Be Approximately Right

Warren Buffett amassed a multibillion-dollar fortune as an investor. These days, his wealth and benevolent reputation help him attract business owners looking to become part of the family of companies he controls. It wasn't always that way. There was a time when Buffett was a veritable nobody -- a paperboy for The Washington Post.

While the rest of us can only dream of achieving Buffett-esque success, we can still learn a lot from his accomplishments. After all, to get to where he is now from where he was when he began, he had to do a lot of things right. Importantly for those of us looking to follow in his footsteps, there was a time before excellent investments started searching for him. Back then, he had no special advantage of reputation and wealth. Instead, he had to actively scour the market to look for the best publicly available values, just like an ordinary investor.

By understanding and following the bedrock principles that catapulted him from zero to investing legend, we mere mortals can hope to enjoy success of our own. Fortunately, Buffett has been exceptionally willing to share his secrets with the rest of us, carrying forward a great tradition started by his investing mentor, Benjamin Graham.

Dangerous precision
In particular, one quote from Buffett stands out as key to his tremendous success: "It is better to be approximately right than precisely wrong." If you really understand what that means and follow the direction it sets out for you, then you're well on your way toward being able to build your own substantial nest egg. Yes, it really is that simple.

To get to the core of why Buffett's words are so sage, though, you have to understand the ultra-short-term thinking that dominates Wall Street. Every quarter, there's an elaborate dance between analysts and the companies they follow. The companies announce they will expect to hit a certain earnings range. The analysts read between the lines of the announcements and come up with their consensus forecast. Most of the time, the companies will later announce actual earnings that either hit the consensus forecast on the nose or just manage to beat it.

There are many reasons why this dance usually works. The easiest one to see is that company managers have the ability to use incentives to entice their customers to make last-minute purchases in a specific quarter. Think of the "cash back" offers, "0% financing" deals, and "employee pricing" that automakers roll out every summer. Ford (NYSE: F  ) , General Motors (NYSE: GM  ) , and DaimlerChrysler (NYSE: DCX  ) aren't simply offering programs like these for your benefit. They do it because they're looking to clear inventory off the lots quickly -- both to make room for new models and to meet financial targets.

Because incentives and other tools are available to help companies manage to specific earnings targets, when a company misses those targets, Wall Street tends to panic. It's not the specific miss that's the issue, it's the concern that the company has run out of means to massage its earnings. This is a problem because it can indicate that, with all the wiggle room gone, things may really be far worse than they appear.

Pebbles in the ocean
When you think about it, though, a small earnings miss shouldn't actually be worth writing home about. If you view a generally successful company over the course of decades, a small shortfall in a single quarter is pretty meaningless to the real value of the business. Yet back in January, when microprocessor titan Intel (Nasdaq: INTC  ) fell $0.03 short of expectations, its shares fell by more than 11% in the next trading session. That was about a $16 billion market value haircut, thanks to approximately $175 million in expected earnings that didn't materialize.

From a purely numbers-driven view of the company, the scale of that loss seems absurd. It only makes sense in a market that is so focused on the very short term that it can't tell the difference between a temporary cyclical or competitive downturn and the next Enron debacle.

Inside-the-park home runs
With that background, the reason why being "approximately right" is so much better than being "precisely wrong" starts becoming clear. In the long run, the money a company earns determines its true worth. On a day-to-day basis, however, how the company did compared to its immediate expectations is really all that matters to the myopic folks on Wall Street.

If you take the long term view, $0.01 here or there simply doesn't matter much at all. The big money isn't made in guessing whether Google (Nasdaq: GOOG  ) is going to make $2.41 or $2.43 this quarter. (The consensus estimate is $2.42.) Instead, real fortunes are earned by knowing, as Buffett himself knew, that American Express (NYSE: AXP  ) was not going bankrupt as a result of the "Salad Oil Scandal." Quite frankly, the difference in true value between a firm with several billion in profits and a bankruptcy is far larger than the difference between a firm earning $1.50 and one earning $1.51.

Free your mind
Don't get me wrong -- valuation certainly does matter. If you ignore it, you may end up on the wrong side of the next bubble. That's why, at Motley Fool Inside Value, we have an online valuation calculator here to help subscribers and free guests get a feel for what a company is worth based on its long-term cash-generating capabilities. Yet even with the calculation, the best you can do is to ballpark a firm's fair value.

That ballpark estimate, however, is all you need. Real Buffett-sized returns are earned from investments where there is a clear and significant difference between the market's current price for a firm and its true value. If you're haggling over pennies, it's not substantial enough to matter.

The next big bargain is out there, today, and you only have to be approximately right to find it. If you'd like some additional guidance, join us at Inside Value. You just might find that a little uncertainty is good for your returns.

At the time of publication, Fool contributor and Inside Value team member Chuck Saletta owned shares of General Motors and Intel. Intel is an Inside Value selection. The Fool has a disclosure policy.


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