Warren Buffett’s Two Rules, and Some Advice from My Mom

Warren Buffett often says he has only two rules for investing:

Rule #1: Don’t lose money.

Rule #2: Don’t forget Rule #1.

Which makes Warren Buffett’s wealth hard to understand. The most novice of stock investors has seen their shares decline in price, which seems the very definition of losing money. How can you accumulate $125 billion, as Buffett has, without owning things that can go down?

Buffett understands there’s a profound difference between observing price fluctuation, an inevitable part of the experience of owning any common stocks, and the permanent impairment of capital, which is the failure of the underlying business. This perspective is wholly in line with the views of the great Benjamin Graham, father of value investing, who trained Buffett at Columbia University’s business school. Say “Chapter 8” in any gathering of well-educated investors and they’ll immediately understand you’re referring to a specific chapter in Graham’s classic text, The Intelligent Investor.

Therein Ben Graham offered the contrast of Mr. Market, whose opinions are driven by emotion, momentum, current sentiment, and transitory news, versus the more durable value of the business enterprise whose ownership the investor holds in shares of common stock. His advice was to ignore Mr. Market, unless perhaps he was offering you a foolishly high price for your shares of stock in a business you own.

Back to Buffett. His maxim, “Don’t lose money,” can be translated as “don’t own businesses that can fail and go to zero.” In other words, own businesses with durable value.

So what creates durable value?

One of our answers, which is also part of Buffett’s answer, is to own investments that produce cash flow—excess dollars the business can either retain and reinvest internally, or distribute to its owners, who can then spend it or reinvest it themselves.

As a simple example, a US Treasury note provides specified and government-guaranteed cash flow, in the form of interest payments, twice a year. Dividend-paying common stocks provide less predictable and non-guaranteed income four times a year. Profitable companies that don’t pay dividends, but which have free cash flow, also have durable value. (This understanding is an evolution of Graham’s calculus, which was a dividend-discount model.)

Apple, for example, has $3.70 of free cash flow per $161 share. It pays $0.88 of that cash flow as dividends and chooses to either reinvest the rest or stick it in the bank. That retained cash flow is still valuable and quantifiable. (Apple currently sits on almost $64 billion of cash.)

We can compare Apple’s dividend to the yield on a Treasury bill or bond. Similarly, we can compare either the T-note’s cash flow or Apple’s dividend to the cash flow from income-producing real estate, or the S&P 500’s dividend yield, or the distributions from a bond mutual fund.

What doesn’t have durable value, by this metric? Assets that produce no cash flow. One such asset is gold, which has been around for thousands of years. Another is cryptocurrencies, which have been around for a little more than ten years, or NFTs, which have only been around for two years.

Gold has always been worth something, despite never producing a dime of cash flow. Right now it’s worth slightly more, adjusted for inflation, than it was a century ago; one dollar in gold purchased in 1871 is worth $3.60 today. Common stocks have done somewhat better. A theoretical $1.00 share of the US market, bought in 1871 and similarly adjusted, is worth $24,779.

Yes, that number is correct. See why Buffett likes stocks so much more than gold?

Cryptocurrencies and NFTs might be worth nothing. Zero. Or they might be worth something. Or some might be worthless and others valuable. But none produce cash flows that can be compared to the Treasury note, dividend-paying common stocks, or income-producing real estate we discussed before.

Perhaps Bitcoin is digital gold, as some of its true believers assert. If so, is there a reason to believe it will perform better than has actual gold, which has underperformed common stocks by four orders of magnitude over a century and a half?

At year-end, the United States hosted 644 “unicorns,” non-public companies worth over $1 billion each. Some of these might be tomorrow’s Facebook, Google, or Netflix. Some might be replacements for those tech titans. And many of them will be tomorrow’s Pets.com.

Few of them produce any free cash flow.

This brings us to another Warren Buffett aphorism, somewhat less well known:

“It’s only when the tide goes out that you find out who’s been swimming naked.”

Bear markets reveal imprudent risk-taking.

During bull markets, when rising tides of speculation are lifting so many boats, it’s often the most speculative investments that deliver the highest returns. It’s only when we get to a bad market that so many exciting “opportunities” are revealed to be dangerous follies. In Buffett’s term, naked swimmers.

As investors, we can’t have it both ways. If we’re going to pay attention to Buffet’s two rules, and if we don’t want to have our nakedness revealed when markets head south, we must choose not to own various things that will make some number of people, for some incalculable period of time, a whole lot of money. While interest rates are low and markets are running hot, just when it appears to be easy to get rich, we’ll be sitting toward the sidelines, watching the party, apparently failing to keep up with current events.

And underperforming other portfolios.

Which brings us to that other font of durable wisdom, my late mother. Back in my boyhood in Memphis, Tennessee, when my roughhousing with my younger brother got too physical, she would caution us:

“It’s always fun until someone loses an eye.”

Risks are real, and shouldn’t be ignored.

Today interest rates are rising, we’ve just had a quarter with the highest inflation since 1984, and European cities are being reduced to rubble by artillery and rocket attacks. The market’s tone and direction have changed.

As always, past performance is no guarantee of future results, and as always, we manage your money with the same care, and using the same strategies, as we do our own. If there is any aspect of our investing strategy you’d like to discuss, don’t hesitate to give us a call.

By James S. Hemphill, CFP®, CIMA®, CPWA®/ Managing Director & Chief Investment Strategist

Jim has been a CERTIFIED FINANCIAL PLANNER™ professional since 1982. Jim specializes in complex wealth transfer and retirement transition strategies and coordinates TGS Financial’s investment research initiatives.

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