The stock market has been a roller coaster so far this year. The CBOE Volatility Index has been high with multiple days of huge gains and losses, and major indexes are down substantially year to date. Fear is a powerful emotion that can derail your investment performance. However, a strong long-term strategy is the best way to overcome fear and confusion. Using the wisdom of hall-of-fame investors like Warren Buffett can be really valuable during turbulent times.
Keep things in perspective
Since Warren Buffett launched his career in 1951, there have been more than 25 market corrections, 10 bear markets, and 10 recessions. I doubt Buffett is thrilled about the current surge in stock market volatility, but it's probably no shock to him. He's no stranger to market cycles. Moreover, Buffett's intense focus on cash flow and valuation would have tipped him off to the rising likelihood of this downturn.
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Investors who maintain a long-term focus need to recognize that cycles are inevitable from time to time. It's important to keep your cool during rough patches. These are the times when opportunities arise, and that's exactly when big winners can stand out in the market.
How to analyze stocks like Buffett
Warren Buffett was heavily influenced by Benjamin Graham's value investing approach. This philosophy maintains that stocks have an intrinsic value that's based on a company's future earnings. If a stock's price is lower than the value of its future cash flows per share, then it's probably a good investment.
This is a powerful method, because it establishes clear investment guidelines that connect a stock's fair price to real-world outcomes. Value investing can help investors block out irrelevant data and short-term distractions.
That's not to say that it's a perfect strategy, though. Accurately forecasting profits is easier said than done, and it's impossible to truly know what the future holds. Furthermore, high-growth stocks, especially those that are unprofitable, aren't good candidates for this process. The math doesn't really work for growth stocks, so other valuation methods are more appropriate in those cases.
Managing for long-term returns
Despite those shortcomings, the value investing approach can create stability amid the chaos. Buffett didn't get carried away in 2020 and 2021 as the stock market charged higher and higher. He recognized that stocks were getting more expensive, and Berkshire Hathaway (BRK.A -0.48%) (BRK.B -0.39%) stockpiled nearly $150 billion of cash.
That pile of cash is waiting to be deployed into value stocks that have been unfairly punished by fearful investors recently. The NASDAQ Composite index has shed trillions in market cap and is down nearly 10% year to date. While the sky is falling for growth investors, Buffett's holdings are producing exceptional cash flows. He's also getting ready to capitalize on buying opportunities created by these market forces.
That's the heart of the disconnect between Buffett and other popular investors like Cathie Wood. Wood recently tabbed railroad stocks as a sector to specifically avoid. Along with other pillars for the Oracle of Omaha, railroads are never going to be a high-growth business due to the industry's maturity and heavy physical infrastructure. They just don't have the room or ability to scale quickly from here. Railroads and insurance companies certainly weren't the best performers during the COVID-19 bull market. However, many of these businesses have predictable cash flows that won't dissipate any time soon.
There are merits to each approach for sure. However, growth investors who weren't prepared for volatility are likely having a really tough time right now. They probably don't have a pile of cash with which to capitalize on a market pullback.
Some key takeaways
Most investors won't be able to replicate Warren Buffett's success. He has enormous resources at his disposal and a lifetime of experience that few people can match. Your goals and risk tolerance might be totally different from his, anyway -- you might not be interested in matching his performance.
Still, there are a handful of key observations that can be valuable for any investor:
- Understand that cyclicality is natural in the stock market. Don't panic about it, and be prepared for when it inevitably hits.
- Manage your portfolio for long-term gains rather than short-term returns.
- Train yourself to see market downturns as an opportunity to acquire good stocks at a discount.
- Recognize that a stock's value has to reflect the cash flows of the underlying business over the long term.
- Don't get overexposed to growth stocks, especially as valuations hit particularly high levels.
- Consider investing a portion of your stock portfolio in value stocks.
Keep this guidance in mind as you navigate this turbulent market.
