In a recent interview with Charlie Rose, Warren Buffett reiterated his most important principle when it comes to thinking about stocks. He also said that (according to his estimates) 90% of people who buy stocks won’t follow his advice.
According to Buffett, the most important thing when it comes to stocks is thinking about stocks as businesses. If Buffett is right, then investors like me have a great opportunity to get ahead on most market participants just by having the right outlook on the stock market.
Investment returns
In his annual letter to Berkshire Hathaway shareholders, Buffett stated that he sees his job not as picking stocks, but as picking businesses. The difference, in Buffett’s view, is crucial to understanding the right way to think about stock market investing.
Here’s one way to bring out the difference. Over the last year, the price of Lloyds Banking Group shares increased by 4p per share. The company also paid out 2p per share in dividends.
Suppose I owned 100 shares in Lloyds at the start of last year. Which of the following is my investment return over the last year:
A: 200p (the dividend)
B: 400p (the share price increase)
C: 600p (the share dividend plus the share price increase)
D: None of the above
According to Buffett, the answer is D.
Buying businesses
Buffett regularly compares investing in stocks to owning a farm. There are two ways to make money by owning a farm. The first is by selling the farm to someone else. The second is by selling the crops it produces.
According to Buffett, the the investment return on a farm doesn’t come from being able to sell the farm to someone else. Rather, it comes from the crops it produces.
In the same way, Buffett thinks that a return on a stock investment doesn’t come from selling it to someone else. It comes from the cash that the underlying business produces.
Returning to Lloyds, this means that the investment return on 100 shares last year is determined by how much cash per share the company generated. Earnings per share from Lloyds were 7.5p last year, meaning an investment return of 750p for someone who owned 100 shares.
Warren Buffett on share prices
This is why Buffett says it is a bad thing for investors when share prices go up. When the price of stocks rise, investors can sell their shares to someone else for more than they paid for them. But this isn’t how Buffett thinks about investment returns.
Instead, Buffett thinks that it’s a good thing for investors when share prices go down. As an investor, my return is the earnings that Lloyds will generate in the future. The stock price only determines how much I have to pay for a share of those earnings. Since I’d rather pay a lower price, it’s good for me as an investor when share prices fall.
Thinking about owning businesses instead of owning stocks is Buffett’s most important advice. But 90% of market participants focus on stocks and hope to make money by selling their investments in the future. I think that means there’s a huge opportunity for investors like me to get ahead by following Buffett’s advice.