Warren Buffett’s Secret – The Equity Bond Investment

Investment Perspective – February 2017

“Neither the investing method nor the fundamentals of the business are right or wrong because the mood of the market is favourable or unfavourable toward the “stock”. That is because when you really think about it, “stocks” (shares) are all about the financials and the trading price, the share price… the cash up value. What matters more is the economics of the business” 

Peter Flannery

For many years, decades even, the world watched and wondered how Warren Buffett seemed to be achieving better results than almost everyone else, more so as time went by. 

Then, there was the way he appeared to be investing. Contrary to popular mainstream belief (Modern Portfolio Theory) he appeared to be investing large sums of money into only one investment rather than spreading it round in order to manage risk. Not only that, he sometimes invested large sums in stocks that were in trouble, with their share price either in decline or having declined significantly. 

Warren Buffett did not appear to be following market trends either. When markets were rising he seemed flat footed, sitting on piles of cash. And yet when markets were in turmoil he seemed at ease placing large sums of money into one investment right in the middle of the turmoil. 

For those unfamiliar with investing in the so-called “share market”, the whole idea of investing in shares or stocks was (still is) considered akin to gambling or speculating because market prices rise and fall unpredictably.  

For those working more closely in the area of investing in stocks and shares on the share market, Warren Buffett appeared to use some of the well-known analysis techniques that analysts around the world used but still, it was difficult to work out just what he was doing in order to achieve his ongoing success with Berkshire Hathaway.

His unique skill notwithstanding, Warren Buffett applied a simple methodology which later became known as “the equity bond”. 

I talked about this in last month’s Investment Perspective, click here to review …

So Why Is The Equity Bond So Important?

The equity bond is an investment that provides the security of a bond (think bank term deposit) and generates a reliable income stream known as a coupon (think interest off a term deposit). At the same time this equity bond provided growth (think growing business with share price rising over the long term or property price rising over the long term).

So what we have is an investment that provides us with the security and reliability of a bond or term deposit but also an investment that will grow and compound long term.

To be clear what we don’t have is speculation or investing in a high-risk investment that is simply a game of chance or based on market events.

What we do have is a reliable investment that will keep our capital safe long term, regardless of economic conditions. Better still it will grow. Not only will it grow, the growth will compound long term. The compounding advantage is often underestimated. Compounding is a simple but very powerful tool for those looking to make money work.

But How Do We Know The Money Is Safe?

What Warren Buffett knew decades ago was that investing in stocks and trying to play the market (like everyone else was doing) was almost a waste of time. 

Incidentally, the market overall has yet to grasp the concept that there is a considerable difference between playing the markets and investing in a business.

Investing in a business that has a sustainable competitive advantage was Warren Buffett’s (unintentional) secret. This is still, to this day a methodology that is overlooked / not understood by most.

That’s why …

That’s why the market’s fascination with price related analysis does not make sense for us as Value Investors. Actually it is incongruent with keeping money safe and making it work too.

It is also why referring to the rise and fall in the cash up value of the portfolio over short-term timeframes is largely irrelevant. Price and value are different things although they tend to align longer term (e.g. 10 years plus).

Worth mentioning too is that a Value Investor’s temperament, our mindset and behaviour, is different to those who play the market. For example we can understand the difference between investing in a business with a sustainable competitive advantage from playing the markets using mainstream financial analysis used by most managers, analysts and sharebrokers.

As Value Investors we grasp the idea that price and value are not the same thing. That price is a market sentiment driven variable, whereas value is based on the underlying business performance, how well it uses capital. Use of capital is driven by its sustainable competitive advantage among other things. 

Investing successfully it turns out is not “rocket science”. It is just that most people do not invest the way we do. Most people feel more comfortable doing what everyone else is doing.

TIP: Trust the method – it works. Stay the course… you will keep your money secure and your money will work for you.

“The key to investing success is compounding growth. The key to compounding growth is a business that uses capital well because of its sustainable competitive advantage – thank you Warren Buffett.“

Peter Flannery