The Best Lessons from Warren Buffet that will turbocharge Your Investment Game
Lessons from Warren Buffet for Beginner, Intermediate, and Advanced Investors. My application of these lessons inside this Note.
Happy Thanksgiving to my wonderful Online Friends: This is an email that will be going out to both my public and private community. Before we get started, make sure we’re connected on Social: Linkedin, Instagram, and Twitter.
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Dear Friends (Both Public and Private Community,
On this Thanksgiving Holiday, I’d like to use it as an opportunity to share insights and knowledge from Warren Buffet’s annual shareholder letters. Most folks do not have a proper mentor to guide them in their investment journey, and I will do my best to provide you the highest quality information possible.
This email will provide significant value for friends from both my Public Community and my Private Community. Additionally, I will assume my readers transact in many different time frames in the marketplace (short-term, intermediate-term, and long-term), and I believe the following insights to still be valuable for all timeframe investors.
I’d encourage you to save this email for future reference, because it has evergreen qualities for your investment journey. I will also make a Youtube Video on this topic in the future.
Warren Buffet’s Annual Letters
Since 1977, Berkshire Hathaway (where Warren Buffet is the Chairman) has written an annual shareholder letter to investors. In these letters, Buffet goes through a review of the year for Berkshire’s business, and then often shares nuggets of wisdom based on his experience in business and long-term investing.
In all these Shareholder Letters, there is no shortage of insights and wisdom.
Whether you are a Intraday Trader, Intermediate-Term Investor, or Ultra Long-Term Investor, these principles are all very helpful in making us more well rounded.
I will recap on 3 takeaways that I personally use and apply to make money in the market and add value to my Community (you as my reader). I’ve carefully selected them based on investor level: Beginner, Intermediate, or Advanced.
From a timeframe standpoint, I classify my primary strategy as an Intermediate-Term Investor (with a longer-term bias). On Youtube and inside my Investment Community, I am best known for my Intermediate-Term views. To balance out my skillset in 2023, I am aggressively learning the science behind Intraday Trading as well as Options. This is because I view the risks to markets in 2023 to potentially be greater than in 2022 from a macro standpoint.
While there is a general stigma behind Intraday Trading or shorter-term timeframes trading (I used to be very against this timeframe), I have personally witnessed that a proper system behind this timeframe in the right context can indeed work if done with extreme discipline. I am not ready to discuss this publicly yet, but will have more details later in the future (at some point in 2023). Any future content related to Intraday Trading and Options would be separate new programs apart from my current Investment Community, which focuses on actionable strategy on intermediate-term equity market/company views. I’m already putting live capital to work every day to test different strategies/emotions related to Intraday Trading and Options while keeping a systematic journal (what works/in what market conditions/what should be avoided). I am always innovating, and I believe 2023 (most likely 2H of the year) will be a period of tremendous opportunity.
Now, here are 3 principles from Buffet that will help any Investor. The first principle is applicable to all timeframes of investing, but the 2nd and the 3rd are geared more for intermediate-term and long-term investors (which I understand that most of my readers are).
1st Warren Buffet Takeaway: Find your Circle of Competence (For Beginners)
In my opinion, finding your circle of competence is one of the most important principles to follow as an Investor. You must invest in what you understand. Allocating capital into an area where you don’t understand the business is a gamble according to Buffet. I agree with this.
As an example, my members inside my Community know that I have a dedicated coverage universe (list of companies that I cover and understand).
Inside this coverage universe of stocks I cover, I have essentially internalized all the valuation multiples, the macro considerations, the key levels this stock has traded in the past 3 months, and the forward catalysts and risks this name has associated with it in the coming 3-6 months.
Because I focus on a set number of stocks, I become a specialist in these areas, and my accuracy level when I provide opinions on them will be higher than say companies that I don’t follow/don’t cover/don’t watch.
Let me provide you an example. There are more examples inside my Community, but this one here will illustrate the point perfectly about Circle of Competence.
Inside our Community in September, I advocated for Dollar Tree when it was priced around 135/share (or approx. a 18.5X forward multiple). With three FOMC meetings (Sept/Oct/Dec) left in the year at the time, the Fed was set to raise Fed Funds Rates to its 4%+ target. I knew that credit card balances would threaten consumer spending, and that folks would trade down their consumption habits. The 2Q of this year when retail giant Target got hammered after earnings was a sign of what’s to come. With DLTR trading at 18.5X forward P/E, which was only a slight premium to the S&P 500 at the time, at the very least, I believed that this company had a better intermediate-term future than the general index itself where much of the index was still heavy in tech - a sector where inflation acts like kryptonite to its equity returns.
Since September, Dollar Tree saw its shares rise to 165/share and saw its multiple expand to 22.5X forward earnings.
Because I cover the name closely, by Mid-November in our Bi-Weekly Dashboard, I shared my opinion that DLTR was approaching a Weak Sell after a tremendous 20% run and that my downside range for this name is the 144-148 region (based on my technical assessment). The reasoning behind this is a blend of technical and valuation momentum that I didn’t believe could be sustained (without a reset) after its share price surge.
After DLTR earnings, the company sold off and reached my Downside target after my opinion. DLTR remains fundamentally sound. Because this name is in my Circle of Competence, I know that the driver of the selloff was technical in nature and a reset of momentum. Fundamentally, DLTR has the same business model and outlook since September. The share price had simply appreciated too quickly, and my understanding of its trading behavior allowed me to let members know that it was time to reduce if they consider themselves shorter-timeframe investors.
My Mid-Month November 15th Bi-Weekly Dashboard where I provide Key Levels I focus on: For DLTR, I said it’s approaching a Weak Sell (when it was at 160+)
Dollar Tree is a name I understand well, based on its fundamentals and its upside/downside potential. I followed the same execution methodology that I discuss.
I also personally shop there as well from time to time, and also to check out the store’s economics while I’m at it. I’ve done my homework on the name, and therefore I have confidence to make a decision on it.
Because it’s inside my Circle of Competence, I have an edge in areas of the market where I compete.
As an investor, find YOUR circle of competence. Warren Buffet is 100% right about this piece of advice.
2nd Warren Buffet Key Takeaway: Understand the Competitive Moat (Intermediate-Level Investors)
Warren Buffet famously said that companies’ moats are actually changing every day - it’s just that small unnoticeable changes over time add up to big changes that are blatantly obvious.
While the formal definition of a moat is quite straight forward (how protected a company’s business model is from competition due to positioning), evaluating it with a clear process is less well-understood.
Firstly, one of the best ways to understand the competitive moat is the Gross Margins reported by a company. This is because it measures two key areas of a company’s performance:
The top-line sales figure, which is organic and difficult to manipulate
The cost of goods sold (input costs), which is what the company pays vendors to create their products
The difference between sales and cost-of-good-sold is the gross profits, and from there we can calculate gross margins.
Most firms cannot rapidly change their obligations for costs of goods sold because these are the input costs to create the products they offer.
But their revenues are subject to a few considerations. As a reminder, a company’s sales is pricing x volume. As a result, here’s how revenue changes…
The average selling price (ASP) can be impacted
The unit volume could also be impacted
This is why the Buyside usually rewards companies that raise their pricing while punishing companies that lower their pricing. This is because a change in average selling prices has a direct influence on the gross margin of a company.
Usually (but not always), a company that lowers their price on a structural level (aside from Holiday sales like Black Friday for instance) is an indication that demand from the marketplace at the current level requires stimulation.
Earlier this Fall, inside our Community, I discussed Kroger being a very strong defensive name even after the Albertson’s proposed merger. I discussed this in one scene of my Youtube videos.
In the current high inflation environment for food prices, Kroger’s average selling prices is likely to remain supported. Perhaps it may even see an incremental increase. Its gross margin profile is steady (may even tick higher), and the Buyside rewards companies with solid gross margins during time of uncertainty with a higher multiple.
As a result, even after the proposed large deal for Albertsons, Kroger’s share price has not formed any lower-lows in terms of its chart’s technical structure.
Should the Albertson merger go through, this would be adverse to consumers but it would mean Kroger’s moat would essentially reach a near monopoly status.
Don’t focus on the share price, and focus on the moat - as Warren Buffet would like to say.
This is an example of it being applied inside our Community.
3rd Warren Buffet Key Takeaway on Operating Leverage (For advanced investors who can read Balance Sheets and Income Statements)
Warren Buffet has in the past shared examples on how Operating Leverage is a powerful double-edged sword.
To make sure that we’re all on the same page, I want to explain what operating leverage is. Here’s an image from Google, but in case this doesn’t click for you, operating leverage means that a company has a ton of fixed costs relative to its overall cost structure.
Well, that means that if revenue goes higher, profit margins will accelerate greatly higher because costs were fixed.
On the other hand, if revenue falls significantly, the fixed cost structure will eat the business alive because profit margins will be decimated.
Now that you understand operating leverage, which is what fundamental analysts like myself use in our decision-making, let’s talk about its implications.
During a macro uptrend of growth for that sector, companies with high operating leverage will see EPS skyrocket quarter after quarter and these companies share prices will follow in tandem because Analysts will not be able to accurately predict the magnitude of upside EPS surprises.
Some examples (not an exhaustive list) of industries with high operating leverage include:
Cruise Ship Operators (extremely high maintenance costs per cruise)
Airlines (large fixed costs per flight)
Pharma (high R&D)
Software companies (high R&D to produce the software, and then cost structure becomes lower operating leverage). Like Salesforce and Twitter.
Members who have been inside my Investment Community since the beginning of the year saw that I removed Salesforce and Twitter from my coverage universe after the first quarter of 2022.
This was deliberate: because I saw they had high operating leverage. It wasn’t suitable in this environment of slower growth and more intense budget allocations among their clients.
You see, my strategy takes time to play out, and folks who stay for long periods of time in my Community will reap the largest returns. This is why I’ve priced the Community to be globally accessible for long-term attendance. This is done deliberately.
To apply the effects of your understanding on operating leverage, it also pays to have a longer term focus on investments.
This Thanksgiving Holiday, take a look at your portfolio and assess whether the companies you hold have high operating leverage.
Because if they do, a deep recession in 2023 is just the beginning of the worries of these companies.
I answer questions such as these in my Community if you need help.
In all my email notes to you, I will write to you from a perspective to help you.
I would seriously encourage you to find a mentor in this market and stick to a long term committment to improving your investment decision making.
It can me, or it can be others.
Whatever you do, take every opportunity to shortcut your learning curve and get ready for what comes next.
I wish you a wonderful Thanksgiving Holiday to my U.S. and Global friends.
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Your Investment Strategist,
Larry
