Warren Buffett’s Magic Formula In 1965?

I recently read through Buffett’s Partnership Letters again. This time I paid particular attention to one of the strategies he used to perform better than the market in down years. Buffett employed three such techniques from 1956-1965:

Generals – Private Owner – Large margin of safety was a cushion when markets fell.

Workouts – Special situations were not correlated to the market.
Controls – Accounting of “controls” typically outperformed the market in down years.
In his January 15, 1965 letter to partners, Buffett introduced a fourth category called:

4. Generals -Relatively Undervalued

“We have recently begun to implement a technique which gives promise of very substantially reducing the risk from an overall change in valuation standards; e.g., we buy something at 12 times earnings when comparable or poorer quality companies sell at 20 times earnings, but then a major revaluation takes place so the latter only sells at 10 times earnings. The risk has always bothered us enormously because of the helplessness position in which we be left compared to the “Generals -Private Owner” or “Workout” types. With this risk diminished, we think this category has a promising future.”

While many people still prefer the “fire and forget” nature of investing in mutual funds, more and more people are rediscovering the excitement and benefits of trading individual stocks. No doubt, this has been aided by the growth of online trading, cheap commissions and a realization that many high-paid advisors and Wall Street research departments consistently fail to outperform low-cost mutual fund strategies.

But with investors’ new found status as managers of their own portfolios comes a dangerous temptation – overtrading. In fact, overtrading can represent a far greater risk to a portfolio than mediocre stock selection or a bad market. Time and time again, undisciplined and hyperactive investors run their portfolios into the ground by increasing their costs, decreasing their tax benefits, and missing the natural action of the stock markets. Getting a grip on how often they pull the trigger is crucial in keeping their portfolio moving in the positive direction. (Learn more inMeasure Your Portfolio’s Performance.)

How Heavy Trading Cuts Profits

Throughout Candlestick Analysis you are going to find many war-like references. Between 1500 and 1600 the territories of today’s Japan were at constant war. Each daimyo (feudal lord) was in constant contention to take over their neighbor. This one hundred year period is known as Sengoku Jidai or the “Age of Country at War”. This was a definite period of turmoil. It slowly came to order in the early 1600’s through three dynamic generals – Nobunaga Oda, Hideyoshi Toyotomi, and Leyasu Tokugawa. Their combined leadership prowess has become legendary folklore in Japan’s history.

On Wall Street, the bulls and bears are in a constant struggle. If you haven’t heard of these terms already, you undoubtedly will as you begin to invest.

The Bulls

A bull market is when everything in the economy is great, people are finding jobs, gross domestic product (GDP) is growing, and stocks are rising. Things are just plain rosy! Picking stocks during a bull market is easier because everything is going up. Bull markets cannot last forever though, and sometimes they can lead to dangerous situations if stocks become overvalued. If a person is optimistic and believes that stocks will go up, he or she is called a “bull” and is said to have a “bullish outlook”.

The Bears

A bear market is when the economy is bad, recession is looming and stock prices are falling. Bear markets make it tough for investors to pick profitable stocks. One solution to this is to make money when stocks are falling using a technique called short selling. Another strategy is to wait on the sidelines until you feel that the bear market is nearing its end, only starting to buy in anticipation of a bull market. If a person is pessimistic, believing that stocks are going to drop, he or she is called a “bear” and said to have a “bearish outlook”.

You’ve now learned what a stock is and a little bit about the principles behind the stock market, but how do you actually go about buying stocks? Thankfully, you don’t have to go down into the trading pit yelling and screaming your order. There are two main ways to purchase stock:

1. Using a Brokerage

The most common method to buy stocks is to use a brokerage. Brokerages come in two different flavors. Full-service brokerages offer you (supposedly) expert advice and can manage your account; they also charge a lot. Discount brokerages offer little in the way of personal attention but are much cheaper.

At one time, only the wealthy could afford a broker since only the expensive, full-service brokers were available. With the internet came the explosion of online discount brokers. Thanks to them nearly anybody can now afford to invest in the market.

2. DRIPs & DIPs

Dividend reinvestment plans (DRIPs) and direct investment plans (DIPs) are plans by which individual companies, for a minimal cost, allow shareholders to purchase stock directly from the company. Drips are a great way to invest small amounts of money at regular intervals.

Stock prices change every day as a result of market forces. By this we mean that share prices change because of supply and demand. If more people want to buy a stock (demand) than sell it (supply), then the price moves up. Conversely, if more people wanted to sell a stock than buy it, there would be greater supply than demand, and the price would fall.

Understanding supply and demand is easy. What is difficult to comprehend is what makes people like a particular stock and dislike another stock. This comes down to figuring out what news is positive for a company and what news is negative. There are many answers to this problem and just about any investor you ask has their own ideas and strategies.

That being said, the principal theory is that the price movement of a stock indicates what investors feel a company is worth. Don’t equate a company’s value with the stock price. The value of a company is its market capitalization, which is the stock price multiplied by the number of shares outstanding. For example, a company that trades at $100 per share and has 1 million shares outstanding has a lesser value than a company that trades at $50 that has 5 million shares outstanding ($100 x 1 million = $100 million while $50 x 5 million = $250 million). To further complicate things, the price of a stock doesn’t only reflect a company’s current value, it also reflects the growth that investors expect in the future.

Most stocks are traded on exchanges, which are places where buyers and sellers meet and decide on a price. Some exchanges are physical locations where transactions are carried out on a trading floor. You’ve probably seen pictures of a trading floor, in which traders are wildly throwing their arms up, waving, yelling, and signaling to each other. The other type of exchange is virtual, composed of a network of computers where trades are made electronically.

The purpose of a stock market is to facilitate the exchange of securities between buyers and sellers, reducing the risks of investing. Just imagine how difficult it would be to sell shares if you had to call around the neighborhood trying to find a buyer. Really, a stock market is nothing more than a super-sophisticated farmers’ market linking buyers and sellers.

Before we go on, we should distinguish between the primary market and the secondary market. The primary market is where securities are created (by means of an IPO) while, in the secondary market, investors trade previously-issued securities without the involvement of the issuing-companies. The secondary market is what people are referring to when they talk about the stock market. It is important to understand that the trading of a company’s stock does not directly involve that company.

Common Stock

Common stock is, well, common. When people talk about stocks they are usually referring to this type. In fact, the majority of stock is issued is in this form. We basically went over features of common stock in the last section. Common shares represent ownership in a company and a claim (dividends) on a portion of profits. Investors get one vote per share to elect the board members, who oversee the major decisions made by management.

Over the long term, common stock, by means of capital growth, yields higher returns than almost every other investment. This higher return comes at a cost since common stocks entail the most risk. If a company goes bankrupt and liquidates, the common shareholders will not receive money until the creditors, bondholders and preferred shareholders are paid.

Preferred Stock

Preferred stock represents some degree of ownership in a company but usually doesn’t come with the same voting rights. (This may vary depending on the company.) With preferred shares, investors are usually guaranteed a fixed dividend forever. This is different than common stock, which has variable dividends that are never guaranteed. Another advantage is that in the event of liquidation, preferred shareholders are paid off before the common shareholder (but still after debt holders). Preferred stock may also be callable, meaning that the company has the option to purchase the shares from shareholders at anytime for any reason (usually for a premium).