Warren Buffett
Who is Warren Buffet and why his is important
Warren Buffet is well known by all investors around the world
for several reasons, one of them, which make him someone unusual is that he is
the richest person in the world. In its annual ranking, the magazines Forbes of
February 2008 had ranked Warren Buffet number 1, with a personal fortune
estimated at $62 billion.
Born in Omaha, Nebraska in August 30, 1930, Warren Edward
Buffett was pre-determined to work in the Stock exchange; his father was a
local stockbroker. As a young boy, Warren Buffett was fascinated by numbers and
mathematics. At only 8 years old; he was reading his father's books on the
stock market. At the time he was in the University of Nebraska studying
business, he read «The Intelligent Investor» by Benjamin Graham,
professor at the Columbia University. So interested by the ideas of Graham,
Buffet applied to Columbia University in order to study directly from Graham,
who became Warren Buffett's mentor.
Only just graduated with a master in economics, Warren Buffett
was going to work in Graham's company. During the Two years he worked in the
Graham-Newman Corporation Buffett was immersed in Graham investment approach of
the market. In 1956, Graham went to retire and Buffett went back to Omaha,
where at only 26 years old he founded an investment partnership with seven
partners and $100,000. For the 13 years he was CEO of this investment
partnership, he has got an average annual rate of return of 29.5% a year. One
of the most famous investments Buffet made at this time was with American
Express which as victim of a scandal saw its shares drop from $65 to $35.
Remembering a lesson of his mentor; that when stocks of successful company are
trading under their value, investors have to act intelligently, Buffett bought
$13 million of American Express shares (40 percent of the partnership's total
assets). Two years later, and after a tripling of the prices of the shares,
partners received a profit around $20 million. In 1969, because he was thinking
the market was too speculative, Buffett closed the investment partnership.
Buffet's shares of the investment partnership had grown to $25million, which
was enough to take the control of Berkshire Hathaway.
At the beginning, Berkshire Hathaway was a textile company
which quickly became the holding of Buffett to invest in other companies. At
first, Warren Buffet through his holding purchased insurance companies. He had
interest in insurance companies mainly for one reason: Insurance provide a
constant stream of cash flow via the premium paid by policyholders. Following
the advice of Graham, Warren Buffet was persuaded that there is an opportunity
when a structural good company is under-evaluated by the market. That was the
case with The Government Employees Insurance Company usually called GEICO. In
1976, GEICO' stock price dropped from $61 to $2, in five years, Buffet has
invested about $45.7 million in this company, persuaded it was a good
investment due to the competitive advantage of GEICO. Few years after, the
company made impressive performance and Buffett continue to invest on it. In
1994, Berkshire Hathaway purchased all the company which is still making really
good profits.
Berkshire Hathaway still exists today and it's still directed
by Warren Buffett. He had closed the books of the Textile Company in 1985.
Berkshire Hathaway now owns companies in many other sectors than insurance,
like in the food industry, clothing, media or luxury industry. Warren Buffet
took the control of Berkshire Hathaway, a company with a net worth of
$22million, nowadays, the same company, 35 years in the hand of this man, has a
net worth of $69 billion. If investors are interested investing in this
company, they just have to know that the share is trading around $134,000. That
makes it the most expensive share in the stock market.
With this kind of resume of Warren Buffet it's easy to
understand why this paper wants to develop his strategy. Based on Graham's and
Fisher's view of the market, Buffett's strategy is more contemporary, it's
easier for the reader to understand what are the criteria that makes Buffett
invest in a company. As well as Graham and Fisher, the strategy and the
approach of Buffett is important for the strategy developed later, it gives a
background in order to understand the context and the factors that are
important for investing in good companies and make profit in the stock
market.
Strategy: Buying good company at a bargain price
The beginning of the strategy of Warren Buffett is made by
some tenets that characterize his way to select a company in which he will
invest. Following are the most important tenets that Buffet is using, there a
combination of his personal experience, his mentor principle and Philip Fisher
theory.
Tenets of the Warren Buffett Way36
Business Tenets
- Is the business simple and understandable?
- Does the business have a consistent operating history?
- Does the business have favorable long-term prospects?
Management Tenets
- Is management rational?
- Is management candid with its shareholders?
- Does management resist the institutional imperative?
Financial Tenets
- Focus on return on equity, not earnings per share.
- Calculate «owner earnings.»
- Look for companies with high profit margins.
- For every dollar retained, make sure the company has created at
least one dollar of market value.
Market Tenets
- What is the value of the business?
- Can the business be purchased at a significant discount to its
value?
36 G. Hagstrom The Essential Buffett: Timeless Principles for
the New Economy(79)
Business Tenets
It's important to understand that for Warren Buffett, stocks
are not the most important factor when he is doing an investment. Warren
Buffett considers that investors have to use the same scrutiny in buying stock
as they will do when they buy the whole company. He based his decision on how
the business is done by the company and not on how the market perceived the
business. Here are some fundamental principles Buffett is attentive of when he
starts looking at a company.
Is the business simple and understandable?
The first tenet of Buffett is to understand very well the
business in which the investor want to invest. It's important to know almost
everything about the industry, the sector and the company. In doing so, any new
information will be understood as a new factor that influences the portfolio of
the investor. Although Buffett was a «disciple» of Graham, he took
one of the main ideas of Philip Fisher when he is talking about investing
within your «circle of competence». The purpose is not how big the
circle of competence of the investor is, but how well he or she can understand
all the parameters inside it.
Does the business have a consistent operating history?
In the Buffet's view of investing; investors have to avoid all
companies that are changing radically their position in the business because
the previous one is not efficient now. He also advocates to never buy stocks of
a company which is actually solving difficult problems. Buffett emphasis the
fact that he avoid Radical change and Difficult problem, in the sense that all
companies are constantly modifying their positions in the market by launching
new products and solving «day to day» problems. Buffett observes that
«Severe change and exceptional returns usually don't
mix.37» For him, best returns are achieved by companies which
are consistent on their product line in the long term.
Does the business have favorable long-term prospects?
In order to understand perfectly the long term view of Warren
Buffet, it's important to distinguish the difference he made between what he
called a «Franchise business» and a «Commodity business». A
franchise business is characterized by the fact that they don't have a close
substitute and they operate in a market which is not regulated. At the
opposite; a commodity business' product is not distinguishable from competitor,
like oil, gas or chemical product. According to Buffett, commodity businesses
have a low rate of return and are more exposed to profit' problems whereas,
franchise businesses he said, «Can tolerate mismanagement. Inept managers
may diminish a franchise's profitability, but they cannot inflict mortal
damage.38»
37 G. Hagstrom The Essential Buffett: Timeless Principles for
the New Economy(81)
38 IBID (82)
Management Tenets
After having watched with scrutiny the business, Buffett tells
investors to have a look at the management style of the company. He thinks that
managers who are acting like the owner of the company are more able to see the
long term objectives and so they will act with more rationality.
Is management rational?
For Warren Buffett, the rationality of a management is seeing
with the allocation of capital. For him, the allocation of capital is essential
because that's what will create the future value for shareholders. The
allocation of capital has to be in accordance with the position of the company
on its life cycle (development, growth, maturity or decline). In Buffett's
mind, all cash that invested internally will produce a rate of return on equity
higher than the cost of capital has to be invested in the company. There is no
logical reason to not reinvest those earnings. The only reason, for him to not
reinvest this cash is that it will not produce a return higher that the cost of
capital. In such situation, the company has to give this cash to shareholders
trough dividend or share buy-backs that will increase the value of each share
in circulation in the market. For Buffett, the way the cash is allocated
between the company and the shareholders is the proof of the rationality of the
management. Berkshire Hathaway, has almost never distributed dividends to
shareholders.
Is management candid with its shareholders?
Because management is human, Buffett insists on the fact that
managers have to be respectful and honest with shareholders and always act on
their best interest. He likes when annual reports contain explanations of what
is right in the company, but he prefers to know what is wrong, and why. For
him, managers who have the courage to discuss publicly the problems of the
company are able to resolve those problems. It's normal that a company
encounters problems, it's business, the most important is to not hide them. As
all managers, Buffet is using the Generally Accepted Accounting Principles
(GAAP), but he also refers to data that are not required by the GAAP.
Does management resist the institutional imperative?
Another point that distinguishes exceptional manager from
others is their ability to resist what Buffett calls, the «institutional
imperative». For him, the majority of managers are not independent in
their way of thinking; they imitate other managers which also imitate them.
Buffett saw «free-managers» as the top of the basket, they are making
their decisions based on their own knowledge and understanding of a situation
and will not fol low the group blindness.
Of course it's difficult to measure the quality of a manager;
there is no quantitative data that can be used to identify strength and
weaknesses of managers, all is about qualitative perception of a Human that by
definition can make errors. «When a management with a reputation for
brilliance tackles a business with a reputation for poor fundamental
economics,» Buffet w rites, «it is the reputation of the business
that stays intact.39»
Financial Tenets
When Buffett has selected companies which are running the
firsts tenets, he analyzes how the company is doing financially. Mostly, he
looks at 3 criteria that are non-negotiable, the return on equity, the high
profit margin and the creation of market value, here are those criteria.
39 G. Hagstrom The Essential Buffett: Timeless Principles for
the New Economy (85)
Focus on return on equity, not earnings per share.
After having looked at the business and the managerial skill
of a company, Warren Buffett analyzes the financial situation of companies he
is interested in. When most investors analyze the earning per share, one of the
main criteria for Warren Buffet is looking the return on equity. For him the
return on equity gives a better understanding of the financial health of a
company than the earning per share. He explained that companies can accumulate
previous earnings and use it to increase the actual earnings per share, so this
time horizon problem can sidestep the analysis of the health of a company. In
order to perfectly use the return on equity ratio that is more accurate of the
company' used of shareholders equity, Warren Buffet told investors to make some
adjustments. Investors should exclude of their calculation all the gains or
losses due to capital operation as well as all extraordinary gains or losses
that influence the earnings. Return on equity should reflect the normal
activities of a company; it should show how the management is able to generate
return with the capital employed. Always concerning the return on equity,
Buffett point of view, is that a company should generate profits without or
with few debts. There are 2 reasons to this «debt allergy». The first
one is because with debt, a company can increase their return on equity through
the leverage effect of the debt-equity ratio. The second reason is that company
with no or few debts are more able to resist to bad economic conditions.
Look for companies with high profit margins.
For Warren Buffett, investors should focus their attention to
companies with high profit margin. He distinguishes 2 types of managers
regarding the profit margin: those running a high-cost operation, and those who
are running a low-cost operation. For him, high-cost operation managers always
added overhead expenses and are fighting against cost only when it
significantly reduces the profit. On the other hand, low-cost managers are
always trying to find ways to reduce expenses.
Buffett reckons that when a company managed in a high-cost way
tries to cut-off expenses through a «cost-killer program», it will
affect the return of the company. He explains that «The really good
manager does not wake up in the morning and say, this is the day I'm going to
cut costs.40» Buffett emphasizes the fact that the overhead
expenses of his company, represent less than 1% of the operating earnings, when
similar companies have something around 10% of overhead expenses; in doing so,
shareholders are losing 9% of the operating earnings.
For every dollar retained, make sure the company has created
at least one dollar of market value.
Another financial tenet Buffett considers is that for each
dollar invested by shareholders, the company should generate at least one
dollar of market value. Less than one-for-one is a loss for shareholders.
Nobody wants to invest $1 and be the owner of 50cents a few years later. Good
companies should increase their value in the market by more than the value of
earnings they retained.
Market Tenets
After having analyzed previous criteria, Warren Buffett is
able to know if the company is a good one or not. If it's a good one, he will
analyze how the market perceived this company. When most investors are looking
at the market first, Buffet is looking at it at the end of his selection
process. By analyzing the market he will try to know if it's time to invest on
the company to take advantage of a bargain price.
40 G. Hagstrom The Essential Buffett: Timeless Principles for
the New Economy(95)
What is the value of the business?
Buffett considers that the value of a company is the total
amount of the net cash flows expected in the future discounted to an
appropriate rate. In doing so, he explains any company, never mind the
industry, will be judged equally in an economic point of view. Buffet also
explains that if an investor can't estimate with precision the future cash flow
of a company, he or she should not invest on it. That's why, Buffett don't
invest in new-technology company because he can't estimate the future cash flow
and he explains that those companies are out of his circle of competence. Once
an investor has made a good estimation of the company, he or she has to
discount this value to today; the investor will use a discount rate. Buffett
considered that this rate should be a risk-free rate, that's why he advices to
use the long term US government bond. (Those bonds are virtually risk-free,
because the government will always pay its debts). Lots of investors will add a
premium to this risk free rate considering the fact that the company's future
is uncertain (in comparison to the certainty of the US government bond). Buffet
doesn't add any premium; he prefers to adjust the discount rate. If the
discount rate is too low, let's say 7% Buffett will correct it to 10%. In doing
so, he increase the «margin of safety». If he is right he just used
the good discount rate, if his wrong, he just increased his margin of safety of
3%.
Can the business be purchased at a significant discount to its
value?
In order to buy companies for less that their value, Buffett
is using the margin of safety. This notion developed by Buffett's mentor, the
professor Benjamin Graham, is the difference between the stock price of a
company and its intrinsic value. If a company is a little bit undervalued by
the market, there is a small margin of safety, if the value stock of the
company is really undervalued there is a big margin of safety. This margin of
safety is a tool to helps investors of 2 different ways. First of all, if the
investor has made a bad evaluation of the company, the margin of safety will
reduce the risk of looses. If an investor evaluate a company at $100 per share
and the market undervalue it at $85, the investor has a margin of safety of
$15. If the value of the company drops to $90, the investor has still $5 of
gain. The second help, which is more or less the opposite of the first one, is
the possibility to earn extra-returns.
Summary
All the strategy of Warren Buffett is a process which starts
from the examination of the business in order to understand perfectly all
factors that influence it. Then he looks if the top management of the company
is good and rational. When Buffet has found a company with those criteria, he
ana lyzes the financial health of the company in order to estimate its value.
At the end of this process, he analyzes the market to see if the stock price of
the company is under-valuated. Buffett likes to say that he is 85% Graham and
15% Fisher. His strategy for picking stocks is inspired by those two men.
Buffett always buys quality companies at a bargain prices. A last remark is
important to be made, Warren Buffett has more than 50 years of experience now,
and he is lucky to have amazing business and financial skills. Most of
beginning investors will not at the first time be able to analyze the market or
companies like Warren Buffett. Investors can know perfectly each tenets or
advice of Warren Buffett, but in order to invest like him, investors will need
time to create their own experience and most of them will unfortunately never
reach the success of Buffett.
Focus investment
Now that investors know about the way Warren Buffett selects
the companies in which he will invest, it's interesting to have a look on what
Warren Buffett says about portfolios. As well as selecting companies, Buffett
is not acting like most of the investors.
The Status-quo of Active portfolio Vs index investing
The general idea about investment in the stock market is that
there are mainly 2 strategies, the active portfolio investment and the index
investment. Investors who trust in the active portfolio style are always
trading lots of stocks in order to outperform the market. They don't select
stock trough criteria based on the company but more on how they perceived the
stock will fluctuate in the short term. For example intraday trading is an
active portfolio style of investment. Investors are buying and selling the same
stock during the day and hope they will outperform the market thanks to their
superior market perception skills.
Investors who trust in the index investment are less
presumptuous; their point of view is to stick the market. Because the market is
composed of thousands of stocks, those investors are creating diversified
portfolios which are similar to indexes like the S&P500, the Dow Jones or
the Nasdaq100. Nevertheless, by acting like that, investors can't outperform
the market because they are following it, so in the best chance they will have
the same return of it but never more. Because of the different way of managing
their investment active portfolio investors and indexes investors are
constantly trying to proof that their way of investing is better than the other
one. Now, it's commonly accepted that index investments have a higher return
than the active portfolio. Nevertheless, those ways of investing have a common
denominator; both are investing with a diversified portfolio. Many books will
claim that diversification reduce risk and maximize profit. Thousands of
business school' students have heard that diversification is the best, if not
the only way to be successful in the market. Let's see what Warren Buffett
proposes.
A third choice
Because Warren Buffett is not satisfied of the result of the
previous strategies, he advises investors to invest in a focused portfolio. The
main aspect of this strategy is to select few stocks of good companies, to
invest more money on high return' stocks and wait without worrying about market
fluctuations.
Find good companies through Buffett's tenets
As it's developed in the previous sections; Warren Buffett
selects good companies through a process of 12 tenets. By doing the same
investors should isolate some companies that are able to give high returns.
Having all his eggs in the same basket is an easier way to
look at them
The main principle of focusing investment is to be able to
invest in few companies with the highest chance of performance. Buffett
explains: « If you are a know-something investor, able to understand
business economics and to find five to ten sensibly priced companies that
possess important lon g-term competitive advantages, conventional
diversification [broadly based active portfolios] makes no sense for
you.41» As he explains, the «know-something»
investor, who is not a professional but someone interested in stocks with a
basic knowledge, should invest money between 5 or 10 companies he or she knows
very well, rather than investing in 50 companies that he or she doesn't know
anything.
10 stocks at 10%?
As Buffett says, he is 15% Fisher, one of the ideas of Fisher
was to invest more in stocks that have a stronger opportunity, that mean, a
higher return. Following this idea, Buffett says «With each investment you
make, you should have the courage and the conviction to place at least ten
percent of your net worth in that
41 Robert Hagstrom, The Warren Buffet Way (122)
stock.42» That's why previously he advises to
have at maximum 10 stocks. Nevertheless, some investments will have a higher
return than others; investors should allocate more resources to those in order
to have an overall higher return.
Time horizon
Focus investment is also different from diversified investment
trough its relation to time. When diversified investment has a short term
vision, Focus investment has a long term vision. One of the reasons to invest
in the long term is to limit the risk. In short term, stock price will
fluctuate due to several factors like a change in the interest rate, a new
report concerning inflation, a natural disaster and so on; but in the long term
share prices will more often increase. Buffett suggests having a relative
turnover of the stocks contained between 10% and 20%, so the time horizon of an
investor should be between 10 and 5 years.
Don't look at price fluctuation
Because prices fluctuate, and the value of stocks can drop
investors are subject to panic. But because focus investors are running the
long term, and because in the long term stocks are rising, there is no reason
to be afraid of short term fluctuation. The reader will not be surprised to
know that Warren Buffett never looks at short term fluctuation of his
stocks.
THE FOCUS INVESTOR'S GOLDEN RULES43
1. Concentrate your investments in outstanding companies run by
strong management.
2. Limit yourself to the number of companies you can truly
understand. Ten is a good number; more than 20 is asking for trouble.
3. Pick the very best of your good companies, and put the bulk
of your investment there.
4. Think long term 5 to 10 years, minimum.
5. Volatility happens. Carry on.
|
When investors have to sell their stocks
It can appear strange, selling stock is really easy. Investors
will sell their stocks due to 3 factors. The first one is because something was
wrong in the equation; stocks return is not as high as expected. The second
reason a change in the equation; what was right yesterday may not be right
tomorrow. The third reason is life cycle, your stocks as still a high return
but new one have a higher return.
42 IBID(122)
43 G. Hagstrom The Essential Buffett: Timeless Principles for
the New Economy(129)
Something wrong in the equation
Error is human; sometimes investors will make a mistake when
they estimate the value of a company, it will appear interesting to invest and
few times later investors will realize that it was not. In such occasion, the
best thing to do is to analyze the actual situation with calm, try to see how
bad the situation is. Maybe it will be necessary to sell the stocks and lose
money. It's business, it happens. Beginning investors are the most exposed to
make errors at the beginning, that's why experience is useful in investment.
Something changed in the equation
Because focus investment is running in the long term,
parameters can change. A really good company can become not so attractive a few
years after. Top management can change, financial situation can become more
risky, and there are several reasons this can affect a company. Even though
good companies generally stay good companies in the long term, exceptions
exist. In order to act and not to be subject of those changes, always staying
informed of the business, the company, the sector is a way to anticipate them.
If an investor sees that the company in which he or she has invested 5 years
ago is not fulfilling the criteria that it should, he or she will have to sell
and take his profit before the market understands the change and the stocks
drop.
Life cycle
The main reason that makes investors sell stocks is that a
better opportunity is coming. Investors can have a portfolio of really good
stock, but sometimes, a new stock give higher expected return. The new stock
will so take the place of an old stock in the portfolio. Generally, it will
take the place of the stock with the lower return. Remember what Warren Buffet
says about the turnover of a portfolio, it has to be between 10% and 20%, which
mean a time horizon of 5 to 10 years. Investor will keep a stock during one or
two years and others during 10 or more if the stock is always a top
performer.
All the strategy of Warren Buffett can be summarized in one
sentence. Buying quality companies at bargain prices. Warren Buffet told us to
understand the market, the business, the company before investing on it;
investors will have a better understanding of companies inside their circle of
competence. He teaches us to buy stocks when the market underestimates the
value of the company and so to take advantage of the margin of safety. Finally
Buffet told us to have a focus portfolio and to run it in the long term.
«I'm the luckiest guy in the world in terms of what I do for
a living. No one can tell me to do things I don't believe in or things I think
are stupid.44»
44 Quotable Executive (118)
|