A few good lessons from Buffett

I am in the process of improving my use of investment checklists. As such, I am always on the lookout for new items that I should include in my list. I have tried to make it a habit that anytime I read or hear about a good idea, I jot it down for consideration in my checklist.

One list I maintain, which was inspired by Monish Pabrai, contains investing mistakes which I have learned from others (although the list also contains my own mistakes). The list continues to grow, but it does not take much time to run down the list in thinking about an investment idea and the potential upside is huge.

Over the last couple days, I listened to Warren Buffett’s testimony for the U.S. Government’s Financial Crisis Inquiry Commission. The Financial Crisis Inquiry Commission was created to “examine the causes, domestic and global, of the current financial and economic crisis in the United States.”

Here is an account by The Motley Fool.

My purpose today is to share a few valuable lessons from Buffett (which he has stated before) that I think should be included in an investment checklist.

Have I drawn the wrong conclusion from a sound premise? Buffett quotes Ben Graham who said, “You can get in more trouble with a sound premise than an unsound premise because you’ll just throw out the unsound premise.” In the financial crisis, people took a sound premise – that real estate prices generally go up – and acted on it as if it would happen with a kind of metaphysical certitude. This led to taking risks based on this assumption that led to massive exposure to a “black-swan” event.

Buffett reminds us that people did the same thing in the twenties when they took a sound premise – that stocks generally outperform bonds, at least over long periods of time, because of stock’s higher earnings yield and reinvestment of earnings – and distorted it to conclude that they would always do so. Finally, the Internet bubble was based on a sound premise that the Internet would change our lives. It did not follow from that premise that one could invest in Internet stocks regardless of earnings or competitive forces.

A second lesson Buffett states is that a warning should go up if a company begins making investments that are totally unrelated to its core mission. It reminded me of how Buffett began to zero in on Coca-Cola as an investment just after the time when Roberto Goizuetta divested the company of non-core businesses such a shrimp farming. It is worth looking for businesses that are jettisoning lower margin businesses to focus on their core mission. Think American Express spinning off Ameriprise Financial or Citigroup’s ongoing divestiture of its Citi Holdings assets.

The third takeaway from Buffett’s testimony is that you should probably sell a stock if it goes up too much in price and becomes overvalued. Buffett said he probably should have sold Moody’s in 2006. This reminds me of similar remarks he made about not selling Berkshire’s Coca-Cola stock when it became grossly overvalued.

Fianally, Buffett reminds us to never invest in things we don’t understand. Virtually no one understood that complex derivatives that took down so many businesses in the crisis, yet people continued to invest in companies with massive exposure to these instruments.

In typical Buffett style, these are fairly simple lessons grounded in common sense and the core principles of value investing. The trick – as is often the case – is putting into place a rational framework that harnesses their wisdom and having the emotional temperament and discipline to put them into practice.

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