TIP Academy
LESSON SUMMARY
In this lesson, we learn about the fundamental approach Warren Buffett uses to invest his money. The method is called value investing and it’s based on the techniques Buffett learned from his college professor, Benjamin Graham. Graham was Buffett’s professor at Columbia Business School and very famous for writing the #1 selling investing book of all time, The Intelligent Investor. This lesson has the following important points.
1) Value Trading Versus Value Investing: When we talk about value trading, this is when a person buys an assets at a low price and expects to sell it at a higher price. This would apply to something like a commodity (like oil). When we think about value investing, we are not only buying an asset at a low price and expect it’s value to increase, but it also has a capacity to earn a consistent income. Assets (or securities) like Stocks and Bonds fit into this category. This concept is very important as you continue to learn more about determining the real value (or intrinsic value) of an asset.
2) Assets Versus Liabilities: Simply put an asset is something that’s going to continue to put money in your pocket, or it’s a safe store of buying power. A liability on the other hand is something that takes money out of your pocket over time. A liability is also a store of negative value for a business. For example, a loan would be listed a liability.
LESSON TRANSCRIPT
VALUE INVESTING VS VALUE TRADING
To start off, Kyle McDonald’s website, One Red Paper Clip, will be the example. In his experiment, Kyle started with one red paper clip to see if he could trade that value and see what item he could trade it into. Looking through his website, think that his paper clip’s worth was 5 cents. At the top of his website is a timeline of the things he traded. Kyle started with the red paper clip to a fish pen to a doorknob until he got to trade a house within a year to a year and half. Even at the beginning, he knew the value and worth of the next item he was trading. He had it mapped and planned already which he took advantage until he actually got what he wanted – a house.
Clicking the house links the answer to the big question: was Kyle McDonald conducting value trading or value investing? Kyle was actually doing value trading. There is a pretty big difference between value investing and value trading.
You will understand value investing and value trading more by taking a look at the following illustration. When Kyle traded the red paper clip for a fish pen, he was waiting to trade it for the doorknob. Again, he had it mapped already. If he held on to the fish pen for 10 days would the fish pen become worth a dollar and 10 cents? If he held onto the fish pen for a year, would it become worth a dollar, 10 cents, or a dollar and 20 cents? Would it still be generally worth a dollar not including inflation? Obviously, the fish pen did not grow in value while he held it. It stayed exactly pretty much the same and did NOT grow value at all. This is value trading.
As we look at the difference between value trading and value investing, holding onto the item or the asset throughout the trading period will grow value and more money in the pocket.
ASSET VS LIABILITY
In order to understand value investing, figure out what an asset is. The fish pen is clearly not an asset, but an item that is going to continue its value. Here are four examples – a house, an apartment building, a microwave, and a car. Is the house an asset or not? Some people would argue that a house is an asset. It is not an asset as it simply maintains its value.
An apartment is an asset, because after buying one, it will continue to put more money into your pocket.
A microwave is a representation of a patent. The patent is an enormous asset, because you don’t have to pay anything more in order to use it and it puts money in your pocket every single month.
The car decreases in value every year and every month. Not only that, but you also make payments every single month. In the end, it is not an asset, but a liability.
To summarize, an asset is something that’s going to continue to put more money in your pocket every single month as you continue to own it. An asset is important in value investing. A liability takes money out of your pocket in your day to day life every single paycheck.
Asset versus liability. Again, an asset puts money in your pocket; a liability takes money from your pocket. Nobody needs a liability in value investing. The difference between a wealthy person and a not-so-wealthy person is that the wealthy person accumulates assets. Every month, he does whatever he can to buy, own, and possess more assets. An example is the apartment building. Again, an asset is anything that puts money into your pocket. That could be a small stock, which eventually is the focus for this entire website. Each time you own that asset (the small stock), it is putting more money into your pocket each month. the wealthy people accumulate assets and do everything in their power to minimize the liabilities, because that’s what takes the money out.
Meanwhile, here’s an example of people who have one asset – their job. Their job, of course, pays them their salary and it goes into the pocket. They keep on accumulating more liabilities. He has the exact opposite thing happening where he can never really improve his way of life and his social standard. A liability does not improve and most especially does not help in value investing.
What is value investing? Value trading is how Kyle McDonald was always trading his red paper clip up. To clear things up, the difference between value trading and value investing is when you value invest, you do exactly what Kyle was doing with the paper clip, but you’re doing it WITH ASSET. While you’re holding onto the fish pen for either 10 days or a year, the fish pen is actually growing in value. It increases and puts more money in your pocket as you wait for the next trade (If you even do the next trade). The asset alone might be enough to just keep putting money in your pocket. That’s really what value investing is – a combination of both of the two.
WARREN BUFFETT: VALUE INVESTING IN ACTION
Here’s a scenario on how to properly invest. When Warren Buffett conducts a value investment assessment, it goes like this:
“Wow, here’s a company called See’s Candies. I’m going to look at all their financial information and determine what this company is worth.” After a little analysis, he determines its worth is $40 a share. In order to buy the shares of the company, he looks for what he can buy the shares for in a stock market. He looks at the market price for the trading price of that company. He notices that the shares are $30 a share which is $10 less than what he thought the company was worth per share. “Wow, what a great deal, I’m going to buy some shares of this company for a really good deal. While I am part of this great company, I get paid continually for owning this asset.” In the long run, Buffett purchases the company and it returns to his value for $40 a share and gets paid money every month from the sales that the product the company makes. That’s what he does: goes right into the financial debt, looks at the company, and figures out the company’s worth. He’d go on and say, “Oh, it’s trading for 30. I thought it was for 40. I think it’s a good business, so I’m going to buy.” He buys it and that asset continues to pay him month in and month out. This is value investing.
BENJAMIN GRAHAM: FATHER OF VALUE INVESTING
Although Buffett is a really smart guy, he actually learned the fundamentals of value investing from his Columbia professor, Benjamin Graham. He is the Father of Value Investing and he’s written two very famous books. These books are Security Analysis and The Intelligent Investor. Buffett attributes to these books most of his investing knowledge. However, they are hard to understand and for beginners.
That’s where we come into the picture. The purpose of this site, buffetbooks.com, is to teach you how to invest like Warren Buffett. We will be teaching the lessons to you in an easy-to-understand and interactive format. In the end, you’ll learn the importance of value investing so you can invest just like Warren Buffett and Benjamin Graham.
LESSON VOCABULARY
Value Investing
Buying assets that have a higher value than the price you can buy them for. The assets will continue to make you wealthier even though you do not put in any additional time and energy.
Asset
Items of various character that puts money in your pocket month after month as long as you own them. Stocks, bonds, renting out apartment units, are just a few examples of assets. As a value investor, you want to accumulate as many assets as possible.
Liability
Items that takes money out of your pocket as long as you own them. A car or a boat is just two examples of liabilities. These items would consistently lose value, be costly in maintenance, fuel, insurance.
Intrinsic Value
Simply put, it is the actual value of a security (a stock or bond) as opposed to the market price (or trading price of stock or bond). Your job as an intelligent investor is to determine an investment’s intrinsic value (follow the steps in this website and you should be on the right path).
