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Investment: Buffett's beliefs and other secrets

ACHIEVING success in the investment discipline requires more skill and refinement than just a whim to make a quick buck, a fact legions of investment professionals can confirm.

Among these investment professionals lies an elite class of individuals who over time have captivated the imagination of the industry, garnering attention from investment managers, analysts and market watchers alike. People such as George Soros, Barton Biggs, Bill Gross and Peter Lynch have amassed great fortunes through their investing prowess and continue to inspire investors across the globe.

Revered as the ‘father of value investing’, Benjamin Graham’s value investment approach is predicated on an investor’s incisive precision to identify company shares which trade below their underlying value (when contrasted with their trading market value) but exhibit significant intrinsic value (yet to be determined by the market).

This fundamental principle is premised on betting against general market consensus. Graham’s investment theory places an overriding emphasis on investing in smaller firms that show great growth prospects, as opposed to market dominant (i.e. large or listed entities).

Start-ups have more scope to grow

The logic behind this investment theory is practical: a start-up or small firm has more scope to grow than a listed entity. A firm like Amazon is unlikely to quadruple its market capitalisation, compared to a smaller revolutionary technology firm gearing up for an initial public offering.

The marginal growth rate in the share price of a juggernaut like Amazon in the next five years is unlikely to surpass that of a rapid-growing tech start-up, which has (in theory) the potential to increase its market value from a R10m, round 1 valuation to R500m when eventually listing on the securities exchange.

Nonetheless, employing this investment approach when investing in start-ups also poses significant risks. On the upside, realising multiples in the share price of a company is fantastic for an investor, yet the major downside lies in fact that small (unlisted entities) and small caps bear higher investment risk than the top 100 listed companies on the JSE.

The global investment community is characterised by ‘rational investor sentiment’, a fear of loss and lack of patience that has become predictable. This is precisely the reason why few investors realise the opportunity of investing in a start-up or small cap stock that blossoms into a multi-billion-rand firm.

Despite the inherent risks associated with investing in small cap stocks and start-ups, as Graham once stated: “The real money is to be made betting on the Davids of the world, not the Goliaths.”

Buffett has little belief in active managers

Warren Buffett framed his investment approach from his self-proclaimed mentor, Benjamin Graham. Over the years, Buffett has been critical of active managers and stock-pickers such as mutual and hedge funds, stating that “when trillions of dollars are managed by Wall Street money managers charging high fees, it will usually be the managers who reap outsized profits, not the clients”,

Buffett’s belief in deploying a low-cost investment approach by tracking diversified stock market indices is feasible, in view of shrinking returns across equity markets in recent years. In 2007, he predicted that a simple market index like the S&P 500 would outperform the hedge fund industry which is ubiquitously known to charge exorbitant fees.  

By the end of 2016, the S&P 500 had outperformed returns achieved by hedge funds that had made the bet against Buffett by a significant margin. Furthermore, major stock markets such as the New York Stock Exchange, the Nasdaq, the London Stock Exchange and the Japanese Exchange Group have rallied to record highs in early 2018 on the back of bullish sentiment in global markets.

This phenomenon has had a spillover effect on emerging markets such as the JSE which have reached new all-time highs over the same period, as global capital flows into equity markets across the world.   

What it takes to be a successful investor

 The most important attributes to become a successful investor are to:

  • Invest with a disciplined approach and a well-engineered exit strategy;
  • Possess a well-defined investment strategy you can explain;
  • Build a strong investment risk management system;
  • Learn to leverage your advantage;
  • Learn from your mistakes and avoid repeating them; and
  • Exhibit a strong passion for investing and build a strong investment team.

To become a successful investor requires more than just sound financial and fundamental investment techniques. It entails developing an investment approach that works for you as an individual or firm, one that is consistent and methodically sound.

Modern investment theorists argue that the era of arbitrage, active investment and short-term investment strategies outperforming longer-term, value investing may be over. The hedge fund industry, particularly among the biggest funds in the US, has proven this phenomenon by returning disappointing annualised returns (as an average of the industry) compared to several equity market indices and asset classes.

As a result of its lower margin for error, active investing has become a specialisation that involves more skill than passive investing, explaining why investment professionals are generally highly qualified individuals.

The starting point for anyone interested in becoming an investor is determining the type of investor you wish to be and secondly, ascertaining whether your current skill level is suited to that approach.

  • Dumile Sibindana is a freelance business writer. Views expressed are his own.  

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