Born in 1930, legendary investor Warren Buffett’s childhood was in the shadow of the Wall Street Crash of 1929 and the depression that followed it.
But rather than seeing stock market volatility just as a problem, the ‘Sage of Omaha’ has made billions of dollars by treating it as an opportunity.
Here is how I would use the Buffett approach when trying to build wealth during periods of stock volatility.
Focus on what you get not just what you pay
Buffett’s career started out with a classic approach to value investing. It was all about paying less for a share than he thought it ought to trade for.
For example, some shares have a market capitalisation below their current asset base. That is a typical value share (and incidentally describes the current situation of a host of UK investment trusts, including Scottish Mortgage).
But as Buffett discovered when selling the mill machinery of Berkshire Hathaway as the firm got out of the textile business, a company’s assets are only worth what someone will actually pay for them. In a fire sale situation, that can be pennies on the pound (if that) compared to the balance sheet valuation.
So Buffett stopped trying to find shares just on the basis that they were selling below their asset value.
He switched to trying to find brilliant businesses with share prices he reckoned significantly undervalued their long-term cash generation potential.
The role of the market
What difference does that make in a period of stock market volatility?
When the market plunges, it often affects a wide variety of shares. Some may have been overvalued before, while others simply get beaten down amid general selling. That is where there might be a Buffett-style buying opportunity, if it means a share suddenly sells for markedly cheaper than the long-term value is considered to be.
Buffett said the stock market can be thought of as a person called Mr Market, but let us call him or her The Market. Every day, The Market offers to sell us any given share at a particular price, or to buy that share from us at that price (or close to it, the buying and selling prices of most shares is actually slightly different).
That does not mean the underlying value of the business has necessarily changed. It simply means that, sometimes, investors have the chance to buy shares in brilliant companies at what turn out to be bargain prices.
Getting ready to take action
Such opportunities might not come along often.
It can also be hard at the time to know whether a share has lost value because of wider stock market volatility, or because its business prospects have worsened.
For example, a stock market crash might be caused by a bank run. But that bank run could also affect the value of a host of listed businesses, from banks themselves to companies reliant on bank financing.
That is why Buffett does not wait for a crash to act.
He is constantly learning about businesses, looking for long-term investment sweet spots and getting ready to act when he thinks the price is right. So am I!
The post Here’s how I’d follow Warren Buffett to profit from stock market volatility appeared first on The Motley Fool UK.
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C Ruane has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
