Following the probability analysis approach favoured by legendary investor Warren Buffett can help you to become a first class financial trader.
Buffett’s biographer Alice Shroeder has said: “Most people find an interesting idea, they figure out the math, the financials, the projections, and then in the end, they ask themselves: okay what could go wrong? Warren starts with what could go wrong.”
Probability analysis is a catch-all term for looking at historical performance and working out the likelihood of that performance being repeated in anticipated conditions. It is dull and risk-averse, but can prove incredibly profitable.
Punching above your weight
This approach can be seen from an example early in Buffett’s career. As part of a court case, IBM was forced to divest its business that made the punch cards that programmed the early mechanical computers.
Two of Buffett’s friends saw an opportunity to compete with IBM and set up a company called the Mid-Continent Tab Card Co. They invited Buffett to invest but he declined. It was a start-up business competing with IBM.
A year later in 1959 the friends approached Buffett again. Their business was producing 35 million punch cards a month and they needed money to buy more of the Carroll presses that produced the cards.
This time Buffett was interested because the company had now proved it could compete successfully with IBM. It also had a year’s worth of figures that Buffett could analyse.
Buffett had an early interest in horse race handicapping and applied a similar technique to the tab company. What could make this ‘horse’ succeed or fail? Sales growth and a continuing cost advantage.
He looked at the historical data for all the company’s plants and compared it with data from its competitors to make his decision. The Mid-Continent Tab Card Co was making 36% returns on annual sales of one million and was growing at a rate of 70% a year.
To invest Buffett wanted a return of 15% on sales of two million. With the company making returns of 36% there was a large margin of safety and Buffett duly invested. He held the investment for 18 years, earning a 33% compounded return.
The Berkshire Hathaway approach
Buffett has explained his approach in more detail in letters sent to the shareholders of his company Berkshire Hathaway. Ones from 1977 and 2007 say virtually the same. In 1977 he said:
“We select our marketable equity securities in much the same way we would evaluate a business for acquisition in its entirety. We want the business to be: