It is a great book tracing the life of Warren Buffett and connecting available materials to piece together his investing philosophy and approach.
What we do is not beyond anyone else’s competence. I feel the same way about managing that I do about investing: it is just not necessary to do extraordinary things to get extraordinary results.
Warren Buffett
It is a worthwhile exercise to Google the noteworthy events of the 1950s, 1960s, 1970s, 1980s, 1990s and the first decade of the twenty-first century. Although too numerous to list here, the front-page headlines would include nuclear war brinkmanship; presidential assassination and resignation; civil unrest and riots; regional wars; oil crisis, hyperinflation and double-digit interest rates; and terrorist attacks — not to mention the occasional recession and periodic stock market crash. When asked how he navigates the treacherous episodes that can disrupt markets and inevitably scare away most investors, Buffett, with his folksy style, confesses he simply tries to be “greedy when others are fearful and fearful when others are greedy.
How I got here is pretty simple in my case. It is not IQ, I’m sure you will be glad to hear. The big thing is rationality. I always look at IQ and talent as representing the horsepower of the motor, but that the output — the efficiency with which the motor works — depends on rationality. A lot of people start out with 400-horsepower motors but only get 100 horsepower of output. It’s way better to have a 200-horsepower motor and get it all into output.
So why do smart people do things that interfere with getting the output they’re entitled to? It gets into the habits and character and temperament and behaving in a rational manner. not getting in your own way. As I have said, everyone here has the ability absolutely to do anything I do and much beyond. Some of you will, and some of you won’t. For thise who won’t, it will be because you get in your own way, not because the world doesnt allow you.
Warren Buffett
When Buffett invests, he sees a business. Most investors see only a stock price. They spend far too much time and effort watching, predicting and anticipating price changes and far too little time understanding the business they partly own. Elementary as this may be, it is the root of what distinguishes Buffett.
Often investors begin with an economic assumption and then go about selecting stocks that fit neatly within this grand design. Buffett considers this thinking foolish. Buffett prefers to buy a business that has the opportunity to profit regardless of the economy. Time is more wisely spent locating and owning a business that has the ability to profit in all economic environments than by renting a group of stocks that do well only if a guess about the economy happens to be correct.
An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.
Ben Graham
There are three important principles to Graham’s approach:
- Business (not the market)
- Margin-of-safety
- Having a true investor’s attitude toward the stock market (rationality)
Rationality: The critical difference
Warren Buffett tells us that successful investing does not require having a high IQ or taking formal courses at most business schools. What matters most is temperament. And when Buffett talks about temperament he means rationality. The cornerstone of rationality is the ability to see the past, the present and analyse several possible scenarios, eventually making a deliberate choice. That, in a nutshell, is Warren Buffett.
Rationality is not the same as intelligence.
Rationality is essential when others are making decisions based on short-term greed or fear. This is when the money is made.
Warren Buffett
At a minimum, you would read a company’s annual report and the annual reports of competitors. If it appears the company has a strong competitive position with a favourable long-term outlook, you next run several dividend discount models that include different growth rates of the company’s owner earnings over different time periods to get a sense of approximate valuation. then you would study and understand management’s long-term capital allocation strategy. Last, you might call a few friends, colleagues or financial advisers to see if they have an opinion about your company or better yet, your competitor’s competitors. Take note: None of this requires a high IW but it is more laborious and requires more mental effort and concentration than simply figuring out the company’s current price-to-earnings ratio.
Graham taught Buffett the twofold significance of emotion in investing: the mistakes it triggers for those who make irrational decisions based on it, and the opportunities it thus creates for those who can avoid falling into the same traps.
Stocks have an investment characteristic and a speculative characteristic. The speculative characteristics are a consequence of human fear and greed. Graham taught Buffett that if he could insulate himself from the emotional whirlwinds of the stock market, he had an opportunity to exploit the irrational behaviour of other investors, who purchased stocks based on emotion. not logic.
Buying a business — The 12 immutable tenets
When investing, we view ourselves as business analysts, not as market analysts, not as macroeconomic analysts. and not even as security analysts. This means that Buffett works first and foremost from the perspective of a businessperson.
Investing is most intelligent when it is most businesslike.
Warren Buffet
If we go back through time and review all of Buffett’s purchases, looking at commonalities, it is possible to discern a set of basic principles or tenets and spread them out for a closer look, we can see that they are naturally group themselves into four categories:
- Business tenets — three characteristics of the business itself
- Management tenets — three important qualities that senior managers must display
- Financial tenets — Four critical financial decisions that the company must maintain
- Market tenants — Two interrelated cost guideline
Business tenets
Is the business simple and understandable?
In Buffett’s view, investors’ financial success is correlated to how well they understand their investment.
Invest in your circle of competence. It is not how big the circle is that counts, it’s how well you define the parameters.
Warren Buffett
Does the business have a consistent operating history?
For some unexplained reason, investors are so infatuated with what tomorrow may bring that they ignore today’s business reality.
Warren Buffett
Experience has taught Warren that turnarounds seldom turn. It can be more profitable to look for good businesses at reasonable prices than difficult businesses at cheaper prices.
Charlie and I have not learned how to solve difficult business problems. What we have learned to do is to avoid them. To the extent that we have been successful, it was because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers.
Warren Buffett
Does the business have favourable long-term prospects?
Buffett defines great business as a company providing a product or service that is (1) needed or desired, (2) has no close substitute and (3) is not regulated. These traits allow the company to hold its prices, and occasionally raise them, without the fear of losing market share or unit volume. This pricing flexibility is one of the defining characteristics of a great business; it allows the company to earn above-average returns on capital.
A moat is what gives a great company a clear advantage over its competitors and protects the business from invasion by competition, wants to tap into its share of profits. So a clear competitive advantage is crucial as well for that competitive advantage or moat to be durable and able to stick around for a really long time.
Management tenets
Is the management rational?
The most important management act is the allocation of the company’s capital. Management must act rationally and act in shareholders’ best interest — best allocate capital in a way that maximizes shareholder value.
Is management candid with shareholders?
Buffett holds in high regard managers who report their company’s financial performance fully and genuinely, who admit mistakes as well as share success and who are in all ways candid with shareholders. Buffett also admires managers who have the courage to discuss failure openly. Too many managers, he believes, report with excess optimism rather than honest explanation, serving perhaps their own interests in the short term but no one’s interests in the long run.
The CEO who misleads others in public may eventually mislead himself in private.
Berkshire Hathaway, An Owner’s Manual, Owner-related business principles Number 12
Does management resist the institutional imperative?
Resist the institutional imperative. The institutional imperative is the tendency of corporate managers to imitate the behaviour of others, no matter how silly or irrational that behaviour might be. He wants managers who are critical thinkers and have the ability to think for themselves.
Taking the measure of management
It is more difficult to evaluate managers along the management tenets than measure financial performance; human beings are more complex than numbers.
Buffett offers a few tips. Most annual reports are a sham. Review annual reports from a few years back, paying special attention to what the management said then about the strategies for the future. Then compare those plans to today’s results; how fully were the plans realised? Also, compare the strategies of a few years ago to this year’s strategies of a few years ago to this year’s strategies and ideas; how has the thinking changed? Buffett also suggests it can be valuable to compare annual reports of the company in which you are interested with reports of similar companies in the same industry.
Financial tenets
Focus on return on equity, not earnings per share
Buffett considers earnings per share a smoke screen. Good business or investment decisions will produce satisfactory results with no aid from leverage. Highly leveraged companies are vulnerable during economic slowdowns. Despite his conservative stance, Buffett prefers to borrow money in anticipation of using it farther down the road, rather than after a need is announced.
If you want to shoot rare, fast-moving elephants, you should always carry a gun.
Warren Buffett
Cheap money has a tendency to force asset prices higher. Tight money and higher interest rates raise liability costs and often force the prices of assets downward.
A truer measure of annual performance because it takes into consideration the company’s ever-growing capital base is its return on equity — the ratio of operating earnings to shareholders’ equity. A good business should be able to earn a good return on equity without the aid of leverage. Companies that depend on debt for good turns on equity should be viewed suspiciously.
Calculate “owner earnings” to get a true reflection of value
To Buffett, the first point to understand is that not all earnings are created equal. Two companies might have the same level of earnings, but one company might be asset-heavy while the other might be asset-light. Inflation and the need to replace the assets in the asset-heavy business make the earnings between the two companies not really comparable.
Cash flow is not a perfect tool for measuring value; in fact, it often misleads investors.
Owner earnings is a company’s net income plus depreciation, depletion, and amortization, less the amount of capital expenditures and any additional working capital that might be needed.
Look for companies with high-profit margins
Great businesses make lousy investments if management cannot convert sales into profits by controlling costs.
For every dollar retained, make sure the company has created at least one dollar of market value
The stock market answers the fundamental question: What is this particular company worth? Buffett proceeds in the belief that if he has selected a company with favourable long-term economic prospects, run by able and shareholder-oriented managers, the proof will be reflected in the increased market value of the company. If a company employs retained earnings nonproductively over an extended period, eventually, the market (justifiably) will price the shares of the company lower. If a company has been able to achieve above-average returns on augmented capital, that success will be reflected in an increased stock price.
The one-dollar rule: The increase in value should, at the very least, match the amount of retained earnings dollar for dollar.
Within this gigantic auction areana, it is our job to select a business with economic characteristics allowing each dollar of retained earnings to be translated eventually into at least a dollar of market value.
Warren Buffett
Market tenets
What is the value of the business?
The value of a business is determined by the net cash flow expected to occur over the life of the business discounted at an appropriate interest rate.
Buffett dismisses the concept of an equity risk premium because it is an artefact of the capital asset pricing model that, in turn, uses price volatility as a measure of risk. In simple terms, the higher the volatility, the higher the equity risk premium. However, Buffett thinks that the whole idea that price volatility is a measure of risk is nonsense. In his mind, business risk is reduced, if not eliminated, by focusing on companies with consistent and predictable earnings.
Buffett’s sense of risk: It has nothing to do with stock price volatility but rather with the certainty that the individual stocks will, over time, produce a profit. To reduce risk is to buy stocks only when the margin of safety is high. Risk, for Buffett, is inextricably linked to an investor’s time horizon.
There are times when long-term interest rates are abnormally low. During these periods, we know that Buffett is more cautious and likely adds a couple of percentage points to the risk-free rate to reflect a more normalised interest rate environment.
Growth and value investing are joined at the hip. Value is the discounted present value of an investment’s future cash flow; growth is simply a calculation to determine value.
Whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value for his investment… irrespective of whether a business grows or doesn’t, displays volatility or smoothness in earnings, or carries a high price or low in relation to its current earnings and book value, the investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase.
Warren Buffett
Can the business be purchased at a significant discount to its value?
Focusing on good businesses — those that are understandable, with enduring economics, and run by shareholder-oriented managers — by itself is not enough to guarantee success, Buffett notes. First, he has to buy at sensible prices and then the company has to perform to his business expectations.
It is Buffett’s intention not only to identify businesses that earn above-average returns but to purchase them at prices far below their indicated value.
The margin-of-safety principle assists Buffett in two ways.
- It protects him from downside price risks.
- It provides opportunities for extraordinary stock returns.
The above tenets can be seen in various forms of investing approaches articulated by many successful long-term investors. Giverny Capital is one of them as shown below.
From theory to reality
Putting together the theory into the reality of the stock market with the chain of thinking:
- Calculate the probabilities: What are the chances that this stock I am considering will, over time, achieve an economic return greater than the stock market?
- Wait for the best odds: The odds of success top in your favour when you have a margin of safety; the more uncertain the situation, the greater the margin you need.
- Adjust for new information
- Decide how much to invest: What proportion should go into a particular purchase? Start with the Kelly formula, then work downward, perhaps to a half-Kelly bet or a fractional-Kelly bet.
Whether or not investors recognise it, virtually all the decisions they make are exercises in probability.
Loss aversion: Cost of holding
The pain of a loss is far greater than the enjoyment of a gain (i.e. asymmetric loss aversion).
Two factors that contribute to an investor’s emotional turmoil are loss aversion and a frequent evaluation period which is known as myopic loss aversion; the idea that the more we evaluate our portfolios, the higher our chance of seeing a loss and, thus, the more susceptible we are to loss aversion.
Warren Buffett bought more than $1 billion in Coca-Cola (KO) shares in 1988, an amount that was then equivalent to 6.2% of the company. The purchase made it the single largest position in Buffett’s Berkshire Hathaway portfolio at the time. When Buffett first started buying in the first quarter, many investors were still skittish from the Black Monday crash in October 1987. Buffett going big on the stock was considered risky, especially because it was not a typical Berkshire investment.
During the first 10 years of its investments in Coca-Cola, the share price went up by 10 times. However, KO only managed to outperform the S&P index 6 years out of 10 years. During conferences, the author often asked the audience who follow Buffett and invested in KO and many raised up their hands. When the author asked who has managed to gain a return near that of Buffett. Almost no one raised their hand.
It is not easy to hold a stock for the long term and worry about volatility and losses. This is made worse when investors often look at share prices and do not study the company to understand it better to increase their confidence and conviction.
Time and patience are two sides of the same coin.
