Wednesday, October 1, 2008

The New Buffettology: Chp 2: How Warren Makes Good Profits Out of Bad News About a Company

A contrarian investment strategy is one that is motivated by a falling stock price. Eugene Fama and Kenneth French demonstrated in their landmark study, that buying companies with beaten down stock prices in the previous two years were more likely to produce an above average return in the next two years. This contrarian strategy does not require an analysis of the type of business the company is engaged in or of the underlying economics of the business. In contrast, Warren Buffet uses a selective contrarian investment strategy whereby he purchases companies that have been beaten down but that also possess a durable competitive advantage.

Companies with durable competitive advantages have strong underlying business economics that helps their stock prices to recover from almost any short term problem scenario. Buffett has made all his big money investing in companies that possess these durable competitive advantages. (The authors will delve deeper into how to identify companies with durable competitive advantages in subsequent chapters.)

Many mutual fund manager's jobs depend on the managers producing above average short term performance results. For this reason, the same mutual fund managers are often leery of investing in stocks that have had recently released bad news or are enduring falling stock prices because they can't afford the risk that the stock will not rebound in a short time frame. They play the extraordinarily difficult game of timing their stock picks just before the stock rises significantly. It is exactly this short term focus that allows Buffett to find excellent businesses with durable competitive advantages periodically selling well below their true economic value in the public stock markets.

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