Dear Mr. Buffett_ What an Investor Learns 1,269 Miles From Wall Street - Janet M. Tavakoli [12]
I suggested one might use a computer program to sort data, identify companies that have a low price-to-earnings ratio and a high return on assets, and then look for value from the companies that make the cut. Warren said: “No, I don’t do that.” I repeated that it might save time to sort this way, thinking of my own portfolio.
Time slowed, and Warren’s eyes seemed to darken as he silently watched me. It was as if we had been jogging, and I had suddenly stopped to tie my shoes. He was waiting for me. It isn’t ideal to have to stop for a running partner, but if they can keep pace with you, you jog in place and wait.
I opened a familiar door in my memory. What had Benjamin Graham said? If you want a “MARGIN OF SAFETY,”8 the business’s past ability to generate earnings well in excess of all requirements (including interest on debt) protects investors if there is an unforeseeable problem that causes future net income to decline. But Graham was not a fan of arbitrary metrics. A stock is not a good investment just because it is trading near its asset value—a nice price tag is not enough. The enterprise has to be in a strong business position relative to competitors, have a strong financial position (low or very manageable debt), and has to have good management (no ratio can tell you that).The business’s favorable long-term economics includes a “satisfactory ratio of earnings to price . . . and its earnings will at least be maintained over the years.”9 Benjamin Graham did not distinguish between “value” stocks and “growth” stocks. He knew that value and growth are inseparable.
I finally grasped what Warren was saying. Warren has such a wide body of knowledge that he does not need to rely on “systems.” His further point was that I do not have to, either. I read the financial reports of each corporation, and high return on assets and low P/E ratios can be temporary distortions that do not necessarily indicate financial health. I have enough experience to identify opportunities myself. Thump! I threw a pair of crutches that I clearly didn’t need out of a window of my mental memory palace.
Warren’s vast knowledge of corporations and their finances helps him identify derivatives opportunities, too. He only participates in the derivatives markets when Wall Street gets it wrong and prices derivatives incorrectly. Warren tells everyone that he only does certain derivatives transactions when they are mispriced. He even states this in his shareholder letters. He plays fair and doesn’t seek to take advantage of anyone; he warns Wall Street that if they are trading with him, they got the price wrong.
I was aware of this, but it did not really sink in until I met him. Looking back, I may not have actually believed it until I met him. He cheerfully filled me in.
Warren says “everyone [in the finance business] has an IQ of at least 140”—I imagined a disintegrator in the elevator that measures and eliminates those who did not meet the threshold (and I had only worried about adjusting my skirt)—but a high IQ is not necessary to be a good investor. Warren is a highly intelligent polymath, but does not credit his investment success to that fact. Consistently following basic financial principles is much more important. Charlie Munger, his long-time partner, tells Warren that the challenge both of them have is staying anchored.
Warren takes advantage of the fact that many Wall Street derivatives traders construct trading models with no clear idea of what they are doing. I know investment bank modelers with advanced math and science degrees who have never read the financial statements of the corporate credits they model. That is true of some credit derivatives traders, too. The global business has grown too fast, and there is a dearth of essential