I feel like I’ve been reading the Essays of Warren Buffett for literally a lifetime, and although it hasn’t nearly need that long, it does feel like I’ve obtained a lifetime of information from his book.
Looking back at some of the previous summaries that I have written, Buffett does an amazing job of making sure that he starts off with a great foundation for the new investor and then by the end of the book, things are moving along at 70MPH on the highway so you better buckle up!
That might seem intimidating, but it shouldn’t. It should actually make you happier that you might not understand it all because the that just means that it will be able to provide value to you now, and in the future, as your investing career continues.
Like I said – I’ve written quite a few different summaries on a lot of these chapters, and I’ve even skipped some really good ones so I wasn’t essentially rewriting the book, but I’ve narrowed my list down to my Top 5 chapters in The Essays of Warren Buffett for our beginner investor:
Buffett’s big investment philosophy is that we should be looking for companies that can drastically change their value for the long-term, not just looking for some sort of short-term gain. Don’t buy a company and then sell it when it goes up 10% – look for that stock that’s going to become a tenbagger!
This is the exact reason why they don’t usually invest in tech companies because the future is so uncertain in terms of what will be a competitive advantage for those tech companies, and he lives by the saying “if you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes.”
In summary, Buffett said that if you want to be a successful, average investor, you need to focus on two things:
- Find out how to value a business
- Understand how to think about market prices
If you can successfully do both of these then you’re going to be poised for long-term success during your time investing in the stock market. It’s very important for you to understand first and foremost what you think a company is worth, and while this might seem hard to do, you can do so by understanding the financial ratios of the company and their potential path forward.
I know that many people will likely get stressed or overwhelmed by me saying you need to “understand the financial ratios of the company” and I totally understand that, but that’s exactly why Andrew created the Value Trap Indicator to help get you the information that you need without having to be as in the weeds as other investors. I mean, work smart, not hard, right?
The VTI also takes into account the market price of the company you’re evaluating, but this is another thing that’s very beneficial for you to understand on your own. The market price of the company is quite simply the price that other investors are willing to pay for the company, not what the company is actually worth.
Now, when I first started investing, I told myself that whatever the company is selling for is what the company is worth because ‘perception is reality’ so if people are willing to pay for it, then that’s what it is worth. While that might sound great in a bull market, when things really get tough, that company that still has negative earnings is likely going to get hit extremely hard and that share price is going to drop faster than a hot potato.
Don’t believe me? Well, during this coronavirus scare, the S&P 500 has dropped 14% over a 3-week span and Tesla has dropped 33%.
In other words, there’s really two pieces you need to know as an investor – what is the intrinsic value of the company and what is the current price of the company.
When you can identify those, your job as an investor is to find the companies that are being sold for well under their intrinsic value, buy some shares, and then sit back and reap the rewards.
This article essentially says that Bonds have a place in the investing world, but it has to be for a very specific person in a very specific situation. The average bond earns 2-4% while the Stock Market average CAGR is 11%, so if you’re investing in bonds waiting for the downturn in the market, you probably are missing out on much larger gains just to buy low in the years despite missing all of that uptick.
Buffett explains that Bonds are good for the investor that needs to have access to short-term cash because that is very liquid and easy to access as compared to investing in company stocks for a major company like Berkshire.
So, how does that impact the average investor?
Well, you should follow the same advice – only invest in bonds if it’s for the short-term. Personally, I invest in a high-yield savings account for my emergency fund but bonds can work well, especially if you use a bond ladder. The only issue is that it’s not as liquid as a savings account, so it’s a bit of risk vs. reward.
Like I said, bonds are usually a good thing if you’re simply just looking for some security that is going to perform right around, or maybe a bit above, the inflation rate, but I wouldn’t expect much more as an investor. I have bonds in my HSA because the last thing that I would want to have happen is for me to invest in stocks, the market crashes and my portfolio is cut in half, and then I need that money for a health related issue and now I might not even be working since it is a health issue.
If it’s not something that you could see yourself needing in the immediate future, avoid bonds! Regarding my retirement accounts – I have 0% invested in any of them because I am young. If you’re going to need the money in 5 years or less, I am ok with you investing in bonds. Any time frame that is greater than 5 years, put it into the market, baby!
Let the entire investing history be your “proof in the pudding” and trust that even if a downturn arises, like the coronavirus fears that we are currently in, then trust that the market will rebound.
You might be asking why you should have that trust and the answer is simple – because it has rebounded in the past and it’s more than likely going to rebound in the future as well.
DIVIDENDS! Andy loves him some dividends, and so does Buffett! I mean, I’d even go to a dividend buffet if one existed…. Get it? Buffett? Buffet? Bad joke, I know…
While Buffett does love dividends, he is more so focused on the company employing their capital correctly. This doesn’t mean always paying a dividend or never paying one – it means that the company should do what is will be the most useful for continued success of the company.
“For every dollar of retained earnings by the corporation, at least one dollar of market value will be created for owners.”
For the company to decide to not pay out that $1 in dividends, they should make sure that they’re able to use that $1 of earnings to generate a future value of something that is $1, at a minimum, or likely much more.
In other words, if the company only paid out a $1 dividend and kept the remaining $3, then that $3 that they retained better generate at least that much in the future and if it doesn’t, then the company is quite simply underutilizing their capital, and that can be a major red flag for investors.
In general, share buybacks are perceived as a good thing! Buying back shares of the company has a couple major benefits that Buffett goes into that should help you as an investor of the company:
1 – The Straight Cash Reason
When a company buys backs shares, the total amount of outstanding shares is shrinking, so this should help you as an investor when looking at the total EPS for the company. It’s important to understand when your companies are buying back shares, however, so that you’re not tricked into thinking that the earnings of the company are growing when in fact they might be shrinking, but since the total outstanding shares are shrinking at a greater speed, the total EPS looks higher.
I’ve written before about how important it is to understand this because you could very easily get tricked, but if the earnings are continuing to increase and the total outstanding shares are decreasing, then your investments are just becoming more and more valuable by the second
2 – The Breath of Confidence Reason
This is more of a qualtitative factor than a quantitative one, but if the company is buying back shares, then they hopefully think that the stock is undervalued, otherwise it would be foolish to buy back shares. Now, while a management team of ANY company is likely the most bullish opinion of their company, and rightfully so, it should still be a breadth of confidence that they’re saying that their stock is undervalued and willing to put their money where their mouth is and buy back those shares.
Of course, you still need to do your homework and make sure that you agree with their analysis of their stock value, but this is definitely a good sign and the market will likely view it as a positive as well!
In summary, the main goal of this chapter is to make sure that the management team of your investments have the same goals that you do. Some management teams are only focused on the short-term, some on the long-term, some are only focused on getting the company to IPO and then cashing out and moving on.
Regardless of what their goal is, you need to understand it BEFORE you invest in that company, because if you don’t, you could very well find yourself with a ‘bad’ investment simply because the management is steering the company in a different way than you were hoping the company was going to go.
In short, just like almost every other chapter, do your homework!
If you purchase the book, you’re going to be able to learn many, many more lessons from Buffett about his investing journey and things that he thinks are incredibly important. In a sense, I think some of these chapters are just Buffett getting some things off his chest. He goes on these rants at times about things that he thinks are just completely ludicrous, such as how Owner Earnings are reported or even talking about the difference in economic goodwill and accounting goodwill.
I’ve included my top 5 chapters for the new investor above in this article, but I’ve also written some other summaries including one on arbitrage trading and how it can have an impact on Buffett’s business as well as in your own personal portfolio.
To buy the essays of Warren Buffett will set you back about $30 but I guarantee you will get much, much greater rewards than $30 by learning directly from the value investing GOAT, Warren Buffett.
Chances are, you might even be able to find the book at your local library but I really encourage you to consider purchasing it because I can tell you for a fact that this book is one that I am going to find myself reading more than once, and likely on a fairly regular basis.