people will approve of you. For Buffett, naturally, this encompasses financial decision making. You have to be able to tune out the world and live by your Inner Scorecard.
To be a great investor, you’ve got to go it alone, at least to a certain extent. You can learn from the masters, as Buffett did (and, well, as you are now doing reading this very book), but in the end, you’ve got to develop your own system for investing. And then you’ve got to stick to it. Don’t abandon your beliefs when times get harrowing. Ask the hard questions. Ask the next question. And then act, or don’t act, as appropriate.
Buffett’s had a long time to perfect this part of his temperament, and it is key to what has made him as successful as he’s been. So keep at it, stay strong, and go your own way. Keep the following in mind as you commence your journey:
• Be willing to be contrarian, as uncomfortable as it may be.
• Take Buffett’s words to heart: “Be greedy when others are fearful, and fearful when others are greedy.”
• Live by your own Inner Scorecard.