Warren Buffett’s Ground Rules (2016) is a study of the investment strategy of one most successful investors of all time. By analysing the semi-annual letters Buffett sent to partners in the fund he managed from 1956 to 1970, author Jeremy Miller isolates key strategies that investors can use to play the stock market to their financial advantage. Compiled for the first time and with Buffett’s permission, the letters spotlight his contrarian diversification strategy, his almost religious celebration of compounding interest, his preference for conservative rather than conventional decision making, and his goal and tactics for bettering market results by at least 10% annually.

Key Learnings

Playing the stock market is not easy. It's not something that will happen overnight, and it won't happen if you don't take it seriously. It requires careful measurement, consistency, and most importantly patience.

Be patient. Careful investment, rather than frenetic speculation, is more likely to create value.

There’s a basic rule Wall Street types don't want us to know. It’s a secret that has helped Warren Buffett amass an $88.9 billion fortune. Investing isn’t rocket science, but there’s a catch. People frequently confuse speculation for investment. But there’s a difference. Speculators obsessively follow unpredictable market fluctuations to buy and sell stocks hoping to get rich quick. Investors, on the other hand, buy businesses based on careful assessment of their inherent value. 

The well-known billionaire, Warren Buffett, is an investor. He attended business school in New York, but he hails from the Midwest, and his methodical, straight-talking approach characterises his letters and overall investment philosophy. Inspired by his mentor Ben Graham, Buffett figured that the prices of most financial assets, like stocks, eventually fell in line with their intrinsic values. When buying a stock, you’re buying a tiny fraction of a business. Over time, a stock’s price changes to reflect how the business is doing. If profits are good, the business’s value grows, and the share price increases. But, if the business loses value – for example, there’s a big scandal or something – the share price falls. Sometimes, the stock price doesn’t accurately reflect the value of a business. Investors who buy shares in undervalued companies, then patiently wait for the market to correct itself, can’t help but make money. 

The key, though, is to focus on what the market should do, not when it should do it. If you trust that the market price will eventually reflect the actual value of a business, you can expect to eventually make a profit. This will help you to avoid selling just because the market dips. And this patience rewards you with compound interest, which is the key driver of value over long-term investments. Compound interest is the process of continuously reinvesting gains so that every new cent begins earning its own returns. Einstein himself called compound interest the eighth wonder of the world, remarking that “people who understand it earn it, and people who don’t understand it pay it.”

Buffett’s favourite story illustrating the power of compound interest involves the French government’s purchase of the Mona Lisa. King Francis I paid the equivalent of $20,000 for the painting in 1540. If he had instead invested the money at a 6 percent compound interest rate, France would have had $1 quadrillion by 1964.

Successful investors all have one thing in common – they compulsively measure.

Warren Buffett has always been a supremely confident investor. Even when he was a relatively inexperienced young fund manager, he saw his main competition as the Dow Jones Industrial Average – the famous New York stock index. His one job was to grow his fund at a faster rate than the market. It wasn’t easy. We all know the stress of checking your bank balance after a big weekend or stepping on the scale when trying to lose weight. For a lot of people, the anxiety of failure might be too much to handle. But to be a successful investor in the mold of Warren Buffett, you’re going to have to get over those anxieties. Careful measurement, clear-eyed analysis, and a steady hand even when you’re down are the only ways to succeed as an investor. 

The difficult truth is that most people aren’t shrewd enough investors to beat the market. It was huge for Buffett to deliver returns greater than 7 percent annually. But the miracle of compound interest means that you only have to do a little better than the market to create the potential for serious financial gains. Knowing what to measure – and then doing it properly – is the only way to know if you’re on the right track. You need to compulsively measure. You need to monitor your investments every day, keep track of how they’re doing relative to past performance, and be patient when your chips are down. It takes energy, commitment, and honesty. In short, you’ve got to know when to hold ‘em and when to fold ‘em.

You’re not just measuring your results against past performance, though. Each year’s results should also be measured against the market. This means if the market is down, and you’re slightly less down, this still counts as a win. When Buffett was a young investor, doing better than the market was a lot harder than it is now. It’s easier today thanks to index funds. Pioneered in 1975, index funds combine slices of many different companies on a given stock exchange. This means their returns broadly match the gains and losses of the overall market. Buffett advises those who don’t have the time or energy to devote to their investments to buy the index. Otherwise, compulsive measuring is the only way to determine how you’re doing.

Young investors should focus on buying shares in undervalued companies, which Buffett calls Generals.

Once you’ve got the measuring part down, you can start developing your personal investing style. Each investor is a unique snowflake. Your investing style should reflect your personality, goals, funds, and especially, your competence set. Example, if you’re an alpaca rancher, you shouldn’t try to get rich off computer chips. If you’re a new investor with less money, you actually have an advantage over investors managing huge funds. This is because you can invest in small companies not listed on the stock exchange, making big percentage gains. Once you’re managing more money, you need much bigger deals to move the needle on your overall results. 

When Warren Buffett started his fund in 1956, he had just over $100,000 to play with. By 1960, his fund had ballooned to $1,900,000. He attributed this incredible rate of return to his focus on small, relatively unimpressive investments. Along with his patient temperament, Buffett’s best asset as an investor is his skill at determining the value of a company. In the early years, he favoured buying Generals, which he defined as “fair businesses at wonderful prices.” This means that the companies were of middling quality, but, for some reason, priced under market value. Once again, Buffett’s patience paid off. Most of the Generals he bought stayed in his portfolio for years.

Buffett also liked buying shares in companies that were worth more dead, that is in liquidation, than they were alive. That way, if the business started failing, he could liquidate it and not lose money. This type of business is called a net-net. Ultra-cheap stocks and net-nets are not glamorous. In fact, Buffett referred to them as his “cigar butts.” But 12 years into his career as an investor, Buffett looked back and determined that this category of investment had done the best in terms of average returns. 

As his success grew, Buffett’s definition of value changed. He began looking beyond cheap stock prices, toward the quality of a business and whether its earnings could be sustainable. As his experience as an investor grew, he transitioned from buying fair businesses at wonderful prices, to buying wonderful businesses at fair prices. Once you have more experience as an investor, you might want to get involved in the management of one of your investments. 

Assuming more risk in markets you know well can yield even more reward potential.

As a kid, Warren Buffett would buy a 25-cent six-pack of Coca Cola from his grandfather’s store. He would then sell individual bottles on to his pals for a nickel each. There was certainly a risk involved: if the neighbourhood kids weren’t thirsty that day, he’d have extra bottles on his hands that he couldn’t move. But if he had a good day, he would earn 20 percent on every six-pack. Buffett didn’t know it, but with the 25-cent Coca Cola deal, he’d done his first arbitrage (is the simultaneous purchase and sale of the same asset in different markets in order to profit from tiny differences in the asset's listed price). He was capitalising on the price difference for one product – his Coca Cola – in two different markets – the store, and the neighbourhood kids.

Arbitrage is a way to bet on what you think a company will be worth in the near future. Returns on arbitrage bets can be very attractive. But to get it right, you have to know the businesses, and their respective markets, intimately. When that product is a piece of a company, this is called merger arbitrage. “Merger arbs” were one of Buffett’s specialties during his years as an early investor. He would buy stock in a company at one price, betting that it would be worth more once it merged with another company. Returns on merger arbs may be enticing, but the risk can be great. That’s why arbitrage is usually tricky for the average investor. Unless the deal is in your specialised field and you’ve studied it inside and out, it’s probably best to leave it alone.

But experienced investors who don’t want to mess with merger arbs can also get their control fix with what Buffett aptly referred to as Controls. That’s when you buy a large enough piece of a company listed on the public stock exchange that you have the right to influence how it’s run. As you might imagine, this type of deal can lead to stressful confrontations between company owners and new board members who may demand drastic operational changes. Buffett was vilified for these deals early in his career; he thought he was saving a company by removing the inefficiencies. But as he matured, Buffett stopped getting involved in Controls, which could turn out to be messy and uncomfortable with layoffs or firings. His core investment principles have never changed, though. 

Your methods may change with the market, but your core principles should stay the same.

Following the crowd can be an effective strategy. If everyone’s running away from something you can’t see, it’s probably a good idea to join them. But when it comes to investing, it can be problematic. By definition, the majority can’t do better than the average. So to be a successful investor, you have to train yourself to go against the crowd. Warren Buffett’s investment style reveals that there’s only one instance in which you should put your money on the line: when you totally understand the whole picture and the best course of action. In all other cases, you should pass. Even if everyone else is making money.

Buffett has always been a cautious investor. When he began his career as a professional investor in 1956, the stock market was generally considered to be too high. But instead of correcting itself, stocks continued to creep up. Buffett not only stayed true to his strategy, but he also doubled down on his ultra-conservative investing approach. He knew a correction was coming, he just didn’t know when.  Meanwhile, other hotshot investors were making big money. In New York, Jerry Tsai had invented a new kind of investment, which took advantage of the general public’s new appetite for speculation. Tsai’s approach was the opposite of Buffett’s. He’d jump in and out of stocks at the drop of a hat. Tsai’s approach worked, for a while. He earned fabulous sums for his firm, even as his fund lost and gained wildly with market swings. But Buffett remained convinced that it wouldn’t last.

When the market reached a new high in 1966, Buffett finally acted. He announced that he wouldn’t be accepting new partners and halved his performance goal. Miraculously, his fund continued to do very well: 1968 was its best year with a 58.8 percent return. But Buffett knew when to fold his hand. He was done risking his fortune on a market that was bound to crash. Tsai’s end was imminent, and he ultimately saw it coming too. He sold his fund at just the right moment in 1968. In the early 1970s, the Dow experienced its most spectacular crash since the Great Depression. Buffett’s net worth was unaffected, because he had taken all his money off the market. Tsai barely dodged defeat, but his investors lost 90 percent of their portfolio assets. Buffett’s courage of conviction is a worthy goal for all investors, if not people more generally.

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