Advice for New Investors

A new investor asked: 'How do you separate emotion from your skill sets?'

Don't buy on stock tips or rumors. Tips and rumors are a good place to start doing research or due diligence but one should put off the trading decision until one has firm opinion of one's own that this is a good deal based on one's own portfolio strategy, whatever that might be.

Peter Lynch advised writing down the stock's story on a 3 by 5 card (he must have been pre PC). Writing down the story forces you to take a closer look at the company and the reason why you are buying. Later, it serves as a reminder of why you bought in the first place and it is a good antidote for itchy trigger fingers. Over the weekend I read Warren Buffett's annual report and it contains the Burlington Northern Santa Fe story. I quote:

The highlight of 2010 was our acquisition of Burlington Northern Santa Fe (BNSF), a purchase that's working out even better than I expected. It now appears that owning this railroad will increase Berkshire's "normal" earning power by nearly 40% pre-tax and by well over 30% after-tax. Making this purchase increased our share count by 6% and used $22 billion of cash. Since we've quickly replenished the cash, the economics of this transaction have turned out very well.

Both of us are enthusiastic about BNSF's future because railroads have major cost and environmental advantages over trucking, their main competitor. Last year BNSF moved each ton of freight it carried a record 500 miles on a single gallon of diesel fuel. That's three times more fuel-efficient than trucking is, which means our railroad owns an important advantage in operating costs. Concurrently, our country gains because of reduced greenhouse emissions and a much smaller need for imported oil. When traffic travels by rail, society benefits.

Over time, the movement of goods in the United States will increase, and BNSF should get its full share of the gain. The railroad will need to invest massively to bring about this growth, but no one is better situated than Berkshire to supply the funds required. However slow the economy, or chaotic the markets, our checks will clear.

Railroads were last century's Internet. Most have gone broke partly from excess costs imposed by labor unions and from competition by truckers and air travel. Rail even had its own Dow Jones Index which used in conjunction with the DJ Industrials was the foundation of the Dow Theory, a forerunner of today's mechanical investing systems. Railroads are a thing of the past yet Buffett finds value in BNSF. He also needs a place to sop up his excess cash and BNSF is going to take care of that, for sure! Whether BNSF will be a good investment remains to be seen.

If you distill the BNSF story it is about the cost of fuel, specifically Diesel. Trains have been running on Diesel-electric for at least 50 years. Buffett is buying the railroad at the time when there is a strong push for alternative energy sources and at a time where more value is being created with bytes than with atoms. Bytes prefer to travel by Internet, not railroad.

Why the long story? Because in the long run stock prices are determined by the value creation abilities of the underlying company. The above analysis is applicable to the long term investment horizon Buffett is using. On the other hand, "dynamic" investors are more likely to be affected by short term happenings like an uprising in Libya or a gun ownership rumor during elections. What this illustrates is that first you have to decide what kind of investor you want to be, then you adjust your trading to that strategy. You overcome emotions by having a clear goal and a path to get there.

Strategies change. Even Buffett's strategy has changed in part owing to his success in accumulating wealth. It seems a paradox that Buffett has been so successful that he has had to change his ways, he has too much wealth to continue doing what created all that wealth. I don't usually read Buffett's annual reports (Mike does and he makes a yearly pilgrimage to the Sage of Omaha's meetings). A fellow Fool posted the link to the latest report so I read it over the weekend. It makes great reading.

One learns best from the masters: Buffett, Lynch, Fisher, Graham...

Denny Schlesinger

Warren Buffett's 2010 letter to stockholders (pdf)