Know yourself and know your enemy, and you will never be defeated : Understanding both yourself and the companies you invest in
"Know Yourself and Your Enemy, and You Will Never Be Defeated; If You Know Yourself but Not the Enemy, Victory Is Half Certain; If You Know Neither, Defeat Is Inevitable."
(The Art of War : Attack by Stratagem)
Sun Tzu said : "If you know both the enemy and yourself, you can fight a hundred battles without disaster. If you know yourself but not the enemy, you will win one and lose one. If you know neither the enemy nor yourself, you are certain to be defeated in every battle."
The principle emphasizes that a thorough understanding of both your own strengths and weaknesses and those of your opponent is essential for success. Without this understanding, your chances of success diminish significantly.
Buffett's "Know Yourself and Your Company" investment strategy is one of the key factors behind his success. This approach combines the investor's understanding of themselves with a deep knowledge of the companies they invest in, allowing them to craft an investment plan that best suits their needs.
Know Yourself
Before entering the stock market, the first thing to understand is yourself. This means knowing your available capital, investment goals, risk tolerance, and the areas or industries you are most familiar with.
Investment Capital
Investors should first consider whether their capital is discretionary income, meaning it can be used for investment without significantly impacting their daily lives. The worst mistake in investing is being forced to withdraw funds prematurely due to an emergency, cutting short potential gains before the investment has matured. As Sun Tzu said, "Take high ground first, then secure supply routes; this will give you the advantage in battle." In investing, capital is like the supplies needed in a battle—carefully plan your funding sources before investing to ensure smooth operations later. While the risks of stock market investing can be minimized, they cannot be entirely eliminated. By pre-assessing the potential losses and setting a financial bottom line, investors can protect their lifestyle from being disrupted by market volatility.
Investment Goals
Investment goals are directly tied to the desired level of returns. If the goal is to achieve quick profits, investing in rapidly growing emerging industries might be a consideration. On the other hand, if the investor is more conservative, stable and growing companies could be more suitable investment targets. Regardless of the approach, investors must have enough patience and maintain a long-term perspective, focusing on investing in companies rather than just their stocks. This means holding onto shares for an extended period to share in the company’s growth. As Buffett famously said, "If you aren't willing to own a stock for ten years, don't even think about owning it for ten minutes." Trying to make money by trading stocks in the short term is more akin to gambling than investing.
Familiar Fields of Expertise
One of the key factors behind Warren Buffett's investment success is his strict rule of not investing in stocks from industries he doesn't understand. Buffett believes that investing in familiar fields allows you to ensure your capital retains its value and grows. Approaching investments with a gambling mindset, putting large sums of money into industries you're unfamiliar with, is extremely risky. He asserts that a person's energy and attention are limited. With thousands of companies in the stock market operating in entirely different sectors, it is impossible to be knowledgeable about all of them. Instead, it's wiser to focus our limited energy on industries we are familiar with, gaining as much insight as possible about these businesses, which, in turn, benefits our investment decisions. "Knowing the edge of your competency is important. If you think you know more than you do, you will get in trouble." – Warren Buffett.
Successful investors are those who possess self-awareness. They have a deep understanding of their capabilities and invest only in areas where they excel, advancing cautiously and steadily to secure victories. On the other hand, unsuccessful investors often believe they know everything, leading them to blindly venture into fields they know nothing about, ultimately incurring losses.
In the 1980s, the rise of internet technology stocks became a hot pursuit for many investors, with their market prices soaring to dozens or even hundreds of times the companies' revenues. However, most investors knew very little about these tech stocks. During this time, Buffett remained clear-headed; since he knew nothing about the stocks of companies like Microsoft and Intel, and couldn't predict what the world would look like in 10 years, he chose to stay away from the tech sector until he could truly understand it. This rational choice allowed him to avoid the subsequent dot-com bubble burst. Buffett believes that investing must be rational, and if you don't understand something, you shouldn't invest in it. This has been a consistent principle in Buffett's investment approach for decades.
Learning from Past Mistakes
Everyone is bound to make mistakes, and even Warren Buffett, revered as the Oracle of Omaha, is no exception. He once said, "We all make mistakes. If you've never made a mistake, you've never made a decision." Despite having made several errors in his investment career, Buffett has always approached them with the right attitude—deep self-reflection, learning from his failures, and then coming back stronger.
Buffett believes that before making new investment decisions, we should carefully review our past mistakes and the lessons learned from them. By identifying past errors, investors can avoid repeating the same mistakes. "It's a good idea to review past mistakes before committing new ones." — Warren Buffett.
Self-awareness is a key factor in successful investing. The more you understand yourself, the clearer you are about your strengths and weaknesses. With this understanding, you can plan investment strategies that better suit your capabilities, leveraging your strengths and improving your weaknesses, which naturally increases your chances of investment success.
Understanding the Company
When Warren Buffett evaluates a potential stock transaction, the first thing he does is approach it as if he were a business operator. He studies how the business operates, where its profits come from, and whether the company has a strong competitive advantage. Buffett believes that achieving success in stock investments without understanding the company you're investing in is like fighting a battle with no assurance of victory—the result will inevitably be defeat. He dedicates a significant amount of time and effort to analysing and researching the companies he plans to invest in. He believes that investment success comes from a comprehensive understanding of the companies in which he invests. His research and analysis focus on the following key areas:
1. Financial Analysis: Buffett emphasises the in-depth analysis of a company’s financial situation. This includes evaluating profitability, debt levels, and cash flow. Only by understanding a company’s financial health can an investor make informed decisions.
2. Competitive Advantage: He looks for companies with economic moats, meaning they have competitive advantages within their industry that make them difficult for other companies to replace easily. This helps in maintaining long-term value.
3. Management Team: Buffett assesses the company’s management team to determine if they have outstanding execution capabilities and financial acumen. He often emphasises that excellent management is crucial to a company’s success.
4. Industry Outlook: Understanding the future prospects of the industry in which the company operates is essential to ensuring it is poised for steady growth. The health of the industry is critical to the company’s long-term performance.
5. Products or Services Offered: He also evaluates whether the products or services provided by the company have lasting competitiveness and whether they possess the brand advantages of consumer monopoly.
Understanding the Value of a Business
When investing, Warren Buffett makes decisions based on an evaluation and analysis of a company's business prospects. He considers himself a business analyst rather than a market analyst, macroeconomic analyst, or securities analyst. He has no interest in analysing charts or predicting stock price trends. Instead, he focuses on the company’s operations, the durability of its products, the competitive advantages of its brand, and the responsibility of its management team. Buffett believes that investors should focus on estimating a company's future earnings, as the future value of a business will ultimately depend on its future earnings.
Buffett's method for assessing a company's value involves first predicting the earnings the company can generate over a long period in the future. He then uses the interest rate of U.S. 30-year Treasury bonds as the discount rate to discount these future earnings, thereby estimating the company’s value. Therefore, the accuracy of a business valuation depends on the accuracy of the company’s future earnings forecast. For companies whose future earnings are difficult to predict, Buffett prefers not to invest, as this reduces the likelihood of investment mistakes. The companies Buffett chooses to invest in typically have a long history of stable operations, as he believes only these companies allow him to more accurately predict their future earnings.
Understanding a Company's Return on Equity
When evaluating and measuring a company’s profitability, Warren Buffett considers the most important indicator to be the "Return on Equity" (ROE), rather than Earnings Per Share (EPS). He believes that using the ratio of net profit to shareholder equity to assess and evaluate a company's performance is very effective, as this metric demonstrates the efficiency of the company’s current capital investment. Although companies can use debt to improve their ROE, Buffett believes that a truly good company should be able to achieve a decent ROE without relying on debt. Therefore, investors should be sceptical of companies that need to rely on debt to achieve good ROE. Buffett thinks that companies with high ROE are usually those with stable operations, that have been consistently offering the same goods and services for a long time, or that focus on a leading core business.
The growth of a company’s shareholder equity depends on a high level of return on equity investment. Only after shareholder equity grows will the intrinsic value of the company and its stock price increase accordingly. Therefore, Buffett is always on the lookout for companies with a high level of return on equity, such as Coca-Cola, The Washington Post, and Gillette.
Understanding a Company's Profit Margin
Warren Buffett consistently seeks out companies with high profit margins, as a high profit margin indicates effective cost control, directly benefiting the company's shareholders.
Understanding the Products or Services Offered by a Company
Buffett classifies a company's products or services into two types: consumer-type and commodity-type. Consumer-type products generally appeal to a broad base of customers and can develop a loyal customer base through brand promotion, becoming what he refers to as "consumer monopolies." In contrast, commodity-type products find it difficult to build a loyal customer base through branding, with customers usually making purchasing decisions based on price and quality alone.
Buffett seeks companies that have consumer monopoly characteristics, as these companies gain a competitive advantage from brand effects without needing to lower prices or constantly update production equipment to maintain competitiveness. Consequently, these companies possess stronger profitability and perform well regardless of economic conditions.
Buffett believes that products with consumer monopoly characteristics should have the following qualities:
1. The product or service is something that customers need or desire.
2. Customers perceive the product or service as irreplaceable.
3. The product’s sales are not significantly affected by price changes.
If a company's products meet these criteria, the company can freely raise prices on its products or services, thereby increasing its return on capital. Companies with such branded products are ideal investment choices for investors.
Warren Buffett's "Know the Company and Know Yourself" investment strategy emphasises the importance of investors making informed investment decisions by thoroughly understanding the companies they invest in, while also being aware of their own investment goals and limitations. This strategy helps reduce investment risk and increases the likelihood of long-term investment success, which is precisely what has made Buffett one of the most successful investors in the world. Therefore, this strategy is well worth studying and emulating for those pursuing long-term investment success.
Case Study:
When Warren Buffett evaluates a potential stock investment, he always ponders one key question: Why is one company more successful than another? To find the answer, Buffett personally investigates the companies he is interested in, rather than relying solely on theories and data to make investment decisions.
In the spring of 1951, Buffett set out to analyse GEICO stock to determine if it was worth investing in. He believed that to understand a stock, one must first understand the company behind it. Therefore, he personally visited GEICO to gain a deeper insight into the company’s operations.
Buffett met with Lorimer Davidson, who was then the Vice President of Finance at GEICO, and they spoke for more than four hours. During their discussion, Davidson used his expertise to explain GEICO's business operations in detail. This meeting was incredibly significant for Buffett, as it opened the door to the world of insurance for him. After the four-hour conversation, Buffett gained a profound understanding of how insurance companies make money: they collect premiums from customers, invest that money, and any profits belong entirely to the insurance company.
Subsequently, Buffett met with several experts in the insurance industry to discuss GEICO and discovered the company's advantages. At the time, the traditional business model in the insurance industry was to sell policies through insurance agents. However, GEICO employed a direct-to-customer model by mailing policies directly to clients, giving the company a substantial cost advantage. Additionally, GEICO's clientele primarily consisted of government employees and military personnel—groups that were stable with low accident rates, thus reducing the likelihood of claims.
Based on his field investigation and interview with Lorimer Davidson, Buffett became convinced that GEICO was a rapidly growing company. In 1951, he purchased GEICO stock in four instalments, acquiring a total of 350 shares at a total cost of $10,282, which was half of Buffett's entire fortune at the time.
Buffett’s investment in GEICO proved to be correct, as within less than two years, GEICO's stock price more than doubled. In 1952, Buffett sold his GEICO stock, making over $5,000 in profit. In this successful investment case, Buffett thoroughly understood GEICO's business model and advantages through multiple channels, rather than relying solely on data analysis to draw conclusions. This demonstrated Buffett's emphasis on understanding the company inside out, paying attention to every detail before making an investment decision.
