I received an e-mail from Andrew who asked;
Your webcast today prompted me to look up some more of Warren Buffet’s letters to shareholders and general advice, I wanted to get your take on something I came across that seemed potentially contrary to what you mentioned about your use of stop losses in your webcast today.
Warren said he believes that when you invest in a company you should be able to see it go down in value by as much as 50% and not sell off because you know that you already bought it at a steep value. I know this is potentially different than what you mentioned because you were talking about protecting gains, but if you have the time let me know what you think.
Now, this is a very timely question …
First, let me tell you the context of what I believe that Andrew was seeing:
Warren Buffett has said that he has only taken a 2% loss on a position … however, he has watched one of his holdings go down 50%. Now, I can’t find the reference so my memory may be failing me, but it seems that warren is saying that he simply held through the drop and the stock came back.
Of course, Warren isn’t saying that he accounted for the cost of lost opportunity when his money was tanking in a stock only to recover to slightly less than break-even, when his track record says that he averages 21%+ compound return …
… in other words, by my reckoning, he actually ‘lost’ 25% on that transaction …. but, he could have just as easily crystallized a real 50% loss had he panicked and sold out.
Here’s where I think warren is at:
He generally buys a business – perhaps 100% or a controlling interest, or sometime a minority share as an ordinary stock-holder (as though having Warren Buffett / Berkshire Hathaway on your share register can be considered ‘ordinary’) – but, in all cases he is buying the underlying cash-flows.
He is not using technical trading to buy a stock because it has broken some mythical ‘support line’ or using some fundamental analysis to determine that the Price/Earning growth rate seems higher than the current stock price is reflecting.
No, he is ‘buying’ the whole shebang – even if he only ends up buying some of the stock.
Under these circumstances, as long as the price he pays is low compared to the future cashflows that the company will produce, who cares if the stock price drops 50%? In a same world, it eventually had to come back, and even if it doesn’t who cares?
As long as you never sell!
The price you pay gives you the right to your fair share of those future cashflows regardless what arbitrary price the auctioning system called the stock market ‘values’ the stock at today.
May we all have the foresight and fortitude of Warren Buffett …. [sigh]
I am facing a dilemma right now:
As part of a deal I made to close a recent business transaction, I took a final (bonus) payment in the form of stock in the acquiring company – just under 1% of its entire share capital.
Of course, the London Stock Exchange crashed a day or two before the share certificates were in my hands … and kept dropping. So far, I have lost half the ‘face value’ of the payment in stocks.
Will I hold or will I sell? Will the price keep dropping or will it reverse? Does the company have the cashflows to justify holding?
Luckily, the outcome shouldn’t affect my financial future … but, it would have paid for a chunk of my new house and the renovations, as well.
BTW: if you are ever offered stock in an acquiring company for stock in yours … decide:
IF they paid you cash instead, would you then turn around and ‘invest’ that money in the acquiring company’s stock?
If the answer is ‘no’ then push for a cash deal … that’s what I did (except for the last little chunk … boom!) …
AJC.
