Berkshire Hathaway
In Reply To:
The Limits of Fundamental Analysis

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By DeliLama
February 4, 2003

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In my opinion, you've brought up the most important questions for investors.

"How do I tell when a company is fudging the numbers and when it is being honest and above board?"

Had I read the book The Bank Director's Handbook before December 2001, I probably wouldn't have lost as much in the same stock that also burned Peter Lynch: ACLN (ASW). I would highly recommend reading the chapter on fraud and the appendix, which lists the FDIC's list of red flags for identifying fraud. It's not so much that any of them would have shown that ACLN was a fraud. They simply show the patterns associated with fraud and the environments in which fraud thrives. It's like watching magic show: after seeing enough of them, you know to be suspicious when someone climbs into a large black box. No matter how many padlocks and chains are wrapped around it, there's going to be a trap door in there somewhere.

There is absolutely no way to avoid ever being wrong other than to simply not invest. You can minimize the chances by watching very carefully for any clues. You might be lucky to find clues that someone is possibly dishonest, but you should mostly be looking for clues that indicate the equivalent of someone climbing into a black box with a trap door.

One thing I believe is true is that investors must be extremely cautious at times where there are very few stocks priced at good values because the likelihood of something bad being hidden is much higher in times like that than when the whole market is selling cheap.

Another thing is that historically, the really bad behavior tends to occur during the height of a boom cycle, much as how a wild party never seems to get really out of control until very late in the night. You don't find a lot of rowdy neighbors at 7:00 AM on a Tuesday morning.

"I find this area particularly frustrating because I find it difficult to accurately forecast future earnings with any fair degree of precision."

Except in trivial cases, you can't, so don't even try. That's the whole thing about being precisely wrong rather than roughly right. What I look for is companies that have lots of highly desirable qualities, which will not be harmed by long-term trends in the world. You can't honestly say what Coca Cola's earnings will be in the year 2020. However, you can say that Coca Cola is extremely likely to remain a very dominant beverage in large parts of the world... and that the world will very likely have a much larger middle class with much larger purchasing power and that Coca Cola is very likely to benefit greatly from this.

When we own stocks, we own pieces of businesses. Businesses sometimes go wrong. We can't stop that. But we can invest such that a few things going wrong are greatly offset by a few things that go right. You win some, you lose some. Even with a .400 batting average, you're still striking out a lot of the time.

"My purpose is not to dissuade people from stockpicking since I know that such an endeavor is doomed to failure. But I do believe that I can help temper the enthusiasm of some and perhaps provide a more sober assessment of what can and will be achieved in this activity."

The real time to temper people's enthusiasm was back in 1999 (when Buffett wrote the Fortune article). Right now, people should be somewhat neutral.


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