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Buy As If You Will Never Sell

"I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years." - Warren Buffett

Buy As If You Will Never Sell
I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.

Warren Buffett

Imagine a real estate market where you only know selling prices...

You wouldn't know anything about rent, population growth, the quality of the neighborhood, the state of the property, its location, what it looks like, whether the property is for commercial or residential use, etc.

The only information would be the selling price of each property.

How would such a market behave with such little information?

Perhaps its participants would come up with elaborate mathematical formulas to try to guess what future price would be, using price patterns as an input. They'd make deep analyses of candlestick charts and trendlines, trying to predict markets like shamans reading patterns in tea leaves.

Perhaps they would make decisions based on price trends:

  • Going up? "It's doing well, let's buy!"
  • Going down? "Oh no, real estate is crashing, sell sell sell!"

(Observe: These decisions lead the participants to buy high and sell low.)

Perhaps some shady figures would try to pump and dump certain properties, making a fat profit in the process. "I KNOW this will go up - my INSIDER INFORMATION tells me! Join me - let's make money together!"

And possibly, a lot of innocent, uninformed citizens would get fooled by these con men, losing large sums of money in the process.

The victims would naturally conclude: "Real estate is a SCAM. It's GAMBLING, and it's completely RIGGED by rich real estate scammers with insider information. Only fools would put their hard-earned cash in real estate!"

Enter: The "Rent Wizard"

Now, let's say a wizard showed up with a special power: the ability to know the rent of every property.

How would she behave to maximize her profits?

She would probably observe the flaws of relying on price appreciation. She would observe that the market's emotional, irrational instincts push prices in random directions. She would watch the markets shift from panic to euphoria at unpredictable times for unpredictable reasons.

She would conclude that you can't make money from trying to guess where prices will go. Too much hype, fear, and irrationality. There's no sense or reason to any of this - better off not trying to play such an unreliable, unpredictable game.

But how could she make money without price appreciation? Isn't the upward movement of price the ONLY way to make money?

Of course not!

This irrational, price-only market is the PERFECT vehicle for her to make money through RENT!

The Rent Wizard Cashes In

The wizard spots property X, renting out at 500,000 pesos per year, selling for 1 million pesos.

She's astounded. A 50% annual return? This is too good to be true!

She asks her friends who have no rental information: "Why is property X selling for 1 million pesos?"

Here are some of the replies she gets:

  • "Everyone HATES property X." Why, asks the wizard? "Because its price went down!"
  • "Ew, property X? Property Y is the hot pick of the year. It's been rising for the past 5 years. Why don't you buy property Y instead?" ("Because I can only collect 1% of my purchase price in annual rent...", thinks the rent wizard.)
  • "Property X has low trading volume. I probably won't be able to cash out on it, so I'd rather not buy." ("Who cares about trading volumes when the rents are this high? You cash out through rent!", thinks the rent wizard.)
  • "I guarantee you that the price of that property will never move. How will you make any money???"

She concludes that none of these things have anything to do with the property's rent. "More money for me, I guess", she says, as she makes the purchase, proceeding to collect a 50% rate of return on her investment every year.

Because of the market's irrational, price-based hatred of property X, the rent wizard was able to purchase it at a cheap price relative to its cash flows from being rented out.

Even if she never gets to sell the property again, the rent wizard will still make money from rent.

Notice that it's also possible for the market's irrationality to reverse, hyping up property X's market price to the moon. This doesn't have to happen though. The rent alone is more than good enough.

Why does this sound so familiar?

This is more or less how the stock market works.

Here are the parallels:

While the stock market has many rational analysts, even intelligent fund managers handle cash from emotional clients. These clients inject capital during uptrends and pull out during downtrends.

In fact, even competent financial analysts feel fear and euphoria, dumping competent analyses to join the crowd. You can see examples in over-optimistic analyst reports during the dot-com bubble of the 90's and the Moody's reports before the 2008 housing crash.

Why price can be nonsense

Let's dig deeper into the irrationality of using price as a decision-making tool. There are only 2 things you need to know about price:

  1. Price is based on the latest transaction.
  2. The transacting parties are not necessarily making rational decisions.

The current price of a stock is just the price of the latest transaction, and nothing more. It's not guaranteed to be anchored on earnings, cash flows, or assets. Many stock market participants have never even read a company's financial statement - we can't expect them to be pricing things based on business information.

Price has little to do with cash flows (most of the time, at least - but the exceptions aren't important here). A company can make lots of profits with a very low stock price, and a dying company can have a very high stock price (Google Gamestop for a great example of the latter).

For these reasons, it makes sense to analyze companies without using stock price as an input. Just like how the rents of our imaginary real estate market aren't at all affected by the mood of its irrational participants, real-life companies' earnings are also generally unaffected by stock prices.

After all, how would a crash in Jollibee's stock price impact the number of people buying fried chicken and burgers?

The answer is obvious: It would have no effect.

Buy businesses; not "stocks" (Also: Buy real estate for rent; not price appreciation)

Because prices are unpredictable and independent of business performance, it's obvious how to make money in the stock market: Buy businesses, not "stocks".

By being able to figure out the expected cash flows of a company, you can purchase its stock when the market is depressed, allowing you to buy good cash flows for cheap prices.

By knowing the business behind the stock, you'll have the security and confidence of knowing that you'll make money, no matter what direction the market goes.

If prices skyrocket, great! More bonus cash for you.

If prices tank, who cares? You're collecting great cash flows for the price you paid anyway.

Do you open a franchise or start a business expecting to sell it at a higher price down the road? No. You go into business for the profits and cash flows.

So why should a stock - an ownership portion in a business - be any different?

If this article made sense to you, you'll enjoy the rest of the blog.

If you want to get started with some basic valuation techniques, check out our intermediate guide on picking individual stocks by clicking here.

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