The Financial Ass Kicking Some Warren Buffett Wisdom Could Have Helped Me Avoid

A bestselling Warren Buffett biography drilled in some lessons I failed to get the first time.

A few weeks ago, I was looking at the stocks and mutual funds in my retirement portfolio and saw a sea of red. It really wasn’t pretty. The S&P 500 was down close to 20%. The tech-heavy Nasdaq was deep in “bear market” territory.

My own portfolio was even worse, because over the last couple of years I have expanded my exposure to individual stocks, including what turned out to be way too many high-flying tech offerings.

My 2001 financial ass kicking

This isn’t my first financial ass kicking. My investing life started around 1998. I was working for one of the hottest technology players of the day, Sun Microsystems, whose servers and software were one of the four technological pillars of the internet, along with databases (Oracle), storage (EMC) and routers (Cisco).

From that lofty insider perch, I thought I understood tech investing. I bought stock in the companies I thought were best positioned to deliver the promise of the internet to the consuming public. Sun, EMC, Quest, Level 3, Global Crossing, America Online (AOL), Commerce One, Palm . . . if it looked like a winning business model for delivering on the promise of the internet, I invested in it.

I made a fortune on paper. For a while. Less than two years later, I rode those exploding paper returns all the way back down, selling for a real loss of more than 30% of my original investment.

I was devastated. My wife and I were just starting out and it was money we couldn’t afford to lose. I felt like a financial failure, though I wasn’t exactly in rare company. We tech investors hadn’t been geniuses even when making huge paper gains. We were just passengers in a boat, lifted on a lake that was rising behind a dam that was about to burst, to mix a whole bunch of investing metaphors.

I told myself that at least I’d learned some hard lessons and learned them early. I read more about investing principles, including a lot about Warren Buffett.

My 2022 Financial Ass Kicking

Yet, here I was twenty years later, again licking my wounds. I picked up a copy of The Snowball: Warren Buffett and the Business of Life by Alice Schroeder. It won a slew of award back in 2009, shortly after the last full-blown financial crisis kicked into high gear and Buffett once again looked uniquely prescient. It rubbed salt in the wounds, with Buffett’s teachings illustrating the extent to which the battering of my portfolio was my own damn fault.

Revolutionary technologies don’t result in revolutionary economics

As The Snowball depicts, while today he’s recognized as perhaps the greatest investor of all time, in 1999 Buffett was getting pilloried by the financial press for supposedly “missing” the dawning of the internet.

He hadn’t missed it. He consciously chose to sit it out, for three reasons.

First, he believed in staying within his narrowly defined “circle of competence.” He refused to invest in tech, because he didn’t understand it.

Second, and perhaps more fundamentally, Buffett thought tech stock prices had become untethered from their “intrinsic value,” i.e. their value based on some objective measure like “book value” or discounted cash flows.

Third, Buffett knew “revolutionary” technologies seldom yielded revolutionary returns.

He summed all this up at a major economic forum in Sun Valley, Idaho in July of 1999, whose attendees included many newly minted internet multi-millionaires and billionaires. He explained in simple terms exactly why they were not geniuses and why the internet stock party would, inevitably, end.

Buffett’s “tough love” message to the technology world’s one-percenters was that technological revolutions are not new and, while they may transform society, they tend not to work out for investors. Automobiles were once revolutionary and their development spawned literally thousands of automakers. Yet, here they were in 1999, down to three American automakers, all of which had at one time or another come close to going belly up.

Similarly, airplanes were revolutionary in 1903 after Wilbur & Orville’s first flight. In the ensuing decades, however, airlines had been a wealth destroyer for investors, with literally hundreds going bankrupt and taking purchasers of their stock down with them.

Buffett was virtually alone in refusing to believe that the same couldn’t happen to the hundreds of supposedly “revolutionary” companies trying to cash in on the internet.

His gut-punch message was that nothing in the current boom had repealed the fundamental laws of economics, which held that in the end stocks can’t grow faster than the overall economy. For short periods they might, but only if interest rates fell and stayed below historically low levels.

Mr. Market, Weighing Machines and Voting Machines, and the Margin of Safety

Buffett summed up the difference between long and short-term stock pricing with this aphorism: “In the short run, the market is a voting machine. In the long run, it’s a weighing machine.”

In the long run, a company’s stock price is a function of its historical profits, together with the predictability of future profits over time. Buffett believed that by analyzing the economic fundamentals of a business, you could determine the “intrinsic value” of its stock, which might or might not be tethered to its actual price in the market.

In the short run, on the other hand, price was determined by a bunch of individual buyers and sellers, the cumulation of which Buffett analogized to a fictional “Mr. Market.” Mr. Market doesn’t really weigh anything. Rather, he reflects the “votes” of those individual buyers and sellers about current value, Because Mr. Market is an aggregation of the current psychological state of all the buyers and sellers, he can be one emotional dude. In fact, he’s like a bipolar patient off his meds, his sentiment swinging higher and lower than the objective situation warrants.

Because Mr. Market is an emotional guy, there can be a big difference between the price he sets and a stock’s intrinsic value. Buffett’s method is to determine a stock’s intrinsic value, then invest only when the stock is selling below what it is intrinsically worth. By buying when Mr. Market is in a downer mood, an investor gets a “margin of safety” against future mood swings.

“Cheaper” is not “cheap.” The difference between “buying the dip” and a “margin of safety.”

This is where I f**ked up in 2001 and again in 2020–2021. I paid too much attention to the business and not enough to the stock; specifically to how price compared to value, to the extent he latter could even be defined when many hot stocks were growing but unprofitable businesses.

As a patent litigator by occupation, I think I do have a reasonable understanding of the world of high technology and the players in it. Therefore, I’m not as worried as Buffett about tech stocks being outside my “circle of competence.” But, what should have been an investing advantage may have been a handicap. I think I picked many good businesses, but they were lousy investments at that point in time because (a) their price was too high; and/or (b) their intrinsic value was indeterminable at best or astronomically high at worst.

Where I blew it was confusing objective versus subjective “cheapness.” Many of the stocks I bought in the last couple of years actually looked cheap, because I “bought the dip” when thy were selling well of their highs. In fact, I usually bought only when a stock was selling at least 20% below its 52-week high. On the surface, that seemed very Buffett-like.

The problem with that strategy, however, is it confuses objectively “cheap” and relatively “cheaper.”

Buffett’s goal was to buy a stock when it was cheap as compared to some objective measure of its intrinsic value, like it’s book value or historical earnings. I, on the other hand, was just comparing the current Mr. Market-driven price to some higher Mr. Market-driven price. Yet both of those prices might be irrationally exuberant as compared to the stock’s intrinsic value. A stock selling at a 20% discount could still fall another 70% if its intrinsic value was 90% lower than its market high. A 20% discount makes it cheaper, but not necessarily cheap.

A concrete example: Zoom

I bought Zoom stock in 2021, after it had dropped significantly from its Covid-driven high.

I still think it’s a great business and a great brand. Its name has become a generic identifier video-conferencing. On the fundamentals, its earnings are up 324% over the last three years. Its sales growth over that period is 151%, with a profit margin of close to 30% and a strong balance sheet.

Yet, I’ve gotten absolutely pummeled on the stock, because I bought at discounted, but still stupid, price. In July of 2021, around the time I bought in, it had a price-to-earnings (P/E) ratio of 130 — close to 10x the market’s historical average! Its price-to-sales ratio (P/S) was 34.

Let me explain how insane that is. It means that as an investor, I am paying $34 dollars for every single dollar the company makes. If the company sells $1 of product each year, it would have to pay that $1 to me every year for 34 years for me to break even. And, in the meantime, the company would not have even a dime to extra revenue to spend on payroll, R&D, marketing, advertising, rent, etc.

There is absolutely no way to rationalize that kind of valuation, and the plain fact is I didn’t rationalize it. Instead, all I was thinking was that (a) it was a great business, and (b) I was buying with a “margin of safety,” because my buy-in price of $370 a share was more than 20% lower than its 52-week high of $478.

But, my margin of safety was illogical and illusory because (a) it compared one irrational price to another irrational price, hardly the comparison of price to objective value that Buffet’s margin of safety hinges on; and (b) it vastly underestimated how much Mr. Market’s previous euphoria had been based on Zoom as a “pandemic play,” ignoring that it was a great business before the pandemic.

A year later, I’ve lost a fortune on Zoom but its objective price to value comparison is no longer irrational. It’s now trading at a P/E of about 19. It isn’t cheap by Buffett standards, but it’s arguably at least reasonably priced based on its actual earnings once you normalize for the Covid surge.

So, am I buying it again? Not yet. One of Buffett’s other lessons for the attendees at Sun Valley in 1999 was that in addition to intrinsic value, in the long run stock prices move inversely to interest rates; stocks can remain historically high only if interest rates are, and stay, historically low.

I’m not sure even Buffett foresaw that, between the financial meltdown of 2008–2009 and the pandemic of 2020, interest rates would stay at virtually zero for over a decade. With rates now going up and stocks having sold off accordingly, are stock prices “cheap” or merely “cheaper”?

My read is they probably are close to fairly priced, but that’s short of a margin of safety, isn’t it? My guess is Buffett isn’t going on a buying spree quite yet.