Daily Brief - The Warren Buffett formula for volatile markets

Most investors fear it, and find it unnerving. The sea of red ink in your portfolio is hard to take. As an investor, however, you should love volatility, said Warren Buffet once. You love the idea of wild swings because it means more things are going to get mispriced.

If you stick to your knitting, you’ll see it as an opportunity to buy your best trade ideas at a steep discount.

Author of The Intelligent Investor and the father of value investing, Benjamin Graham, explained this concept by saying that in the short run, the market is like a voting machine--rewarding firms almost like in a popularity contest. But in the long run, the market is like a weighing machine--assessing the substance of a company.

Said differently, in the long run it’s the company's actual underlying business performance that matters, and not the investing public's fickle opinion about its short run prospects.

Yup, there is a market formula

The key is to identify the metrics that best represent the company’s long run potential, its “intrinsic value”, and enable the investor to identify the dislocation caused by market volatility. Buffett summarized the intrinsic value as “the discounted value of the cash that can be taken out of a business during its remaining life.”

Benjamin Graham actually published a formula to calculate this value, and it became foundational for value investors everywhere.

The Discounted Cash Flow model is one of the successors of this early work. In fact, there are a number of tweaks experienced analysts will make to this basic workhorse model to create a range of alternative valuation frameworks.

Ok, but this doesn’t look that easy. How do you fill in all those variables?

The bigger the downswing, the safer the investment

It’s important to remember that valuation is more art than science and the expected result is a range, not a single number. However, it’s worth spending time understanding one of these valuation models, thinking about the inputs (expected growth, interest rates) and seeing how closely market values follow it. It gives you an immediate insight into why investors obsess about earnings forecasts, and the path for Federal reserve hikes.

The reason why volatility is appreciated as an opportunity by value investors is that your margin of safety, to paraphrase Ben Graham, grows with the magnitude of the downswing. You don’t have to get it exactly right to still profit when the market starts to weigh rather than vote.