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The Answer to Why Warren Doesn't Play the Stock Market— and How Not
Doing So Has Made Him America's Number One Investor
A fool does not see the same tree that a wise man sees.
— William Blake
Before we bust out of the gate you need to know something important about
Warren Buffett. He doesn't
"play" the stock market— at least not in the conventional sense of the word.
He is not interested in current investment trends, and he avoids the popular
investments of the day. He doesn't chart stock prices, nor does he partake of
the current Wall Street rage known as momentum investing, which dictates
that a stock is attractive if its price is rising fast, and unattractive if it is
quickly falling. This is the most unusual aspect of his investment
philosophy, for throughout his investing life he has made it a point to
sidestep every investment mania to sweep the financial world. He happily
admits to missing the Internet revolution and the biotech bonanza, and he
will tell you with a sly smile and a wily chuckle that he has probably missed
all of the big Wall Street plays. Then again, he has managed to turn an
initial investment of $105,000 into a fortune that now exceeds $30 billion,
solely by investing in the stock market.
Here is the big secret: Warren Buffett got superrich not by playing the stock
market but by playing the people and institutions who play the stock
market. Warren is the ultimate exploiter of the foolishness that results from
other investors' pessimism and shortsightedness. You see, most people and
financial institutions (like mutual funds) play the stock market in search of
quick profits. They want the fast buck, the easy dollar, and as a result they
have developed investment methods and philosophies that are controlled by
shortsightedness. Warren believes that acts of shortsightedness have great
potential to unfold into investment foolishness of huge proportions. When
this happens, Warren is patiently waiting with Berkshire's billions, ready to
buy into select companies that most people and mutual funds are
desperately trying to sell. He can buy fearlessly because he knows which of
today's corporate pariahs the stock market will covet tomorrow.
Warren is able to do this better than anyone else because he has discovered
two things that few investors appreciate. The first is that approximately 95÷
of the people and investment institutions that make up the stock market are
what he calls "short-term motivated." This means that these investors
respond to short-term stimuli. On any given day they buy on good news and
sell on bad, regardless of a company's long-term economics. It's classic herd
mentality driven by the sort of reporting you'll find in the Wall Street
Journal on any given morning. As goofy as it sounds, it is the way most
people and mutual fund managers invest. The good news— the news that
gets them to buy— can be a headline announcing a prospective buyout or a
quarterly increase in earnings or a quickly rising stock price. (It may seem
insane that people and mutual fund managers would be enthusiastic about a
company's shares simply because they are rising in price, but remember,
"momentum investing" is the current rage. As we have said, Warren is not a
momentum investor. He considers the approach sheer insanity.) The bad
news that gets these investors to sell can be anything from a major industry
recession to missing a quarterly earnings projection by a few cents or a war
in the Middle East. Remember that the popular Wall Street investment fad
of momentum investing dictates if a stock price is falling, the investor
should sell.
This means that if stock prices are falling, many mutual funds jump on the
bandwagon and start selling just because everyone else is. Like we said,
Warren thinks this is madness. On the other hand, it's the kind of madness
that creates the best opportunities.
Warren has realized that an enthusiastic stock price— one that has recently
been going up— when coupled with good news about a company, is often
enough to push the price of a company's shares into the stratosphere. This is
commonly referred to as the "good news phenomenon." He has also seen
the opposite happen when the situation is reversed. A pessimistic stock
price— one that has been going down— when coupled with negative news
about a company, will send its stock into a tailspin. This is, of course, the
"bad news phenomenon."
Warren has discovered that in both situations the underlying long-term
economics of the company's business is often totally ignored. The short-
term mentality of the stock market sometimes grossly overvalues a
company, just as it sometimes grossly undervalues a company.
The second foundation of Warren's success lies in his understanding that,
over time, it is the real long-term economic value of a business that
ultimately levels the playing field and properly values a company.
Warren has found that overvalued businesses are eventually revalued
downward, thus making their shareholders poorer. This means that any
popular investment of its day can often end up in the dumps, costing its
shareholders their fortunes rather than earning them a bundle. The bursting
of the dotcom bubble is the perfect example of this popular here-today,
gone-tomorrow scenario.
Warren came to realize that undervalued businesses with strong long-term
economics are eventually revalued upward, making their shareholders
richer. This means that today's stock market undesirable can turn out to be
tomorrow's shining star. A perfect example of this phenomenon is when the
insurance industry suffered a recession in 2000 that halved insurance stock
prices. During this recession Allstate, the auto insurance giant, was trading
at $19 a share and Berkshire Hathaway, Warren's company, traded as low as
$40,800 a share. One year later Allstate was trading close to $40 a share and
Berkshire popped up to $70,000, giving investors who bought these stocks
during the recession quick one-year returns of 75÷ or better.
What has made Warren superrich is his genius for seeing that the short-term
market mentality that dominates the stock market periodically grossly
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