Buffett’s Teacher Shares a Game You Can Win
- It’s no secret that one of Warren Buffett’s biggest inspirations is Benjamin Graham.
- Buffet’s other influence is a legend that can give investors the upper hand in the stock market.
- Searching for high-profit margins when analyzing stocks is a mistake. Here’s a better way to find winners.
Warren Buffett celebrated his 90th birthday this week. Due to his great success, he’s frequently been asked to share the secrets to his accomplishments.
Buffett freely credits his business school instructor Benjamin Graham as an inspiration. From Graham, he learned to patiently wait for value.
Graham explained that stock prices are set by an irrational fellow named “Mr. Market.” Sometimes, Mr. Market is overly optimistic and quotes high prices. Other times, Mr. Market’s pessimism creates prices that are lower than expected.
Investors can ignore Mr. Market. They can sit tight when he’s irrationally exuberant. Smart investors wait for low prices and then spring into action.
Buffett’s respect for Graham is well-known. But not as known is his admiration for another market legend whose insights are particularly useful for small investors.
Buffett’s Little-Known Mentor
At an annual meeting in 2018, Buffett said:
There was a book by Phil Fisher written around 1960 called Common Stocks and
Uncommon Profits. It’s one of the great books on investing. And it talks about the
‘scuttlebutt method’ of investing, which was quite a ways from what Ben Graham
taught me in terms of figures. But it’s a very, very good book. And you can learn a lot,
you know, just by going out and using some shoe leather.
Individual investors may find Philip Fisher’s work more useful than Graham’s. And here’s why…
Follow Gossip Over Numbers
With Graham’s strategies, investors analyze numbers. Fisher, on the other hand, starts with scuttlebutt. That’s just a word for gossip.
To find it, ask small-business owners which vendors they like working with. Question others to find out which companies they admire.
Scuttlebutt investors listen. When they hear about a promising company, they dig deeper.
The first thing to check is the size of the company.
Fisher noted the biggest winners are “…small and frequently young companies.” They make “…products that might bring a sensational future.”
One of his big winners was Motorola, which made the first car radio in the 1930s.
Fisher bought as Motorola popularized transistor radios in the 1960s, then continued to hold as the company created radios for astronauts and first responders, cell phones and other products.
Fisher liked the products. But Motorola’s financials were just okay.
And that’s an important point. Many investors search for high-profit margins. Fisher thought that was a mistake.
He wrote: “High margins attract competition, and competition erodes profit opportunities. The best way to mute competition is to operate so efficiently that there is no incentive left for the potential entrant.”
The Winners’ Game
What Fisher wrote makes analysis simpler for investors looking for the best stocks. We want to use company data to verify profits. Next, we want to make sure profit margins are average.
Then, we look at the price-to-sales (P/S) ratio.
First, a company should have sales. That sounds obvious. But this week, 1,791 publicly listed companies report sales below $100,000 in the past 12 months. That’s 29% of all traded stocks.
Although Fisher wrote over 60 years ago, his work is especially timely.
Low P/S ratios are “particularly important in inflationary environments,” according to Fisher. As the Federal Reserve threatens to increase inflation, investors can’t afford to ignore this advice.
Fisher’s career spanned the Great Depression, runaway inflation of the 1970s, and numerous bubbles and crashes. With all that experience, he believed it was best to buy stocks with low P/S ratios.
His work also explains how small investors can beat the pros.
As always, it’s important to remember we aren’t Warren Buffett. He can call the CEO of any company in the world for scuttlebutt. But we can’t.
That means our edge is in small companies. By listening, we can pick up scuttlebutt about the next big winner, long before the stock is big enough for Buffett and other large investors to buy.
My colleague Ian King is finishing a special presentation on small caps and will share his work soon. Keep following us here in Smart Profits Daily for the full details later this month!
Editor, One Trade