I’ve watched and read all publicly available material
to bring you the most important investment advice
from the world’s greatest investor, Warren Buffett in 2017.
Four different takeaways were those that stood out the most to me this year.
Warren Buffett has:
- Talked about the importance of having a circle of competence,
and how to build your own
- Explained how interest rates should affect
the price you are willing to pay for stocks
- Shamed managers for the way most of them use share repurchases; and
- Well, this wasn’t Buffett who said,
but Bill Gates presented how Buffett taught him about time management in an interview
where both of them participated
and I think this is a great quick little tip which you can benefit from
This is the Swedish Investor,
bringing you the best tips and tools for reaching financial freedom,
through stock market investing.
Warren Buffett has often been quoted talking about something
which he calls a “circle of competence”.
The concept itself is fairly simple to understand.
Buying a stock is the equivalent of betting on the future of a company.
The future is of course always unpredictable
and basically anything can happen,
so, therefore, we, as investors, must learn to think in terms of probabilities.
In industries and companies where you are well-educated,
that future will be at least less blurry than elsewhere.
This is where you can place your high-probability bets.
This is your circle of competence.
First, it’s important to consider where you might have such superior information.
Warren Buffett said that:
“It’s important to have a large circle of competence,
but it’s much more important to know where its boundaries are.
You can make huge money in the stock market by only knowing about 5% of its companies.
”In identifying your circle of competence,
you can, for example, consider this:
- Which products or services do you consume on a regular basis?
- What did you study in school?
- Where are you situated?
Do you have specific local knowledge?
- In which industry do you work?
For example. I consume a massive amount of Pepsi Max Lime.
I know what type of value this brings me,
I’m fairly certain about my price sensitivity
(hint to Pepsi: you can probably charge me more)
and I know about the company’s competitors.
I studied Industrial Engineering and Management at University.
So perhaps I have some informational edge when it comes to industrial companies.
Say Boeing, Lockheed Martin or Volvo.
Moreover, I am from Sweden myself
so I should know a bit more about Swedish companies than the average person does,
as I’ve grown up hearing about these companies.
And finally, working with social media and finance
might give me an edge in that area.
I encourage you to pause the video here
to think about where your own circle of competence might be.
With that said. In the stock market, it is very important to stay opportunistic.
Some industries underperform for decades
so if you niche yourself too much
you risk being stuck where there are no opportunities left to be found.
You should always aim at expanding your circle of competence.
Moreover, you don’t have to limit yourself just to specific industries or countries.
Look at this table, presenting the 25 most important investments
ever made by Warren Buffett.
You’ll notice that, apart from insurance,
there is basically no overlap between industries.
This is because firstly, well, Buffett has quite a large circle of competence
which he has built over many decades,
but secondly, because he has chosen to focus
on a certain type of situation of a company,
in addition to avoiding some industries and sectors.
The companies that Buffett invests in often fulfill the following 5.
I’ll give you some time to pause here too before moving on to the next …
Investing in the stock market is all about evaluating opportunity cost.
Committing your money to the stock market
means that that same money won’t be available for rental properties
bonds, or for instant gratification.
The trick lies in evaluating when the stock market
is better than other alternatives.
Warren Buffett thinks that the ultimate yardstick
for this is the 10y US governmental bond.
And typically, the yield on these bonds follow the interest rates.
Interest rates are gravity for the stock market.
The price of stocks and interest rates have an inverse relationship,
meaning that when interest rates are low, stocks will become more expensive.
When interest rates are high, stocks will become cheaper.
It is actually a bit misleading to speak in terms of “expensive” or “cheap” though
as it is only the relationship between interest rates and stock market prices which determines this.
To understand, perhaps this analogy will help.
Even if you don’t go to the gym very often,
you could probably deadlift 500 kilos just like Eddie Hall if you were on the moon.
The weights can only be considered “heavy” or “light” when you take gravity into account.
Much like gravitation works on that barbell, interest rates affect stocks.
And well, currently, stocks are on the moon.
An often-used metric for determining if stocks are expensive or cheap is the P/E-ratio.
The average P/E-ratio of the S&P500 is 36.2 at this point.
Now you know that it isn’t enough just to look at this number,
establish that it is historically high,
and then say that the stock market is expensive.
No. We must also consider where the interest rates are,
or preferably the 10y US governmental bond as I stated earlier.
First, notice that the P/E expresses how many dollars you pay for every dollar of yearly earnings.
A P/E of 20 means that you pay $20 for $1 of earnings per year.
To make it easier to compare stocks to bonds,
we could use a similar metric which is the exact inverse of the P/E, called the earnings yield.
A stock with a P/E of 20 has an earnings yield of 5%.
It earns you $1 on your $20 investment each year,
or 5% on your invested capital.
Now have a look at this chart which shows
the average 5-year earnings yield of the S&P500
and compares it to the 10y US treasury rate.
An improved method of stating whether stocks are expensive or cheap
is to compare these two to each other.
When stocks have a higher earnings yield than the yield of these 10y bonds
stocks could be said to be cheaper.
Here, we may come to something of a conclusion
when asking ourselves if stocks are expensive or cheap at current prices.
The opportunity cost of being in stocks is very low right now,
at least when compared to US Governmental bonds
which basically earn nothing.
In fact, the discrepancy between stocks and bonds
has only been this large on 5 other occasions during the last 50 years.
So here’s the conclusion:
If interest rates can remain at their current level for a prolonged time,
stocks are cheap at the moment.
It is popular for companies to repurchase their own shares for a few reasons:
- It’s a tax-efficient way of distributing money to shareholders
- It signals that management has faith in the prospects of the company;
and - It keeps up demand for the stock
Warren Buffett thinks that share repurchases are being overused.
In fact, he thinks that most managers are doing a disservice for their own shareholders
by doing it as they usually do not consider the most important factor
for making share repurchases:
It must be done at intelligent price-levels.
I’ll quote Buffett from his 2017 annual shareholder letter here:
“From the standpoint of exiting shareholders, repurchases are always a plus.
Though the day-to-day impact of these purchases is usually minuscule,
it’s always better for a seller to have an additional buyer in the market.
For continuing shareholders, however, repurchases only make sense
if the shares are bought at a price below intrinsic value.”
Buffett continues:
"The question of whether a repurchase action
is value-enhancing or value-destroying for continuing shareholders
is entirely purchase-price dependent.
It is puzzling, therefore, that corporate repurchase announcements
almost never refer to a price above which repurchases will be eschewed.”
For example, have a look at how much McDonald’s has spent
in repurchasing its own shares during the last 15 years.
By initiating new share repurchasing “programs” every 3rd year or so
the company has bought back shares in every single one of these years.
Now for the million-dollar question:
“Has McDonald’s been undervalued for 15 years?”
I highly doubt it.
Nonetheless, the managers of the company have been acting like it.
I should mention that McDonald’s is far from alone.
And at least they have been buying back the share in varying quantities every year.
Buffett, as always, eats his own cooking.
That’s why Berkshire Hathaway’s repurchases look like this.
In 2017 Buffett had a rule which said that
Berkshire will only buy back shares at 120% or less of its book value.
In these situations, Buffett gauges that continuing shareholders
are getting their money’s worth.
I want to end with a quick tip about how to manage your time.
Bill Gates and Warren Buffett are really good friends
and they have had a great influence on each other.
When they first met, Gates always had a schedule
which was chock-full of meetings, traveling, planning, etc
which you would probably expect from the founder of one of the world’s most valuable companies.
But then he met Warren Buffett, someone who was running a company of a similar size
who only had a few appointments per week.
Gates quickly adopted Buffett’s strategy.
Warren Buffett is an expert on saying "no" to things
and thinks that staying active all the time is not a good proxy for one’s success.
Just sitting down thinking is highly underrated according to him.
No matter if you want to become a successful entrepreneur or a stock market genius,
this is important.
Prioritizing can help execution tremendously,
especially once you’ve got that snowball rolling.
If you are interested in hearing more from the greatest investor of all time,
and how his definition of investment risk affects your first home purchase
(well, among other things)
head over to this video
where I'll summarize the most important advice from Warren Buffett in 2018.
Cheers!