Warren Buffett's Best Advice Ever

It's funny how often a prominent person's legacy is remembered with a single speech, or even a single phrase. Four score and seven years. I have a dream. Ask not what your country can do for you. One small step for man. Tear down this wall. You know what I mean.

Without comparing the contributions of those men, I wondered whether one speech could define the career of the world's greatest investor, Warren Buffett, and his creation Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) .

Turns out, it can. While Buffett had been dominating for decades, his talent wasn't truly apparent to the world until he gave a 1984 speech at Columbia University titled "The Superinvestors of Graham-and-Doddsville."

The lengthy speech can be found in its entirety here (opens PDF file), but I'll give you the Cliffs Notes version.

Dumb luck, pure skill, and flipping coins
Buffett begins by imagining a nationwide coin-flipping contest. Everyone in the country participates and calls the flip of a coin. Call correctly and move on to the next round, guess wrong and you're out.

After 20 days, about 215 lucky flippers will have correctly called 20 consecutive flips. They gloat in success, yet the nature of coin-flipping tells us they're just lucky. It's a game of random chance.

But what if all 215 flippers lived in the same town? What if they all hailed from the same school? The same fraternity? Then we'd get excited. The laws of probability suggest 215 winners after 20 days. But those same laws tell us that if all 215 belonged to an associated group, that almost certainly wouldn't be the product of random chance. These 215 flippers clearly would know something we don't.

Meet nine "lucky" flippers
The real flippers in Buffett speech are nine "superinvestors" -- himself included. All nine crushed the market averages over multiyear periods by between 8% and 22% per year.

In a world with millions of investors, such returns can occur by sheer luck -- just like the 215 coin-flippers appeared at first glance. But all nine superinvestors hailed from the investment school of Benjamin Graham and David Dodd -- Columbia professors now known as the fathers of value investing. That meant something big. It meant that their success wasn't the product of luck. It almost had to be attributable to the only common link they shared: the investing philosophy learned from Graham and Dodd. The "intellectual origin," as Buffett put it.

What set Graham and Dodd's philosophy apart? That's where the title of this article comes in. Explaining it was simply the best advice Buffett ever gave.

Here it is
Buffett states the superinvestors' core values quite succinctly:

The common intellectual theme of the investors from Graham-and-Doddsville is this: they search for discrepancies between the value of a business and the price of small pieces of that business in the market. Essentially, they exploit those discrepancies without the efficient market theorist's concern as to whether the stocks are bought on Monday or Thursday, or whether it is January or July, etc ...

It's very important to understand that this group has assumed far less risk than average ...While they differ greatly in style, these investors are, mentally, always buying the business, not buying the stock.

It's that simple
Most investors aren't superinvestors. To them, there's little distinction between price and value. A cratering stock means risk, while a soaring stock somehow indicates strength and safety -- all with little regard to other, more deeply rooted factors. This is akin to assuming that all attractive people make great spouses.

But a more philosophical view shows how crazy this is. Risk appears when market value equals or exceeds the long-term value of a company's discounted cash flows -- its intrinsic value. It then diminishes in proportion to how far market price drops below intrinsic value. Really simple. The relationship between price and risk is often the opposite of what it's comfortable to assume.

Here's an example: Was Google (Nasdaq: GOOG  ) riskier in 2007, when optimism was on fire and shares exploded, or in late 2008, after shares crashed and bottomed out at around 12 times forward earnings? The answer is easy. Google was enormously risky in 2007, when the market assumed it was a surefire bet, and steadily approaching riskless territory in late 2008, when market volatility made investing look suicidal. Same goes for companies such as Alcoa (NYSE: AA  ) and Dow Chemical (NYSE: DOW  ) . Investing risk was lowest when the performance and volatility of their shares looked bleakest. That was when the gap between price and intrinsic value was widest. That's when you want to invest.

Looking ahead
Our Motley Fool Inside Value service looks for this kind of gap. Right now, the team has identified Western Union (NYSE: WU  ) and Wal-Mart (NYSE: WMT  ) as companies whose market is price is far below their long-term intrinsic value. Since inception, the team's picks have outperformed market averages by more than seven percentage points, making them superinvestors in their own right. To see what else Inside Value is recommending, click here for a free 30-day trial. There's no obligation to subscribe.

Fool contributor Morgan Housel owns shares of Berkshire Hathaway. Berkshire, Wal-Mart Stores, and Western Union are Motley Fool Inside Value selections. Google is a Motley Fool Rule Breakers pick. Berkshire and Western Union are Motley Fool Stock Advisor recommendations. Motley Fool Options has recommended writing puts on Western Union. The Fool owns shares of Berkshire, and has a disclosure policy.


Read/Post Comments (13) | Recommend This Article (126)

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  • Report this Comment On January 25, 2010, at 3:21 PM, miteycasey wrote:

    Many companies are run by hard working managements yet they are shunned by Warren Buffets...

    Why do you think that is???

  • Report this Comment On January 25, 2010, at 3:36 PM, catoismymotor wrote:

    De-caf for you from now on!

  • Report this Comment On January 25, 2010, at 3:37 PM, Turfscape wrote:

    lomaxlovescrocs wrote:

    "f we all invest the way Warren Buffet does, we would not have touched Intels, Microsofts, Ciscos, Ebays, Apple, Dell, those great companies that hired so many happy people who have homes"

    Wow...there's missing the point, and then there's lomaxlovescrocs. Congratulations, sir. You have left me speechless.

  • Report this Comment On January 25, 2010, at 3:58 PM, catoismymotor wrote:

    LLC,

    Thank you for expressing yourself. To say any more would be like gilding the lily.

    Cato

  • Report this Comment On January 25, 2010, at 4:10 PM, kennyboy81 wrote:

    Don't you see, everyone??? He's right!! Power to the people! Viva la revolucion!

  • Report this Comment On January 26, 2010, at 9:28 AM, sept2749 wrote:

    thank you for the 2 "freebees". generally speaking you guys (who I like and subscribe to ) usually don't give the name of the stocks that are recommended in one of your subscription services. Here you gave us 2 and good ones at that. It beats the hell out of ending with a pitch ie:"if you want to see our latest picks click here for your free 30 day trial" Thank you for your generosity - it just makes you want to subscribe to see more picks. Thumbs up!

  • Report this Comment On January 30, 2010, at 2:11 AM, TMFDanielSparks wrote:

    It's funny to see so many people criticize Warren Buffett. Let's let your investing track record speak for itself. Once you can show me how you managed to get in that eBay, Apple, Google, Starbucks, Dell, etc at the perfect time and make your fortune and maintain it, for a longer period than Buffett, then you might have some credibility. Until then, I'll be ignoring your criticism.

  • Report this Comment On January 30, 2010, at 4:18 AM, Zidanebuffet wrote:

    hey crocs, are u like obsessed with WB?

  • Report this Comment On January 30, 2010, at 6:19 AM, abrahamomega1 wrote:

    understanding the role of a game will tell how visible would your productive strangth be.it does really matter you know,but the truth remain;the only one that can be a giant of his day is that one or person who would learn to single out him self for wealth.that person who will not be selfish at all,and will not also be lucrant in every of his doing.i will soon come up with a new concept and also the application of the law of attraction which will be used to be compared to that reach bay and also to that bull dog.i will justgive one word of advice for you, dont give your right for a penury.

  • Report this Comment On January 30, 2010, at 11:26 PM, Turfscape wrote:

    DanielSparks wrote:

    "It's funny to see so many people criticize Warren Buffett."

    It's just one guy...not many people.

  • Report this Comment On January 31, 2010, at 3:21 PM, Gardnermiles wrote:

    I believed I was well invested with Merrill Lynch and would have a great retirement. My original Financial investor either retired or was terminated. His replacement didn't know me by sight or hold any special interest in my small but formally growing portfolio. My portfolio crashed almost overnight. I would love to get back to having the funds to invest again but this market is all over the place. This yoyo created by Wall St. and overpaid white collar boys is holding me back from even small investments.

  • Report this Comment On February 01, 2010, at 4:18 AM, gi1man wrote:

    So stocks are less risky when they're down alot? Did that apply to Citigroup when it dropped from 50 to 20? I guess that's why you're a blogging know it all and not a rich investor.

  • Report this Comment On February 01, 2010, at 11:11 AM, xjp83x wrote:

    gi1man:

    well one thing for sure, google wasn't in a situation like citi was with the suprime loss. even a 2nd grader would have known not to buy citi during that time. i personally think banks right now are the stuff. my opinion though.

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