A Digest of Robert Hagstrom's
Rene Descartes, the 17th century French philosopher, said "It is not enough to have good intelligence, the principle thing is to apply it well." It has often been said that there three keys to wealth: making it; saving it; and investing it wisely. Many people are good at one of these; many less are good at two, and very, very few (exclude me) are good at all three. Obviously, you can't save what you can't make, and you can't invest what you can't save. Warren Buffett's amazing success gives rise to this digest, which deals only with the third key, fully realizing that those without money must either make and save it on their own or revert to "OPM" (other people's money). As this digest will demonstrate, one does not need to start with very much to begin practicing use of all three keys. Indeed, it is likely a blessing to start with very little, as your mistakes will be great lessons for the future, when you will likely be investing more.
In an era when "dart throwers" regularly and embarrassingly beat stock market experts in picking stocks, as frequently and discouragingly reported in The Wall Street Journal , it is all the more instructive to examine the phenomenal success of America's richest man, Warren Edward Buffett (WB or Buffett hereinafter), whose wealth exceeds $8 Billion. In Forbes' 1993 list of America's richest people, Buffett is the only one who obtained his wealth from the stock market — i.e., from buying minority and majority interests in publicly traded and privately owned companies. It continues to be rare to find anyone who consistently makes money from trading stocks, bonds or commodities, other than brokers who are effectively on the floor of the exchanges every day. Most "investors" lose consistently, forever. Put differently, the "pack" or the "crowd" generally losses in mass, while a handful profit. It's almost as bad as buying lottery tickers, however not quite, and it's much more fun to "play the market", if you don't lose too much. Lessons "in the market" (stocks, bonds, convertible bonds, etc.) always seem costly, but, if you start very small and cautiously, there's hope for later success. It is the inevitability of losing with the pack, at least initially, that causes me to sometimes note that "Cash can be a real problem." People who sell their businesses simply exchange one asset (stock) for another asset (cash), and few have any idea what to do with the latter. With investment losses and taxes on interest and dividends and the insidious, inscrutable ravages of inflation, cash soon becomes much less (both in absolute and purchasing-power terms) than was the stock. All the more reason to study the history of WB, the most successful stock-picker in American history. (As you will see, this fascinating man approaches the purchase of a few shares in the identical manner as when he is buying the entire business — i.e., with great study and caution, and only after methodical adherence to very strenuous rules.) Even a half-baked mastery of his approach could save anyone an infinite number of mistakes. As this digest is only roughly 10% of the girth of the book, it clearly omits a great deal, but, hopefully, it captures the essence of it.
Warren Edward Buffett's Background
He was born in Nebraska in 1930, where he still lives, a son of local stockbroker and Republican congressman. As a boy, he "marked the board" at Harris Upham's stock brokerage office, where his father worked. WB also had two newspaper delivery routes (in Washington, D.C., when his was in Congress) and bought used pinball machines with his earnings and placed them in local stores; he then bought a used Rolls Royce with his earnings and rented it daily for a sum equal to 10% of its cost, and amassed $6,000 in savings by the time that he graduated from high school (likely the equivalent of $150,000 or so, assuming a doubling every 10-12 years, in today's purchasing power) — an auspicious start for a 17-year-old.
After graduating from the U. of Nebraska, he went to Columbia Business School to study under Benjamin Graham (often called "the father of financial analysis", due to his renowned books, Security Analysis and The Intelligent Investor). Buffett went to work in Graham's NYC consulting and money-managing firm for two years, after which (in 1956 at age 26) he returned to Omaha and began his own limited partnership (LP), which was backed by family and friends. A total of $105,000 was invested by seven partners; WB invested only $100, following the OPM (other people's money) approach immediately; he paid a 6% annual return off the top (about twice the then bank prime rate) plus 75% of the profits, retaining 25% of the profits for himself. During the next 13 years, his LP earned a compound profit of 30% per annum. Although the Dow Jones Industrial Average declined during five of those years, the LP never had a down year. As word of his success spread, new investors flocked to him, and, by the tenth year, the assets of his LP had grown to $26 Million. After 13 years, in 1969 at age 39), he terminated his LP, sending partners a letter explaining that his investment philosophy was "out of step with current market conditions" (i.e., the market was sky-high and scared him to death) and that he no longer felt comfortable managing their money. However, it was more than that: four years earlier, he had bought control of Berkshire Hathaway.
WB's share of the LP, on liquidation, totaled $25 Million, which he had used (presumably as collateral for a loan) to gain control (40%) of Berkshire Hathaway, a cotton and textile business which he has used to form the enormous holding company (Berkshire). In the early years, Berkshire's results were disappointing, as profits declined. He hung tenuously on the brink of failure. He learned the hard way the truth of John Maynard Keynes statement, "The difficulty lies not in the new ideas, but in escaping from the old [bad] ones." While he was not able to turn Berkshire's original businesses around, he used their early profits (which he had purchased at a distressed price) to buy an insurance company. In the 1960's, insurance companies were gold mines. An amazingly deft trader after his training with father and Graham, from its stock portfolio, he obtained a return from investing that was three times the total return of Berkshire's textile division, although the latter had ten times the equity capital invested — i.e., $1 of stocks produced three times the profit of every $10 invested in textiles. Despite a dismally declining profit-picture in textiles, with its profits and those rich ones from the insurance-company's stock portfolio, he caused Berkshire to purchase many other companies: a newspaper, a candy company, a furniture store, a jewelry store, and encyclopedia publisher, a vacuum cleaner business, and a uniform manufacturer.
Berkshire has never had an acquisition department or a staff of trained MBA's, nor does it ever attempt to supply the management. It normally requires the prior owners to retain a sufficient minority piece to assure their continuing stewardship. Further, it requires its companies to keep salaries low but to provide an innovative cash-bonus system — WB refuses to hand out stock — to all key management but bases those bonuses solely on performance. This forces "managers to walk in the same shoes as the owners". Known for his "simple" philosophies, he often quotes the slogan of one of his most successful retailers, "Sell cheap and tell the truth." WB embraced an alter ego of sorts, one Charles T. Munger, who became his co-managing partner of Berkshire. Munger, too, was a devotee of Graham and a very successful manager of his own, smaller investment partnership. His presence greatly enhanced WB's ability to analyze and invest in new companies. (WB and Munger take very low salaries, about $100,000 each, and Berkshire has never paid any dividends; so they prosper solely by the appreciation of their stock and rare sales of small quantities of same.)
So, in Berkshire's early investments, it concentrated on Graham's way of buying only those stocks or companies that were available at a substantial discount to their underlying value, which was defined primarily as net assets and even more strictly as net current assets. As WB learned from the steadily deteriorating performance of the textile business, this approach, in isolation, was often unwise, and he later called it "the cigar butt approach to investing", i.e., likening it to a cigar that one finds on the street, free, but which has only one, bad puff left. In such cases, time is the enemy of the investor. Such was the case with Berkshire's original cotton and textile businesses. Moreover, in raging bull markets (as in 1995), there are few to no investment opportunities for the pure discount-buyer. A more enlightened approach was and is required.
Combining The Brilliant Theories of Graham & Fisher; The "Greening" of Warren Buffett
It has been said that "There are no original thoughts under the sun." Put differently, each of us has sources; virtually all of our ideas have their seeds in the observations of our predecessors, although we may expand them greatly. Many of us decline to give attribution where it is due (Aristotle); others (Plato and WB) are sufficiently humble to freely cite our sources and mentors — a sign of integrity and appreciation of the wisdom of others, and the mark of an avid reader and attentive listener. WB proudly lists three principal mentors: his father, Ben Graham and Philip Fisher.
The key to the brilliant Ben Graham's approach was mathematical. In the 1970's, WB's name became synonymous with Graham's ("buy cheap") value investing. His "margin of safety" approach was based upon: (1) buying the stock at a discount of approximately two-thirds of net (current) assets and (2) focusing on low price-to-earnings ratios. Graham argued that, if you bought "cheap enough", you could overcome the subjective factors, such as management. While this "cigar butt approach" often led one to a rapidly declining business (like Berkshire's textile division), it tended to throw off huge profits initially (although not necessarily returning a healthy percentage of equity) and/or to have an excellent liquidation value, based on the total invested, in the early going. (Interestingly, Dickstein Partners, a NYC-based investment fund, has done extremely well pursuing an even more severe application of this "buy cheap" approach; Dickstein buys only businesses in bankruptcy, and last year he was recognized in the WSJ as being in the very top group of all U.S. investment funds.) However, in a bull market, there were basically no opportunities to invest. Graham averred that the single most important rule in investing was this: Don't lose! While admitting that future profits are the single most important factor in determining value, he maintained that profits are great, but preservation of capital is more important. If you can avoid losing and sometimes make profit, you will prosper. Hence, his margin of safety approach. He cited, Horace, the 1st Century Roman poet, who said, "Many shall be restored that are now fallen, and many shall fall that now are in honor." This statement has been called "the reversion to the mean" tendency of investors, similar to the gambler who invariably gives back his winnings to the house. Berkshire both profited and suffered from this approach: reaping large cash profits in the early stages and/or liquidating well, but faced declining profits and business values over the longer term.
While WB has never abandoned Graham's well-proven quantitative or mathematical approach to investing, he has expanded it to embrace the qualitative approach of Philip Fisher, a Stanford grad who built a very successful money-managing firm in the early 1930's, when the U.S. was in the deepest depression in history. Fisher followed two basic approaches: (1) investing in companies with above average profit potential (high profit margins and excellent potential to increase sales) and (2) aligning oneself with the most capable, and unquestionably honest, management team — approaches that Graham thought were too subjective and would lead one to emotional and irrational buying at ever escalating prices (the vastly overpriced Netscape offering being a prime, 1995 example). He also espoused "a catch-all inquiry" of the target company: i.e., exhaustive interviews with company staff, its customers and, above all, its competitors. According to Fisher, there are two types of companies: those that are "fortunate and able" and those that are "fortunate because they are able". Fisher believed that a great company required a great research and development program to enable it to continually increase the quality and quantity of its products and/or services and a great sales organization to market same. Great management also included superior analysis and controls of costs, i.e., very good accounting and frugality. (Until WB recently purchased a jet, both he and Munger traveled coach class, in addition to paying themselves almost nothing. These people know how to save first and invest second. As long as they don't die before they enjoy their earnings, it's hard to argue with their parsimony.) If a business had superior accounting and cost controls, it rarely needed to resort to equity financing, which dilutes all shareholders and offends Berkshire greatly. Finally, while Graham espoused substantial diversity in one's portfolio (a rather large quantity of stocks), Fisher took the opposite view, arguing that, with too many eggs in too many different baskets, it was impossible to key one's eye closely enough on any investment. Hence, Fisher would have 75% of his investments in only three or four companies, and he would invest only "within his circle of competence".
Berkshire adroitly follows both mentors: it has continued to apply mathematical/quantitative analysis (Graham) to each investment but has leaned its investment-decisions more toward subjective/qualitative factors (Fisher), has tried to buy at discount (Graham) but will sometimes pay closer to then FMV (Fisher), and has occasionally invested beyond its circle of direct competence (Graham) but has confined itself to relatively few total investments at one time (Fisher), a "killer" blend of both financial gurus.
WB has become known for his ability to grasp the difference between purchasing individual stocks and speculating about the direction of the general market. While purchasing companies requires certain mathematical, quantitative and management/industry-trend/qualitative skills, assessing market fluctuations requires investors to master their emotions; WB has been able to disengage himself from the emotional forces of the stock market, no small feat considering that emotions are generally stronger than reason, explaining why stocks invariably move far above and below their intrinsic value — such as the recent Netscape's flight from $13 to $74 to $51 (still way overvalued) but all within a scant 24 hours of its opening on NASDAQ. WB knows that stocks move above and below their intrinsic, business value, and he looks for those opportunities, but he doesn't wait for bottoms or tops, as they can't be known. When he sees true value, he buys, regardless of current market sentiments. As such, in the short term, he is often wrong, but rarely is he wrong long term. (One definition of short term might be one to three years.)
When Berkshire's core businesses (multiple insurance companies) became unprofitable in the 1970's (due to rising costs, huge court awards to plaintiffs suing insurance companies and declining premium-rates), Berkshire, unlike most of its competitors, refused to compete by selling insurance below costs and rather emphasized its financial strength as its principle attribute. While Berkshire remains a major force in the insurance industry (while many of its then competitors have collapsed), it has long since made much greater fortunes through its typically minority investments in companies like American Express (1965), The Washington Post (1973), GEICO (1978), Capital Cities (1986), and, above all, Coca Cola (1988), and Wells Fargo (1990).
Berkshire's goal is to increase its book value by 15% per annum, far above the increase of most companies. Since 1964, Berkshire's book value per share has grown from $19 to $8,800, or a compounded return of 23.3%, despite many negative years. This growth is even more impressive when you consider that it is penalized by both income and capital gains taxes, while the Standard and Poors' much lower average growth (about 8-12% p.a.) is calculated before all taxes. (Over a 30-year period, the return on equity (pretax?) of most US businesses averaged 10-12%.) Additionally, as explained below under "Portfolio Management", WB calculates that Berkshire's "look-through earnings" have grown at roughly the same 23% annual rate as has its book value.
Lemmings, of course, are those rodents that have distinguished themselves for their habit of racing, in a mass migration, every few years, off cliffs into the sea, normally to their death — a little understood phenomena that is attributed to crowding and the chaotic mental stress that flow from it. (A mass psychology that is repeated more subtly by homo sapiens who historically place their fate in the hands of politicians, bureaucrats, generals, religious leaders, et al., marching in unison to their deaths in wars or simply by allowing themselves to be systematically and continuously pillaged by their "leaders"; similarly, the stock-trading-public, the bulk of whom remarkably buy, as on cue, in mass at market tops and sell at the bottoms, to the enrichment of those like the famed Bernard Baruch, who said, "I always sell too quick.") Many, many market gurus and psychologists believe that mob psychology rules the markets absolutely! Often called the "mania" of the market, it is infectious, blinding and compelling — and generally off the mark by 180 degrees. (With that I can concur from personal experience. An almost identical phenomena occurs in real estate cycles.) Perhaps the most ludicrous market mania in recorded history occurred in Europe in the 1700's — "the tulip bulb mania" — during which tulip bulbs grew popular and took off, bringing prices that were hundreds of times their cost to produce, collapsing literally overnight, wiping out thousands of investors. This sort of mass-malaise has also been called, "the greater fool theory"; that is, the buyer assumes that there will always be a "greater fool", until one day, there isn't, and the "hot potato" then burns the final investors (the masses, who buy in a group panic). (Yours truly shamefully admits falling prey to this insanity more than once. My excuse is simple: no training in the analysis of business values, all the more reason to consume The Warren Buffett Way . I may be a slow learner, but I can and will learn. I can't be totally self-effacing; I have spotted some big winners, but they were industry trends, not individual businesses. More saliently, I need to concentrate on my weaknesses, rather than to chronicle my successes, lest I backslide ad infinitum.)
WB, like Graham, notes that the basic difference between speculators (i.e., lemmings and "the public") and investors (e.g., Baruch, Graham, Fisher, et al., and above all, Buffett) lies in their attitudes toward stock pricing: the speculator tries to anticipate and profit from price changes; the investor seeks only to acquire companies at favorable prices. Graham maintained that stock-players worst enemy is not the market, but himself. The mentality of most is short-term, which explains the success of vendors (and the failure of buyers) of penny stocks, casino gambling and the most ludicrous of all, lottery-ticket sales.
By residing in Omaha, rather than NYC, WB has placed himself geographically remote from the market's emotions, and he places zero value on the opinions of market forecasters. However, he is a voracious of newspapers, magazines, journals, financial letters, and, above all, of corporate annual reports, where he does his real homework.
Market levels, however, do not preclude WB from buying stocks. Good values exist in all markets; they're simply harder to find in a bull market. "You pay a very high price for a cheery consensus," he once wrote. Attitude is the key. WB maintains that individuals are not a disadvantage when forced to compete with large institutional investors; individuals are disadvantaged only if they are forced to sell at unfavorable times; WB believes that, unless you are able to watch your stocks decline by 50% without becoming panic-stricken, you should not be in the stock market. IF you bought value initially, the value will return. Obviously, if the facts about the company have changed dramatically for the worse, then a swift exit is warranted, but, if not, a calm, patient attitude will generally succeed.
Not surprisingly, then, WB buys stocks that are then "out of favor" — and, hence, not overpriced. General Foods and Coca Cola were very unpopular when he bought them in the 1980's, but they have tripled and quadrupled, respectively, in less than ten years, as commodity prices have since plummeted and consumer spending has escalated. "Optimism is the enemy of the rational buyer," he says, while pessimism produces low prices. The key is to identify the weaknesses of the company first, then its strengths. He bought Wells Fargo after it had declined 50% from its high. When one of his stock declines dramatically for no substantive reason, he buys more. Good economic fundamentals will eventually reveal themselves in stock prices. Those, who have not done their homework, cannot know the economic fundamentals of their stocks; so, they sell and buy on emotion and sharp swings, predictably at market tops and bottoms, where the most trading is invariably done. The public, circles like sharks, in selling or buying frenzy; the market volumes explode, and the top or bottom has again been market in blood bath that purges the excesses of over or under pricing. "The stock market" is the mass psychology of the moment. Buffett has proven that he can ignore these paranoid emotional swings, because he is confident that he does a better job at valuing companies than do the masses. The masses create the prices only briefly; to paraphrase Milton, "Value will out" (or prevail) eventually. Published stock prices, then, do not concern WB, nor does the stock market generally; he views the market's value as simply offering buyers, should he decide to sell. In most cases, he is happy with the earnings of his companies and is content to retain them indefinitely, until something adverse occurs or he sees a better opportunity. Indeed, over half of his holdings, he considers "permanent holdings", as discussed below under that heading.
Inflation: The Ever Present Concern
WB believes that there are only five ways for companies to increase their return on equity: increase asset turnover (the ratio between sales and assets); widen operating margins; pay lower taxes; increase leverage; and use cheaper leverage. Since WB is not a believer in debt, only the first two are available to him, and both of those can be severely affected by inflation.
WB gives no time to the study of unemployment figures, interest rates, currency exchange rates, or politics. He devotes all of his energies to analyzing business fundamentals, management, prices and inflation and the latter's affects on business returns. Again, he is an avid reader of business media and the annual reports of companies.
Like the renowned "Austrian School" economists (sound paradigms for Buffett), Ludwig von Mises (the father of the revered Austrian School of Economics in the 1880's) and Murray Rothbard (the current, leading apostle of same), Buffett believes, among many other things, that potentially business and economy-killing inflation springs from political actions, rather than from some mysterious gyrations in the economy. This view is best supported by the fact that, throughout recorded history, inflation has seemed to occur only when governments manipulated the monetary system — e.g., shaving gold coins, printing worthless paper and requiring that it be accepted as "legal tender" for the payment of debts, etc., as is the case today.) WB is not too openly critical about the government's manipulation of the monetary "supply" (as to be so would threaten his safety), but he does express grave concerns about it, and he seeks businesses that seem relatively immune to its effects.
Companies with the most fixed assets are hurt the most by inflation, and those with the most "economic goodwill" (with prices the farthest above costs and, hence, the highest ratio of profits to assets) are hurt the least. For example, Berkshire's See's Candies earns after tax profits equal to 25% of its fixed assets, due to the profit margin of its candies. A company that earns 10-12% p.a. of its fixed assets is probably not worth more than its fixed assets. A company, then, should not be valuable simply on a multiple of its earnings, but, rather, the amount of capital invested to produce those earnings must is of critical importance, because, in an inflationary environment, the ratio of capital to earnings will have to be maintained. Thus, if companies A and B earn the same, the one with the highest ratio of earnings to capital invested will be worth more; if the ratio were double, the value of the company might be 50% more, even with identical earnings. Therefore, fixed asset-heavy businesses are to be avoided in an inflationary environment. Moreover, companies that require heavy capital expenditures tend to be heavy cash-users, not cash generators. Berkshire's See's Candies is an excellent example of a company with "economic goodwill" (a high ratio of earnings to capital) and, hence, the ability to prosper during inflation. WB states that Berkshire has made a great deal more money in stocks from the lessons that it learned from See's.
Contemporary portfolio managers are concerned primarily with stock weighting, diversification and performance relative to a major index. WB, on the contrary, is concerned with none of the foregoing. He is concerned with: (1) the company's long term prospects , (2) the quality and depth of management, and (3) the extent of the discount-to-value at which he can buy.
Berkshire, in 1980 (when he still leaned more towards Graham's views), had its most diversified portfolio to date: over $5 million in 18 companies, ranging from insurance to advertising, broadcasting, publishing, and consumer cyclicals. To date, he has not owned a technology company, because he is "unable to understand it well enough to make the investment" or a utility company, because its profits are regulated. By 1986, Berkshire was down to five common stocks, with 93% in only three: Cap Cities/ABC, GEICO, The Washington Post, aggregating $2 Billion. In 1988, Berkshire put $500 million in Coca Cola, which appreciated 50% in one year.
WB will not invest in any company, unless it is "an easy decision" for him, i.e., clearly a "winner" in his mind. (In one's early investments, no decisions may seem "easy", as there will no personal experience as a foundation.) The ability to say, "No" is a tremendous asset for an investor, as Graham admonished; hence, his First Rule of Investing: "Don't lose." (Put differently, the emphasis upon the "upside" is not nearly so important as the avoidance of the "downside". If you can't quantify the risks to your satisfaction, build-in fail-safe protections — collateral, priorities on dissolution, etc.) Find ways to prevent or minimize loss; after that, consider the potential gains. In sum, much of WB's success in money management can be attributed to his inactivity. Wait for that exceptional opportunity, and don't "tinker" with your portfolio very much. Buying and holding quality is easier, safer, requires less knowledge, and is less mentally exacerbating. He is content not to buy or sell one share of anything all year. "Lethargy bordering on sloth remains the cornerstone of our investment style," he observes in Berkshire's 1990 Annual Report. Concentrate on locating a few spectacular investments rather than jumping from one mediocre one to another. "An investor should act as though he had a lifetime decision card with just 20 punches in it," he cautioned in a 1992 Forbes article. Such a card would demand extreme caution and great patience, and a effectively zero emotion.
WB's "buy and hold strategy" has an obvious tax advantage: his paper gains aren't taxed until they're realized — which, in the case of 50% of his portfolio, he does not expect to occur in his lifetime, barring major changes within those companies! He concedes that this strategy is clearly "out of step" with present day thinking of institutional money managers, who flit from stock-to-stock erratically, always seeking to be in the avant guard "hot" area (medical stocks, high tech, etc.) and to maintain maximum diversity. WB amusingly observes that referring to money managers as "investors" is like calling a person who engages in one night stands a romantic. Critics of WB prefer the "safety" that much greater diversity affords. WB has little interest in his popularity or lack of it among "important people". Most money managers can't afford to be "different", as their failure makes them too identifiable and expendable; so, they, like lemmings, may not look very good as a group, but, as individuals, they rarely receive bad press.
Since good, well-managed businesses are rarely available at attractive prices, WB tends to buy major positions when they are. He does not allow himself to be deterred by the negative market sentiments that often accompany those opportunities. In his 1991 Annual Report, he quotes John Maynard Keynes, "As time goes on, I get more and more convinced that the right method in investments is to put fairly large sums into [a few] enterprises which one thinks one knows something about and in management of which one thoroughly believes...there are seldom more than two or three enterprises at any given time [in which I will invest]..." With the limitations of time, money and knowledge, this "just a handful of investments" approach seems inescapable in the long run. Fisher, of course, concurred. When you diversify so broadly, you tend to put too much in some and too little in others, as you lack sufficient data to make the best choices. Of course, in any given year, a handful of investments can look much worse (or better) than a portfolio that more emulates a mutual fund. So, WB is remarkably unconcerned about short term results or comparisons to any major index. If his underlying values are sound, the markets will eventually recognize that fact.
Earnings reports are generally misleading, due to accounting rules that distort them. The percentage of voting stock owned determines which one of three accounting methods an investor can use to report earnings. If the investor owns more than 50% of the voting stock, the investor can fully consolidate all revenues and expenses and deduct for minority interest the unowned percentage. If the investor owns 20-50% of voting stock, you report only your share. Under 20%, the undistributed or retained earnings are not included in your income statement. All of Berkshire's common stocks fall into the last category.
Berkshire likes buying less than 20%, because it can do so for much less (per each 1% bought) than if it bought a controlling interest. WB prefers to own 10% of a company at $1 per share than 100% of it for $2 per share, if he believes in the management sufficiently. The "value" of being able to report the earnings means nothing to WB, because it will be reflected in the value of stock in due course, as retained earnings will be put to good use by good management. So much of Berkshire's value is based on retained earnings that WB coined the term "look-through earnings", defined as operating earnings from consolidated businesses, retained earnings from its common stocks, and an allowance for taxes that would be due on same if paid. Berkshire's goal is to have its intrinsic value increase by 15% annually; any increase in "look-through earnings" should be included, as it will be reflected in market values soon enough. WB has calculated that Berkshire's look-through earnings have grown at almost the same 23% annual rate as its gain in book value! So, Berkshire's book value has grown at a 23% annual compounded rate and so have its (look-through) earnings. Finally, Berkshire prefers minority positions because it chooses to rely on the management of every company that it buys, preferring to buy talent than to find, train, insert and oversee it.
Buying A Business
There is no fundamental difference between buying a stock and/or a business. The primary advantage of controlling a business is the ability to control capital allocation. This advantage is often outweighed, to WB, by the two advantages of buying a minority position: a much larger arena of potential acquisitions and the bargain prices at which minority pieces can be obtained. So, whether he is buying a stock or a business, he employs the same holistic analysis: of all quantitative and qualitative aspects of its management, financial position and its purchase price. An analysis of those businesses of which Berkshire has acquired control reveal certain tenets to which WB adheres: basic tenets; management tenets; financial tenets; and market tenets. Comments on each follow.
The Basic Tenets. The key questions: Is the business simple and understandable to the buyer? Does the business have a consistent operating history? Does the business have favorable long-term prospects?
Simplicity. Financial success in investing is directly tied to the degree of understanding of the investment. "Invest within your circle of competence," he cautions. Critics mock his resultant absence from technology stocks. WB replies, "An investor needs to do very few things right as long as he avoids big mistakes." Knowledge of the business minimizes the risk of big losses. You must know it or learn it, first.
Consistent operating history. WB avoids companies that are solving difficult business problems or are fundamentally changing direction. The bigger an imminent company change, the bigger risk of major business errors. "Severe change and exceptional returns usually don't mix," he notes in his 1987 Annual Report. "Turn-arounds" generally don't." WB adds that he hasn't learned to solve business problems but, rather, to avoid them. So, don't buy another man's headaches.
Favorable long-term prospects. He likes "franchises", i.e., companies that provide products or services that are (1) needed or desired, (2) have no close substitute, and (3) are not regulated. He does not like "commodity businesses", i.e., those that offer products that cannot achieve meaningful product differentiation. Commodity businesses can compete really only on the basis of price, a constant threat to profits. He looks for economic strength in an area "where I understand it and where I think it will last", as quoted by Lenzner. Eventually, good franchise businesses attract more competition, reducing product differentiation and rendering the business more like a commodity business and more dependent upon good management.
Management Tenets. All key management must always think and behave like an owner; must be rational; must be candid with shareholders; and must resist the institutional imperative (the urge to imitate others rather than to innovate). Rationality, or its absence, may be exemplified by management's use of earnings: if earnings, reinvested internally, can produce an above-average return on equity, they should be reinvested; it not, they should not. As a minority owner, this is a key point to WB. (Berkshire has always retained all of its earnings, but its return on equity is 23%, double that of most other businesses and almost five times more than a 90-day T Bill. When polled, 88% of Berkshire's owners prefer this course; i.e., they can't do as well with their money as can Berkshire, particularly considering the deferral of taxes.) Candor in communicating with shareholders without hiding behind generally accepted accounting principles (GAAP) or otherwise obfuscating facts is also essential. To be candid, managers must disclose sufficient data to enable the shareholder to determine: the company's worth, its ability to meet its future obligations and the job that management is doing, including open disclosure of failures. The Institutional Imperative is WB's way of describing the lemming-like manner in which most managers imitate other managers mindlessly, rather than act independently and risk looking foolish. WB loathes such behavior.
Financial Tenets To Evaluate Performance. WB doesn't take yearly results too seriously, preferring 4-5 year averages. Loathing accounting-slight-of-hand, he focuses on four things: (1) return on equity, NOT earnings per share, (2) calculation of "owner earnings", (3) looks for companies with high profit margins (a good markup and a lot of cost consciousness), and (4) every dollar retained should create at least one dollar of market value.
Earnings per share he views as a smoke screen; return on equity, i.e., the ratio between operating income (adjusted to delete extraordinary items and capital gains and losses) and shareholder equity (valued at cost not at market, as the latter would inflate or deflate the real return), reveals how well the capital is being used and is the best test of management's performance. He opposes "leverage" (i.e., debt) as a tool to increase the earnings on equity, due to its obvious dangers. IF debt is to be used, he prefers borrowing it well in advance of the need, when it should be easier to obtain and on better terms.
"Owner earnings" he defines as cash flow plus all non-cash items (e.g., depreciation, amortization) minus capital expenditures and any sums needed for working capital.
High profit margins cover a multitude of other mistakes; and a devotion to cost-controls creates profits. Low-cost managers seem to find ways to cut costs, while high-cost managers invariably do the reverse. Berkshire itself is a study in economy. With ten or so staff, it employs no legal department, R&D department, messengers, limos, etc., and its total cost is less than 1% of Berkshire's operating earnings.
Market Tenets. To buy or not to buy? Two tests: (1) What is the value of the business? (2) Can the business be purchased at a significant discount to its value? (While he never defines "significant", he purchases reveal a wide range of 10-50%. The greater the risk, the greater the discount; this is the "margin of safety".
Determining value is generally done in one of three ways: as a liquidation (asset sale), going-concern (multiple of cash flow) or current market value (of stock). Not WB. Buffett prefers John Burr Williams method of evaluating a business: the net cash flows expected to occur over the life of the business discounted at an appropriate interest rate (the long-term US bond rate). So valued, all businesses become economic equals. If he can't project cash flows with confidence, he will not attempt to value the business! The predictability of future cash flow should have a "coupon-like" certainty that is found in bonds. (He admits that he could not so value Microsoft, as he doesn't understand it well enough to predict cash flows, despite his close friendship with Bill Gates.)
Buying at attractive prices is essential. Simply buying understandable businesses with enduring economics and shareholder-oriented and talented managers isn't enough. If we make mistakes, it is either because of the price that we paid, the management that we joined or the future economics of the business, or all three. The price that we pay is our "margin of safety", to recall Graham.
Finally, WB stresses the importance of being an "intelligent investor", one who clearly understands that he doesn't simply own pieces of paper (stock) but, rather, businesses, and that he must understand the operating functions and its financial statements and reports. "Investing is most intelligent when it is most businesslike" wrote Graham in his Intelligent Investor, and WB refers to that quote as "the nine most important words ever written about investing." A person who buys stock can either view himself as a business owner or as bearer of tradable securities. Being the former is the key to investment success.
As Graham noted, "In the short run, the market is a voting machine [ignoring financial results], but in the long run it is a weighing machine [valuing businesses based on their realities rather than on emotional overreactions]."
Buffett is willing to hold any investment that he buys indefinitely, weathering manic highs and lows, as long as (1) the underlying business is satisfactory, (2) management remains competent, honest and candid, (3) and the market does not overvalue the business and/or (4) he does not need the cash to invest in a better business. Barring one or more of the foregoing, all of his holdings are permanent holdings.
Of course, as some people are "more equal" than others, some of his permanent holdings are "more permanent" than others; i.e., would be the very last to go. He has a "'till-death-do-us-part" attitude about four of his holdings: The Washington Post, GEICO (Insurance), Capital Cities/ABC, and, above all, Coca Cola. Why? Each of them is stronger in each of his "Financial Tenets", above described, than any of his other holdings, and he knows the management of each better and respects them more. In the book, it details exactly and convincingly how each of these far outperforms the major indices and any other use that he could make of his cash. The management of each effectively mirrors Buffett's investment philosophies.
It is noteworthy that all of these businesses rely on their managers to a fault, to the point that they provide effectively 100% freedom to make decisions. As the head of Cap Cities admonished the manager of the Albany TV station, "I won't come to Albany unless you invite me — or I have to fire you." Such CEO's, and/or owners, work hard to understand the details of the business and its financial reports, but they decline to make the field, day-to-day decisions. If the manager can't do that, he is replaced.
While all of his beloved "permanent holdings" have had many "ups and downs", over any several-year period, their results have been awesome.
Fixed Income, Marketable Securities
"Fixed income securities" (e.g., cash, bonds and preferred stocks) are all viewed by Buffett as emergency liquidity and funds that are available for the next, great business opportunity that comes along. He tends to keep around 17% of Berkshire's assets in same. As between cash, bonds and preferred stocks, he has no preference; he simply invests in whichever one is paying the most, among highly liquid and secure sources.
Bonds. WB has little enthusiasm for bonds and considers them to be, at best, mediocre investments. Why? They are the most vulnerable to (1) inflation and (2) currency instability. Like the devotees of the Austrian School of Economics, he views inflation and currency problems as of purely political origins, and, thus, totally unpredictable. Thus, bonds, no matter who issues them, have enormous, unquantifiable risks. Still, Buffett has made fortunes in them; for example, he has waited for municipal bonds to crash to 80% or less of their face values, then riding them back to 100% or more and pocketing the interest along the way. Still, he derisively calls the long-term bond "the last fixed-priced, long-term contract in an inflationary world." Bonds simply aren't worth the inherent risks of inflation and currency crisis. So, WB will buy them only when they are greatly misappraised by a manic market. As to junk bonds, he states they "were sold by those who didn't care to those who didn't care to those didn't think." However, when woefully under priced (like the RJR Nabisco junk bonds in 1989), he'll buy them by the carload.
Arbitrage. Confronted with more cash than good businesses/stocks to buy, WB sometimes turns to arbitrage — i.e., purchasing a security in one market and simultaneously selling the same security in another market. To wit, if a stock in NY is selling for $10.00 and in London for $10.02, he'll buy it in NY and sell it in London and pocket the spread. That's "riskless arbitrage". "Risk arbitrage", however, usually involves buying something that is at a discount to some future value, which may or may not materialize. Most "arbitrageurs" will make 50 or more trades a year; Buffett, as with stocks, makes very, very few, a handful yearly, but large transactions.
Convertible Preferred Stocks. A hybrid security, part stock and part bond, is fundamentally a debt/bond instrument that is convertible into common stock at a premium (usually 20-30%) over the stock's current price. The bond pays interest, enjoys a priority on dissolution, and has the potential to share in the ride, if the stock appreciates to a sufficient level. Also, corporate bonds tend to pay more than equal-term government bonds and are often about as secure. In a bull market, the premiums tend to be very high; in a bear market, preferreds sell much better than common.
Equity Marketable Securities
While Berkshire views all of its holdings as permanent, there appear to be two classes: not expendable and possibly expendable. The former category, as discussed above, includes four named stocks. The latter category, also called "equity marketable securities", includes five stocks (General Dynamics, Wells Fargo, Gillette, Federal Home Loan Mortgage and Ginness, a British Coke-Gillette-type entity, being Berkshire's only foreign-company investment). (Thus, Berkshire has its $20 Billion or so invested in only nine stocks.) In this chapter, the author details the way in which all of Berkshire's/Buffett's "tests" for new purchases are met by each of these.
Buffett stresses that the purchase mechanics, research, disciplines, and requirements (tenets, etc.) are the same for all stocks/businesses purchased. It is the personal relationships that the make the difference, and which provide more resistance to their sale.
Still, the rules for sale are the same: No holding will be sold unless (1) the return on equity capital of the underlying business remains satisfactory; i.e., no major, adverse change; (2) management remains competent, honest and candid; (3) the market does not overvalue the business; and (4) he does not need the money to invest in a much better opportunity. These I call, Buffett's "Sales Triggers".
An Unreasonable Man
George Bernard Shaw observed, "A reasonable man adapts himself to the world." In an article about Buffett, the author wrote, "The unreasonable one persists in trying to adapt the world to himself. Therefore, all progress depends on the unreasonable man." Does this define Warren Buffett? In significant part, it would seem so. He stresses the importance of management that resist "the institutional imperative" (or the tendency to simply imitate ones peers and superiors). He seems to be looking for Emerson's self-reliant man, one who researches and carefully weighs all of the a priori and empirical data but who reaches his own conclusions and, then, has the courage of those convictions. So, careful research and very independent thinking are at least two keys to this gargantuan achiever. The key appears to be that Buffett does not care what anyone else thinks about him, his investments or anything else; Buffett truly has the courage of his convictions. Buffett, then, is "unreasonable", in that he is quite willing to be "different" from the pack. Indeed, Thoreau said, "There is little virtue in the actions of the masses." The renowned philosophical playwrite of the late 19th Century, Henry Ibsen, said, "The minority is always right." History does seem to reveal that most of the people are wrong most of the time — whether they're simply following Hitler, Stalin, Atila the Hun, Alexander the Great, Napoleon, Pope-whomever, et al., or deifying a singing-pedaphile, a blond bimbo or a rapist-boxer. The masses don't "think"; they react to the swings of those around them, like lemmings. Only individuals, who do not allow themselves to be disswayed by the "madding crowds", think. Progress, then, does seem dependent upon the individual, and we would do well to distance ourselves from the masses.
The Warren Buffett Way - A Summary Is he emotional? Never. Equally important, Buffett remains UNemotional about the market, the economy and his investments. He looks for value in all markets and ignores the mania and paranoia that seems to engulf the world so often; it is simply static to him, static that creates huge misappraisals of real worth, too high or too low, and he sells or buys at both extremes, while never seeking to hit "the top" or "the bottom", and he never "falls in love" with any investment.
What does he think about the prevailing sentiments of the market or The Street about the market or the economy? He ignores them. If he buys true value, using his tried and tested formulas, and the stock continues to decline to a manic bottom, he will hold and will buy more, if he has the cash on hand, price averaging even lower. Eventually, he reasons, the market will recognize the true value of his purchase and take the stock price back, and often far above its prior levels. If and when the market seriously overvalues one of his holdings, he UNemotionally sells it and uses the cash to buy something else that is undervalued, but his permanent holdings would be the very last to go and then only for a very high overvaluation of them. Then, when the market recognized the overvaluation and the price came back down, he would re-purchase.
How does Buffett see himself? When invests, be it millions or pennies, he sees a business, and he views himself as an owner. When most buy, they see only a stock and view themselves as stockholders. The masses spending far too much predicting and anticipating profits and far too little researching the business before and after the purchase.
When does he buy? Anytime, if the business meets his tests. If Buffett can't understand the business, he won't consider buying it. If he can't determine the long term value of the business (the projected earnings of the likely life of the business), he won't buy it. If he can't buy at a significant discount to current value ("the margin of safety"), in most cases, he won't buy it. If he can't rely totally of management to be competent, honest and candid, he won't buy. If management doesn't think independently (i.e., resist "the institutional imperative"), he won't buy it. If the business doesn't have the required ratio of "owner earnings-to- equity capital", he won't buy. Finally, if the decision isn't easy for him, he won't buy. The foregoing capsulize Buffett's Fundamentals.
Then, IF he decides to buy, the purchase is considered permanent.
When does he sell? His mind-set is not to sell, because he saw real value with a "margin of safety" when he bought; however, he will sell anytime one of Buffett's Sales Triggers (as defined above) occur. A short term market decline, or decline in performance of one of his businesses, doesn't matter to Buffett; he concentrates on the fundamentals, as revealed in the annual reports, which he studies assiduously — return on beginning shareholder's equity; change in operating margins, debt levels and capital-expenditure needs; the company's cash-generating ability. If they are improving or remained in tact, Buffett does not waiver. The world views businesses almost exclusively in terms of its current stock price and the history of same; not Buffett. Stock price often has no relationship to the Fundamentals. The mania of the market is always short-lived, up or down; it is to be ignored. Fundamentals will prevail eventually.
Still, "The Warren Buffett Way" is more than all of the above. The author concludes that it is: "relationship investing". Quite unlike the corporate raiders of the 1980's who attacked management and broke up companies, Buffett avoids companies that need overhauls, and, when he buys, he often assigns his voting rights to management, giving the latter even more freedom from worry and more ability to pursue their instincts. By the mid-1990's, even the institutional investors (who own over half of all equities), who were once the paragons of short-term trading, are now beginning to act more like business owners and are becoming patient investors and somewhat immune to short-term price fluctuations and market mania. This "Warren Buffett Way", in its most over-simplified form, is:
Step 1. Turn off the stock market. Step 2. Don't worry about the economy. Step 3. Buy a business, not a stock. Step 4. Manage a portfolio, not a business.
Buffett has said, "It is just not necessary to do extraordinary things to get extraordinary results." While Buffett is complex and brilliant, his system is not. It depends, as much on anything else, upon the failure of others to adhere to sound fundamentals, simple principles of common sense that generally enable one to succeed.
The above Step One is impossible for most people to achieve; they can't "turn off the stock market"; its movements and noises make most investors second-guess themselves to death. WB does not even have a stock quote machine in his office. He has said that after he buys a stock, "We wouldn't be disturbed if the markets closed for a year or two." In other words, virtually nothing will cause him to change his mind over that short a period of time. He simply doesn't need to have the market validate his purchases.
If they can achieve that, then they have similar problems with Step Two, the economic cycles. WB generally buys businesses that tend to profit in all economic conditions anyway. He simply refuses to agonize over cyclical swings.
Step Three requires work, honest, definitive research, careful study of annual reports, analysis of management's attitudes-candor-ability and their competitors, and selection only of those businesses that are within your circle of competence.
His tenets should, perhaps, be placed on our desks, next to the monitors of our computers.
Buffett's Tenets Business Tenets: * Is the business simple and understandable? * Does the business have a consistent operating history? * Does it have favorable long-term prospects?
Management Tenets: * Is management rational? * Is it candid? * Does it resist the "institutional imperative"?
Financial Tenets: * Focus on return on equity, not earnings per share. * Calculate "owner earnings". * Look for firms with high profit margins. * For every dollar retained, does the company create least one dollar of market value?
Market Tenets: * What is the value of the business? * Can it be purchased at a significant discount?
Business Tenets. You can't make intelligent predictions about the future of business, unless you understand how it works and how it makes money. Nor should you invest in a business that has not stood the test of time, having been in business long enough to demonstrate an ability to survive. As to long-term prospects, the worst business to own is a "commodity business", which he defines as one whose products or services are indistinguishable from its competitors. Those are distinguishable, he calls "franchise businesses", or those that sell distinguishable things and, therefore, do not need to compete solely on the basis of price. He notes that all franchise businesses gradually become commodity businesses, but this can take decades. If you attempt to compete on the basis of price wars, particularly with those who will sometimes sell below cost, you are doomed. Most businesses fall somewhere in between commodity and franchise businesses. Then, to earn above-average returns, they must be the lowest-cost supplier. The more indistinguishable the product/services, the more competent the management must be.
Management Tenets. The rationality of management can be determined only by observing its actions. Since you don't have to watch the stock market or the economy, you should have time to watch your companies' cash instead. Is it producing excess cash, as it should? If so, management should never reinvest its cash, unless it can produce a return that is higher than the cost of that capital. The candor of management is demonstrated by the way that they communicate with their shareholders, with reports that are easy to follow and which confess failures as openly as it touts its successes. Management's ability to avoid the "institutional imperative" or herd mentality is more difficult to observe, but it can often be identified in company reports that justify actions based upon what others are doing.
Financial Tenets. (1) Focus on the most important data. Most investors judge a company based upon its earnings per share, but, since some, most or all earnings aren't distributed, earnings is often largely meaningless. Return on shareholder-equity is a much more revealing test of growth and prosperity. (2) The cash-generating ability of a business determines its value. However, not all earnings are created equal. Businesses with high ratios of fixed assets to profits will always demand more cash to sustain growth trends. Buffett relies on: "owner earnings" as the barometer of cash-generating ability, and he defines this as "net income plus depreciation, depletion, and amortization charges minus capital expenditures needed to maintain income. (3) High profit margins reflect a healthy business and management's devotion to cost-controls. Buffett abhors managers who allow costs to escalate. Pride should be taken in cutting costs. (4) Not retaining a dollar of earnings without creating a dollar of market value is critical. Retained earnings are net income minus dividends paid to shareholders. Over a ten-year-period, a companies retained earnings should be reflected in share values; that is, whatever was retained per share should eventually be reflected an equal or greater appreciation of share value. If not, the investor is being slowly robbed. (5) The value of the business is the estimated cash flows projected over the life of the business, discounted at an appropriate interest rate (e.g., the 30-year U.S. T Bond rate). While he is conservative in his income projections, he does not add an equity risk premium to this rate. Choosing businesses that are simple and stable in character, he is better able to predict future earnings with some accuracy. (6) Purchasing at a "significant discount" to a business' value provides a "margin of safety" and should dramatically reduce the risk of loss. (Remember Graham's first tenet: "Don't lose.") Only at this final step, does WB look at stock market price.
Managing A Portfolio, Not A Business. Buffett believes that wide diversification is only required when investors do not understand what they are doing and buying. The more businesses (stocks) that you own, the more smart decisions that you must make. You shouldn't own any more stocks than you would own businesses. Moreover, the farther down the list you go (from your first choice), the weaker will be your selections and the greater your risks. While Berkshire has owned as many as 18 stocks, for many years now, it has owned less than ten!
Finally, once the purchase of the business has been made, its operation is left to that management, as the owner/investor concentrates on his portfolio, rather than upon day-to-day affairs, and the purchase is "permanent", unless and until one of the above -discussed events occurs.
The Essence of Warren Buffett
The essence of Buffett's investment strategy is rational allocation of capital. He locates the line of reason and never deviates from its path. Buffett has lost money in the past and surely will do so in the future; he is not infallible, but the simplicity of his approach minimizes his losses.
When he buys a business, he concentrates on two simple variables: (1) the price of the business and (2) the value of the business. It is the latter that requires the work and the rational application of his principles.
Your best business ideas will come to you only after you do your best homework. Don't be intimidated. You can apply his principles. While most of the readers of this report likely know enough right now to apply Buffett's tenets on their own, there is nothing wrong with engaging a financial analyst for in-depth dialogue as needed, until you reach a satisfactory comfort level.
Applying Buffett, Personally
Personally, my biggest asset in my past is probably my biggest problem today. I never had any money to invest, other than what I was constantly forced to re-invest in my own business at the time; so, I survived entirely "OPM" (on other people's money). I knocked myself out trying to find sure winners (e.g., radio, TV, cable TV, cellular), then convinced others to invest in them and to pay me a fee for the privilege and give me a small percentage as an incentive-bonus. Then, as I prospered (i.e., as my minority interests gradually sold), I did the obvious things: eliminated all debt in my life and gradually began to live off capital, as "Life isn't forever," to quote a friend, but investing? Are you kidding? What the heck is that?
My first instinct was to find experts to help. Problem: "There are only 'experts for a while' but there aren't any 'experts for all seasons'," as another friend once wrote. Or, "No one knows." Nothing is certain. No investment can be totally safe — from loss, inflation-erosion or even theft (by the expert, a financial institution or, most likely, some government). For that reason, some diversity (geographically and institutionally at least) makes me sleep better.
For most of us, the safest "experts" do very little beyond buying T Bills or their equivalent, something that we can do ourselves, and leaving one's "nest egg" in T Bills is guaranteed loss. Inflation and currency devaluation's (the two least noticed forms of government theft) scare Buffett to death, but he insulates himself from them by buying businesses whose products/services can be adjusted fairly easily. A savings-account or T-Bill investor dies from them. To wit, at a 7% rate of inflation, there is a 50% devaluation in every dollar saved in ten years. So, at that 7% rate, the purchasing-power-parity of $100 today is $50 in ten years, $25 in twenty years, $12.50 in thirty years, and so on. This is the folly of "saving" when criminal governments cede to themselves total control of the currency; this is the ultimate form of taxation, and, to make it worse, they all lie about it constantly — about its existence and the rate at which they are "inflating", i.e., deflating the value of your money.
Clearly, everyone requires cash — for emergencies and for investment. To me, emergency-cash means at least one year's living expenses, and, as one's net worth grows, it means 10-25% of one's net worth. Cash for investments is everything that is left, minus investments, or probably the same 10-25% of one's net worth.
HOWEVER, as one liquidates businesses for profits, one's net worth becomes cash, and, then, cash becomes the problem! That is, it is eroding and fast everyday, and what should an unskilled investor do with it?
That's the reason for studying The Warren Buffett Way . It may not be the best book ever written on this subject, but it's the best one that I have ever read. I don't know whether I am capable of applying his principles or not, but I intend to try. One of my biggest problems is that I have made my net worth doing "start-ups" rather than "investing" in established businesses; so, his concepts are all foreign to me; have always looked for "rocket ships" that are just about to leave the launching pad. While nine of every ten may go bust, the tenth one has carried me to the stars — a ten, fifty or more times return on my meager investment. (As Graham said, you don't have to be right very often to be a big winner, IF you can keep losses to a minimum. In my case, the nine that failed usually did so very early on; that is, I put very little cash into any of them. Of all the things that I ever pursued beyond six months, probably 90% of them generated at least some profits.)
Anyway, where does that leave us? Trying to apply Buffett's proven-principles as best we can. So, read the book and try it! Good luck to all and good night!