What investment strategy is that? Technical analysis.
Invest like a lemming
Technical analysis is the
practice of predicting where stocks will trade based on charts of
historical pricing and volume information. There's a certain logic to
it. Stocks trade based on supply and demand, which is greatly
influenced by investors' attitudes about the stocks. The charts should
reflect those attitudes and might predict where the individual stocks
will go.
It's an attractive idea. Quest Diagnostics (NYSE:
DGX) has bounced between $45 and $55 quite a few times in the past few
years. Why not buy at the low, and sell at the high? Or look at McAfee
’s (NYSE: MFE) chart. Clearly, investors love the stock. Its rise from
$28 to $38 seems unstoppable. Why not jump aboard and profit?
Technical analysis is a simple yet compelling strategy. You can see
why Buffett spent years early in his career trying to master it.
An expensive mistake
But Buffett discovered one
small problem. Technical analysis didn't work. He explained, "I
realized that technical analysis didn't work when I turned the chart
upside down and didn't get a different answer."
After eight years of trying, he concluded that it was the wrong way
to invest. Then he focused on the teachings of Ben Graham, which
stressed business fundamentals, finding a strategy that both made sense
and, more importantly, worked.
Three simple rules
The billionaire discussed that strategy at the 2008 Berkshire Hathaway
general meeting. When he was asked how to avoid the crowd mind-set, he
said he simply followed Graham's three most important lessons:
The first lesson usually makes the headlines. It means that you
should buy stocks for less than they're worth. But when Buffett talks
about the second and third lessons, he's basically admitting that he
wasted eight years of his investing life.
Buying a business
After all, thinking about a
stock as part of a business is the opposite of what technical analysis
is all about. Technical analysis focuses on trading securities. It
doesn't matter whether the security is a share of Valero
(NYSE: VLO), with its dozen different energy products; or whether that
security is a derivative promising the delivery of three tons of
Italian meatballs. It's all the same because technical analysis doesn't
care about the business -- or the fundamentals.
In Graham's second lesson, stocks are far more than just pieces of
paper or lines on graphs, and to understand them, you need to
understand the business. If you're looking at PepsiCo
(NYSE: PEP), ignore whether the stock has been up three days in a row,
and focus instead on why the company plans to acquire its top two
bottlers.
Ways to serve man and woman
Similarly, when
Buffett says the market isn't there to instruct, he's saying the
movements in the market aren't telling you how to invest.
When Aeropostale (NYSE: ARO) fell to $2.50 per share in 2002, the market was saying that teenage shoppers had fled for the likes of Abercrombie & Fitch (NYSE: ANF), never to return again.
When McDonald 's hit $13 in 2003, the market was
announcing that the Big Mac would end up in the Museum of Neat Ideas
Gone Wrong, alongside the tapeworm diet, land wars in Asia, and Paris
Hilton's home videos.
But in both cases, the market was wrong.
So, instead of listening to the market, Buffett seeks to take
advantage of it. Sometimes, the market will offer to buy a stock for
far more than it's actually worth. Other times, it'll offer you the
chance to buy shares of a great company for far less than its fair
value. An investor who understands the true value of a business will be
able to profit when the market offers great companies on sale.
The Foolish bottom line
You can learn from
Buffett's error -- don't focus on charts. Instead, understand
businesses and seek excellent stocks that the market offers at low
prices. These days, the market is particularly treacherous. Some stocks
that seem cheap will turn out to be very expensive. Others that are
simply beaten down by negativity will post amazing returns.
Our Motley Fool Inside Value
team is working to take advantage of the situation, and we've
identified several stocks we think will post some of those amazing
returns. If you're interested in reading about them, click here for a 30-day free trial.
Already subscribed to Inside Value? Log in at the top of this page.
This article was first published June 16, 2008. It has been updated.
Fool contributor Richard Gibbons
should not be used as a dessert topping. He owns shares of Quest
Diagnostics. The Motley Fool owns shares of Berkshire Hathaway.
Berkshire is a Motley Fool Inside Value and Stock Advisor recommendation. Quest Diagnostics is an Inside Value selection. PepsiCo is an Income Investor pick. The Fool's disclosure policy bears an eerie resemblance to Charlie Munger
© 2009 UCLICK, L.L.C.
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