Cap is
short for capitalisation which is a measure by which we can classify a
company's size. Big/large caps are companies which have a market cap
between 10-200 billion dollars. Mid caps range from 2 billion to 10
billion dollars.
These might not be industry leaders but are well on their way to becoming one. Small caps are typically new or relatively young companies and have a market cap between 300 million to 2 billion dollars.
Although their track record won't be as lengthy as that of the mid to mega caps, small caps do present the possibility of greater capital appreciation, but at the cost of greater risk.
These might not be industry leaders but are well on their way to becoming one. Small caps are typically new or relatively young companies and have a market cap between 300 million to 2 billion dollars.
Although their track record won't be as lengthy as that of the mid to mega caps, small caps do present the possibility of greater capital appreciation, but at the cost of greater risk.
What Buffett means by owner earnings
Both earnings
per share (EPS) and cash flow have serious deficiencies in business
valuation. Earnings per share was briefly mentioned in the previous
article on return on assets, its problem being that in times of
inflation, companies with a low return on assets suffer as the
replacement cost of these assets increases. A better way of assessing
earnings would be to look at actual cash flow.
But cash flow has problems of its own, as it is invalid to compare the cash flow of a company requiring high capital expenditure with one with low capex. Cash flow works fine when a company has little need for large ongoing outlays past initial setup costs, such as real estate companies, cable and telco companies and oil and gas industries. However cash flow is a poor measure of the worth of companies that require extensive ongoing capital expenditure, such as manufacturers and airlines.
"Owner earnings" is a concept invented by Warren Buffet that overcomes the capex deficiency of cash flow. You add back to earnings the deductions made for depreciation etc and subtract off capital expenditures. Owner earnings is calculated as:
Owner earnings = net income + depreciation + depletion + amortization - capital expenditures - additional working capital
Admittedly it isn't a precise measure, it requires the analyst to make an estimation of upcoming capital expenditures, which can be a fairly approximate excercise, however this is probably the best anyone can do. The answer is going to be approximately right, rather than exactly wrong.
But cash flow has problems of its own, as it is invalid to compare the cash flow of a company requiring high capital expenditure with one with low capex. Cash flow works fine when a company has little need for large ongoing outlays past initial setup costs, such as real estate companies, cable and telco companies and oil and gas industries. However cash flow is a poor measure of the worth of companies that require extensive ongoing capital expenditure, such as manufacturers and airlines.
"Owner earnings" is a concept invented by Warren Buffet that overcomes the capex deficiency of cash flow. You add back to earnings the deductions made for depreciation etc and subtract off capital expenditures. Owner earnings is calculated as:
Owner earnings = net income + depreciation + depletion + amortization - capital expenditures - additional working capital
Admittedly it isn't a precise measure, it requires the analyst to make an estimation of upcoming capital expenditures, which can be a fairly approximate excercise, however this is probably the best anyone can do. The answer is going to be approximately right, rather than exactly wrong.
The Warren Buffett You Don't Know - Part 4
Buffett bought
Executive Jet in mid-1998 for $725 million. Although this is a pittance
compared with what Berkshire paid for General Re, the EJA deal was no
less a milestone in its way. EJA, which pioneered the fractional
ownership of business jets, is the first true emerging-growth company
that Buffett has ever owned. What's more, the very idea of investing in
business aviation would have been considered downright sacrilegious
throughout most of Berkshire's history.
For years, Buffett mocked corporate ownership of jets as a wasteful executive perk. But in 1986, he bought a small used plane for Berkshire, then traded up to a more expensive model a few years later. He named the jet ''The Indefensible'' and made sport of its purchase in his 1989 report to shareholders: ''Whether Berkshire will get its money's worth from the plane is an open question, but I will work at achieving some business triumph that I can (no matter how dubiously) attribute to it.''
The truth is, Buffett had fallen in love with his plane but could not yet admit it. In 1995, he was introduced to Santulli by the head of one of Berkshire's operating companies and bought a one-quarter share of a Hawker for personal use. His wife, who has become a frequent flier, called the new plane ''The Richly Deserved.'' (Not to be outdone, Buffett renamed Berkshire's jet ''The Indispensable.'') Santulli offered to sell his company to Buffett when Goldman, Sachs & Co. (GS), a founding minority investor, began pressuring him to float a public stock offering.
Executive Jet in no way resembles the sort of business on which Buffett cut his teeth as an apprentice to the late Benjamin Graham, co-author of the value-investing bible, The Intelligent Investor. Graham's method emphasized creating a ''margin of safety'' by investing only in stocks trading at two-thirds of net working capital. He called them ''cigar butts''--companies the stock market had discarded but that still held a puff or two of value to extract.
Buffett was Graham's most accomplished disciple. But as the pupil established himself, he began to feel constrained by the mentor's method. For Graham, a business was an abstraction wholly defined by a set of numbers on a page; he had no interest in its products, its management, its personality. But Buffett's boundless curiosity and enthusiasm were not satisfied by the ghoulish exercise of profiting from the last dying gasps of derelict companies. Buffett's yearnings and dissatisfactions did not begin to coalesce into an investment philosophy of his own until he met the blunt-spoken Munger in 1959. The two, closely matched in intellect and outlook, quickly became the closest of partners. Munger urged his friend to leave the cigar butts in the gutter and think of value in more expansive terms. Says Buffett: ''Charlie kept pushing me back to the idea that what we really needed to own was the wonderful business.''
Even so, it took Buffett a long time to tailor Graham's straitjacket conservatism to the more generous dimensions of his own personality. His $11 million purchase of Berkshire Hathaway in 1965 was a costly case in point. Initially, Buffett saw the floundering old-line company as a classic Graham play. But then the textile manufacturer rallied unexpectedly, and Buffett sank more money into it on the belief that this cigar butt had a future after all. It did indeed, but not in textiles.
Buffett did not come fully into his own until he and Munger collaborated on the $25 million acquisition of See's Candies in 1972. The San Francisco maker of boxed chocolates was the first business of any sort for which Buffett paid more than book value--three times book, in fact.
What, in Buffett's view, makes a business wonderful? It starts with ''a sustainable competitive advantage.'' Underline sustainable. Buffett will not invest in a business unless he feels reasonably certain how much it will earn over the next 20 to 25 years. But for all of Buffett's cerebration, he does not feel truly comfortable unless a business ties into his own everyday experience. His favorite companies tend to traffic in elementally appealing brand-name products that Buffett not only uses himself but also invests with almost totemic meaning: a bottle of Coca-Cola, a Gillette razor blade, a box of See's candy, and, yes, even a Gulfstream jet.
Buffett has always been especially partial to companies that can sustain a competitive edge without tying up much capital. Consider Scott Fetzer, which makes a variety of industrial and consumer products, including Kirby vacuum cleaners and Quikut knives. Since 1986, when Berkshire paid $315 million for Scott Fetzer, its earnings have risen by only 5.5% a year on average. Yet Buffett repeatedly has praised it as a model of capital efficiency. In 1998, Scott Fetzer netted $96.5 million after taxes on its $112 million in equity, a return on equity of 86%. This is all the more breathtaking considering that Buffett has been milking it for 13 years, extracting more than $1 billion all told.
Ever since Berkshire's 1967 acquisition of National Indemnity Co., insurance has held double appeal for Buffett. Not only does he like the economics of the business--or parts of it, anyway--but a well-run underwriter also generates a steady flow of low-cost investment dollars, or ''float,'' as a matter of course. The 1996 acquisition of GEICO, now the sixth-largest U.S. auto insurer, doubled Berkshire's float at one stroke, and the Gen Re buy nearly tripled it, to $21 billion.
In Buffett's view, the quality of a company's management is integral to its value as a business. And when acquiring companies, Buffett is as concerned with the motives of the selling CEOs as he is with their abilities. ''What I must understand is why someone will continue to get out of bed in the morning once they have all the money they could want,'' Buffett says. ''Do they love the business, or do they love the money?''
No less an authority than John F. Welch, CEO of General Electric Co., considers Buffett a superb judge of managerial talent. Buffett and Welch have gotten to know each other over the years as golf partners and as rivals in auto insurance and other businesses. ''Take 20 people you know quite well but Warren has just met casually,'' Welch says. ''If you ask Warren his opinion about them, he'll have each one nailed. He's a masterful evaluator of people, and that's the biggest job there is in running a company.''
In 34 years, Berkshire has never lost an operating chief except to death. In fact, the great majority of its subsidiaries are still run by the same executive who brought them to Berkshire in the first place. The operating head of longest tenure is Charles N. Huggins, who has been president of See's Candies since Buffett acquired it. Huggins is 74 years old now, but he's not Berkshire's oldest manager. That would be 85-year-old Harold Alfond, who founded Dexter Shoe Co. in 1956 and sold to Buffett in 1993 for Berkshire shares now worth $1.5 billion.
Berkshire's operating ranks contain a second octogenarian billionaire: 82-year-old Albert L. Ueltschi, chairman and CEO of FlightSafety International Inc., a pilot-training concern Berkshire bought for $1.5 billion in 1996. An ex-pilot, Ueltschi founded the company in a LaGuardia Airport hangar in 1951. ''I'm like Warren,'' says Ueltschi, who has no plans to retire. ''I like what I do so much that I don't consider it work.''
For years, Buffett mocked corporate ownership of jets as a wasteful executive perk. But in 1986, he bought a small used plane for Berkshire, then traded up to a more expensive model a few years later. He named the jet ''The Indefensible'' and made sport of its purchase in his 1989 report to shareholders: ''Whether Berkshire will get its money's worth from the plane is an open question, but I will work at achieving some business triumph that I can (no matter how dubiously) attribute to it.''
The truth is, Buffett had fallen in love with his plane but could not yet admit it. In 1995, he was introduced to Santulli by the head of one of Berkshire's operating companies and bought a one-quarter share of a Hawker for personal use. His wife, who has become a frequent flier, called the new plane ''The Richly Deserved.'' (Not to be outdone, Buffett renamed Berkshire's jet ''The Indispensable.'') Santulli offered to sell his company to Buffett when Goldman, Sachs & Co. (GS), a founding minority investor, began pressuring him to float a public stock offering.
Executive Jet in no way resembles the sort of business on which Buffett cut his teeth as an apprentice to the late Benjamin Graham, co-author of the value-investing bible, The Intelligent Investor. Graham's method emphasized creating a ''margin of safety'' by investing only in stocks trading at two-thirds of net working capital. He called them ''cigar butts''--companies the stock market had discarded but that still held a puff or two of value to extract.
Buffett was Graham's most accomplished disciple. But as the pupil established himself, he began to feel constrained by the mentor's method. For Graham, a business was an abstraction wholly defined by a set of numbers on a page; he had no interest in its products, its management, its personality. But Buffett's boundless curiosity and enthusiasm were not satisfied by the ghoulish exercise of profiting from the last dying gasps of derelict companies. Buffett's yearnings and dissatisfactions did not begin to coalesce into an investment philosophy of his own until he met the blunt-spoken Munger in 1959. The two, closely matched in intellect and outlook, quickly became the closest of partners. Munger urged his friend to leave the cigar butts in the gutter and think of value in more expansive terms. Says Buffett: ''Charlie kept pushing me back to the idea that what we really needed to own was the wonderful business.''
Even so, it took Buffett a long time to tailor Graham's straitjacket conservatism to the more generous dimensions of his own personality. His $11 million purchase of Berkshire Hathaway in 1965 was a costly case in point. Initially, Buffett saw the floundering old-line company as a classic Graham play. But then the textile manufacturer rallied unexpectedly, and Buffett sank more money into it on the belief that this cigar butt had a future after all. It did indeed, but not in textiles.
Buffett did not come fully into his own until he and Munger collaborated on the $25 million acquisition of See's Candies in 1972. The San Francisco maker of boxed chocolates was the first business of any sort for which Buffett paid more than book value--three times book, in fact.
What, in Buffett's view, makes a business wonderful? It starts with ''a sustainable competitive advantage.'' Underline sustainable. Buffett will not invest in a business unless he feels reasonably certain how much it will earn over the next 20 to 25 years. But for all of Buffett's cerebration, he does not feel truly comfortable unless a business ties into his own everyday experience. His favorite companies tend to traffic in elementally appealing brand-name products that Buffett not only uses himself but also invests with almost totemic meaning: a bottle of Coca-Cola, a Gillette razor blade, a box of See's candy, and, yes, even a Gulfstream jet.
Buffett has always been especially partial to companies that can sustain a competitive edge without tying up much capital. Consider Scott Fetzer, which makes a variety of industrial and consumer products, including Kirby vacuum cleaners and Quikut knives. Since 1986, when Berkshire paid $315 million for Scott Fetzer, its earnings have risen by only 5.5% a year on average. Yet Buffett repeatedly has praised it as a model of capital efficiency. In 1998, Scott Fetzer netted $96.5 million after taxes on its $112 million in equity, a return on equity of 86%. This is all the more breathtaking considering that Buffett has been milking it for 13 years, extracting more than $1 billion all told.
Ever since Berkshire's 1967 acquisition of National Indemnity Co., insurance has held double appeal for Buffett. Not only does he like the economics of the business--or parts of it, anyway--but a well-run underwriter also generates a steady flow of low-cost investment dollars, or ''float,'' as a matter of course. The 1996 acquisition of GEICO, now the sixth-largest U.S. auto insurer, doubled Berkshire's float at one stroke, and the Gen Re buy nearly tripled it, to $21 billion.
In Buffett's view, the quality of a company's management is integral to its value as a business. And when acquiring companies, Buffett is as concerned with the motives of the selling CEOs as he is with their abilities. ''What I must understand is why someone will continue to get out of bed in the morning once they have all the money they could want,'' Buffett says. ''Do they love the business, or do they love the money?''
No less an authority than John F. Welch, CEO of General Electric Co., considers Buffett a superb judge of managerial talent. Buffett and Welch have gotten to know each other over the years as golf partners and as rivals in auto insurance and other businesses. ''Take 20 people you know quite well but Warren has just met casually,'' Welch says. ''If you ask Warren his opinion about them, he'll have each one nailed. He's a masterful evaluator of people, and that's the biggest job there is in running a company.''
In 34 years, Berkshire has never lost an operating chief except to death. In fact, the great majority of its subsidiaries are still run by the same executive who brought them to Berkshire in the first place. The operating head of longest tenure is Charles N. Huggins, who has been president of See's Candies since Buffett acquired it. Huggins is 74 years old now, but he's not Berkshire's oldest manager. That would be 85-year-old Harold Alfond, who founded Dexter Shoe Co. in 1956 and sold to Buffett in 1993 for Berkshire shares now worth $1.5 billion.
Berkshire's operating ranks contain a second octogenarian billionaire: 82-year-old Albert L. Ueltschi, chairman and CEO of FlightSafety International Inc., a pilot-training concern Berkshire bought for $1.5 billion in 1996. An ex-pilot, Ueltschi founded the company in a LaGuardia Airport hangar in 1951. ''I'm like Warren,'' says Ueltschi, who has no plans to retire. ''I like what I do so much that I don't consider it work.''
How Buffett Values Stocks
Many valuation
methods have been put forth over the years to determine the intrinsic
value of a stock, but Buffett only respects one of them. Buffett's
method is a development of John Burr Williams' discounting of future
cash flows method. In Buffett's case it is not dividends, or earnings as
such that he discounts, but Buffett's owner earnings , discounted by an appropriate interest rate.
This method, which is not at all unlike methods used for the valuation of a bond puts all investments on an even keel. The purpose of owning a business is not so you can profit from its breakup and cash in its assets (something deep value investors buying at below book value do), to sell it to the next speculator in line or even to flog a whole bunch of stock options then nick off to start a new life in Thailand, but to benefit from the revenues generated by the business.
If you are investing in stocks because you see them as businesses that you want to own then this is the only rational point of view. You don't buy a business because businesses are becoming expensive, you buy them because they make profits. Applying all of Buffett's avenues of research to try to make best guesses about what future owner earnings are going to be and discounting them by likely interest rates, the problem is reduced to a simple equation.
Here we see why Buffett is so mad about companies that are simple and reliable and predictable, and why he has shunned esoteric technology companies for so long. Buffett refuses to lose money, he takes no chances at all, and hence he has such an affection for companies with earnings that can be readily estimated for a while into the future, and have a good track record and good management to back this all up.
How do you value a technology company? What earnings streams do you apply to something that hasn't earned any money at all yet? It is entirely speculative, and hence the intrinsic value of this business is really anyone's guess. This is why so many of Buffett's companies make simple consumer goods and provide understandable financial services. Many of these businesses seem to operate like clockwork, steadily increasing their earnings over many years because they are mature and dependable blue chips.
What is the appropriate discount rate to use? Buffett's answer is simple, the rate that is risk-free. For a long time Buffett used present rates for long term bonds. The likelihood of the US government defaulting on long term loan obligations is virtually nil, and hence this is the rate he used.
When interest rates are low, Buffett adjusts this number upward, so when bond yields dipped below 7% he started discounting at 10%. If interest rates start to rise over time he has successfully matched his discount rate to the long term rate. If not, he has merely bought with a greater margin of safety.
Many would argue that another risk premium is justified, to increase the discount factor even further using a higher interest rate. That is up to the individual, but Buffett doesn't use one because he always buys at a substantial discount to intrinsic value anyway.
This method, which is not at all unlike methods used for the valuation of a bond puts all investments on an even keel. The purpose of owning a business is not so you can profit from its breakup and cash in its assets (something deep value investors buying at below book value do), to sell it to the next speculator in line or even to flog a whole bunch of stock options then nick off to start a new life in Thailand, but to benefit from the revenues generated by the business.
If you are investing in stocks because you see them as businesses that you want to own then this is the only rational point of view. You don't buy a business because businesses are becoming expensive, you buy them because they make profits. Applying all of Buffett's avenues of research to try to make best guesses about what future owner earnings are going to be and discounting them by likely interest rates, the problem is reduced to a simple equation.
Here we see why Buffett is so mad about companies that are simple and reliable and predictable, and why he has shunned esoteric technology companies for so long. Buffett refuses to lose money, he takes no chances at all, and hence he has such an affection for companies with earnings that can be readily estimated for a while into the future, and have a good track record and good management to back this all up.
How do you value a technology company? What earnings streams do you apply to something that hasn't earned any money at all yet? It is entirely speculative, and hence the intrinsic value of this business is really anyone's guess. This is why so many of Buffett's companies make simple consumer goods and provide understandable financial services. Many of these businesses seem to operate like clockwork, steadily increasing their earnings over many years because they are mature and dependable blue chips.
What is the appropriate discount rate to use? Buffett's answer is simple, the rate that is risk-free. For a long time Buffett used present rates for long term bonds. The likelihood of the US government defaulting on long term loan obligations is virtually nil, and hence this is the rate he used.
When interest rates are low, Buffett adjusts this number upward, so when bond yields dipped below 7% he started discounting at 10%. If interest rates start to rise over time he has successfully matched his discount rate to the long term rate. If not, he has merely bought with a greater margin of safety.
Many would argue that another risk premium is justified, to increase the discount factor even further using a higher interest rate. That is up to the individual, but Buffett doesn't use one because he always buys at a substantial discount to intrinsic value anyway.
The Warren Buffett You Don't Know - Part 3
In mid-April,
Buffett led a small entourage on a whirlwind European tour to promote
one of Berkshire's latest acquisitions, Executive Jet Aviation. I went
along for the ride (on one of EJA's Gulfstream IV-SP jets) and got an
unusual chance to observe the notoriously press-shy Buffett at close
range against a kaleidoscopic backdrop of private airports, luxury
hotels, and banquet halls stretching from London to Frankfurt to Paris.
Buffett survived a demanding regimen of midmorning coffees, two-hour luncheons, 90-minute press conferences, and four-course banquets. ''I never get tired,'' he told reporters in London, ''except for my voice.'' Actually, Buffett was ashen with fatigue midway through the third day but soldiered gamely on, answering even the lamest questions with the same expansiveness and wit the fifth time he heard them as he did the first.
Only once did Buffett show annoyance. During a press conference at the Frankfurt airport, Richard Santulli, EJA's normally understated chief executive, let his admiration of Buffett overflow. ''People say that he's the most astute investor of the 20th century,'' he said. ''I say ever.'
Buffett, who was sitting at Santulli's side, gave a little snort. ''Why not?'' he said sourly. ''I'm sitting right here.''
Like any mogul, Buffett has his special needs. On this trip, he indulged two of them, listed here in reverse order of importance: red meat (at lunch and dinner) and Coca-Cola (all the time).
Whenever I lost track of Buffett, Coke often appeared to guide me--a carbonated version of the proverbial trail of crumbs. In London, our party went from airport to hotel in separate cars. When I arrived at the Berkeley Hotel, I did not have to wonder for long whether Buffett had preceded me. A bellhop approached with a shopping bag. ''Is this yours?'' he asked. Inside were two six-packs of Cherry Coke. Two days later, I was in the crowded lobby of the Schlosshotel Kronberg near Frankfurt, following a white-gloved waiter bearing aloft a single bottle of Coca-Cola on a silver tray.
Buffett survived a demanding regimen of midmorning coffees, two-hour luncheons, 90-minute press conferences, and four-course banquets. ''I never get tired,'' he told reporters in London, ''except for my voice.'' Actually, Buffett was ashen with fatigue midway through the third day but soldiered gamely on, answering even the lamest questions with the same expansiveness and wit the fifth time he heard them as he did the first.
Only once did Buffett show annoyance. During a press conference at the Frankfurt airport, Richard Santulli, EJA's normally understated chief executive, let his admiration of Buffett overflow. ''People say that he's the most astute investor of the 20th century,'' he said. ''I say ever.'
Buffett, who was sitting at Santulli's side, gave a little snort. ''Why not?'' he said sourly. ''I'm sitting right here.''
Like any mogul, Buffett has his special needs. On this trip, he indulged two of them, listed here in reverse order of importance: red meat (at lunch and dinner) and Coca-Cola (all the time).
Whenever I lost track of Buffett, Coke often appeared to guide me--a carbonated version of the proverbial trail of crumbs. In London, our party went from airport to hotel in separate cars. When I arrived at the Berkeley Hotel, I did not have to wonder for long whether Buffett had preceded me. A bellhop approached with a shopping bag. ''Is this yours?'' he asked. Inside were two six-packs of Cherry Coke. Two days later, I was in the crowded lobby of the Schlosshotel Kronberg near Frankfurt, following a white-gloved waiter bearing aloft a single bottle of Coca-Cola on a silver tray.
Avoiding big mistakes according to Warren Buffett
An investor needs to do very few things right as long as he or she avoids big mistakes. - Warren Buffett
Warren Buffett sees investors success as coming directly in proportion to the degree to which they understand their investment. This differentiates those that take to investment with a methodical businesslike approach and the more hit and miss types that get into stocks based on a vague notion of there being something "hot" about an issue.
As Ben Graham put it, investment is at its most intelligent when it is most businesslike. The key to Buffett's success has always been a focus on the operations and business model of companies he is considering investing in. Fisher's idea of investing in what you know about comes up all the time with Buffett, and each and every business he invests in, whether it is as a minority shareholder or as an outright purchase gets scrutinized in fine detail before he purchases and as long as he owns them.
Buffett more or less ignores what the market does, in his words: "As far as I am concerned, the stock market doesn't exist. It is there only as a reference to see if anybody is offering to do anything foolish." By doing something foolish he means he is looking out for some of the great companies he has his eyes on trading at prices that are far too low to be justified. In his view the market is not efficient at all, frequently great jewels are cast out and trampled into the mud, to know the difference between a jewel and a kitsch trinket Buffett tries to value a company, and to do that he takes a very close look at the business this company operates.
Volatility, beta and alpha (relative strength) are all market derived factors which mean very little to Buffett. Rather than sending powerful computers to look at the way the market values a stock to chase correlations and limit "risk", he prefers to get to know the managers, revenues, cash flow, labour relations, pricing flexibility and capital allocation needs of the company.
Buffett is famous for his reticence toward investing in technology companies. Because of this he is frequently dismissed by critics as being behind the times and one of the old dinosaurs of the "old economy". In reality, Buffett's methods work perfectly well with technology stocks, he stays out because by his own admission he hasn't a clue how to estimate future cash flows of the business. In this area he is outside his "circle of competence", he has no confidence in his ability to assess the business model of a company built on such a rapidly changing landscape. His friend, Bill Gates, is the first to point out the tenuous situation that a technology company is in, a new innovation from a totally unexpected quarter could render an entire company's business obsolete. It is interesting to see as the "Tech Wreck" starts to bottom out just how fragile a technology companies grip on profitability can be, and how unsuccessful analysts have been in bringing forward any meaningful insights into how a technology business is supposed to make money.
The small number of companies owned by Berkshire Hathaway allow Buffett to keep a very close eye on their daily operations. This is the only form of risk management that he believes in. Buffett is able to maintain a very high level of knowledge about all of his businesses because he purposely limits his selections to companies that are well and truly within his area of financial and intellectual expertise. If you own a company (either in full or as a shareholder) in an industry you do not understand, you cannot possibly interpret developments accurately or make wise decisions.
Finally, Buffett believes that a company should be simple to run as well. While he does value quality management very much, he prefers it when he doesn't need it. "Invest in a company any idiot can run", he councils, "because sooner or later any idiot is going to run it".
Warren Buffett sees investors success as coming directly in proportion to the degree to which they understand their investment. This differentiates those that take to investment with a methodical businesslike approach and the more hit and miss types that get into stocks based on a vague notion of there being something "hot" about an issue.
As Ben Graham put it, investment is at its most intelligent when it is most businesslike. The key to Buffett's success has always been a focus on the operations and business model of companies he is considering investing in. Fisher's idea of investing in what you know about comes up all the time with Buffett, and each and every business he invests in, whether it is as a minority shareholder or as an outright purchase gets scrutinized in fine detail before he purchases and as long as he owns them.
Buffett more or less ignores what the market does, in his words: "As far as I am concerned, the stock market doesn't exist. It is there only as a reference to see if anybody is offering to do anything foolish." By doing something foolish he means he is looking out for some of the great companies he has his eyes on trading at prices that are far too low to be justified. In his view the market is not efficient at all, frequently great jewels are cast out and trampled into the mud, to know the difference between a jewel and a kitsch trinket Buffett tries to value a company, and to do that he takes a very close look at the business this company operates.
Volatility, beta and alpha (relative strength) are all market derived factors which mean very little to Buffett. Rather than sending powerful computers to look at the way the market values a stock to chase correlations and limit "risk", he prefers to get to know the managers, revenues, cash flow, labour relations, pricing flexibility and capital allocation needs of the company.
Buffett is famous for his reticence toward investing in technology companies. Because of this he is frequently dismissed by critics as being behind the times and one of the old dinosaurs of the "old economy". In reality, Buffett's methods work perfectly well with technology stocks, he stays out because by his own admission he hasn't a clue how to estimate future cash flows of the business. In this area he is outside his "circle of competence", he has no confidence in his ability to assess the business model of a company built on such a rapidly changing landscape. His friend, Bill Gates, is the first to point out the tenuous situation that a technology company is in, a new innovation from a totally unexpected quarter could render an entire company's business obsolete. It is interesting to see as the "Tech Wreck" starts to bottom out just how fragile a technology companies grip on profitability can be, and how unsuccessful analysts have been in bringing forward any meaningful insights into how a technology business is supposed to make money.
The small number of companies owned by Berkshire Hathaway allow Buffett to keep a very close eye on their daily operations. This is the only form of risk management that he believes in. Buffett is able to maintain a very high level of knowledge about all of his businesses because he purposely limits his selections to companies that are well and truly within his area of financial and intellectual expertise. If you own a company (either in full or as a shareholder) in an industry you do not understand, you cannot possibly interpret developments accurately or make wise decisions.
Finally, Buffett believes that a company should be simple to run as well. While he does value quality management very much, he prefers it when he doesn't need it. "Invest in a company any idiot can run", he councils, "because sooner or later any idiot is going to run it".
8 Investing rules that have stood the test of time
1. Don't trust
the market to value a stock. You've heard about the efficient market,
where investors' knowledge magically and correctly sets the best price
for a stock? Baloney. Even when bales of information are available
through the click of a mouse, the market is too often inefficient and
prices don't always reflect values. As Graham put it in the 1930s: "The
market price is frequently out of line with the true value; there is an
inherent tendency for these disparities to correct themselves."
Painfully, we might add. The fact that a hot young technology company is
trading at $280 a share does not make it worth $280 a share. Its price
could reflect a small float of available shares and the temporary effect
of momentum traders, the ones who buy because a stock is already
moving.
2. Don't think it's easy to beat the market. You have to approach stock picking with a certain humility. It's pretty hard to beat a broad-based index fund over a long period of time. After a lifetime of analyzing investment results, he wrote, "A creditable, if unspectacular, result can be achieved by the lay investor with a minimum of effort and capability; but to improve this easily attainable standard requires much application and more than a trace of wisdom."
3. Trend-following works over short periods, not long ones. Momentum investing--buying the stocks that have already had good runs in the past few months or so--has worked well recently. It can't keep working. At some point the stocks that are already expensive become absurdly expensive. And then they crash.
What's the opposite of trend-following? The philosophy that price matters. Your objective as an investor is to pay less than a company is intrinsically worth as a business concern--worth being defined in terms of earnings, liquidating value or (perhaps) future prospects. Norfolk Southern is worth something because it owns tracks and has demonstrated an ability to collect more cash from these assets than it consumes. Microsoft is worth a lot because it generates far more revenue than it needs to pay in salaries to keep that revenue coming in. The software firm may be worth a higher multiple of its earnings than the railroad because its prospects are better, but it is not worth infinitely more.
4. You can't time the market. As someone with a mathematical bent, Graham spent much of his career trying to devise a good formula for when to get into--and out of--the stock market. All formulas, he concluded, failed. Stocks should be bought when they are available for comfortably less than your best estimate of their intrinsic value, and sold when you can collect comfortably more than that sum. But the broad direction of the market is impossible to gauge.
In Graham's view it was acceptable to let the apportionment of your wealth between stocks and bonds fluctuate somewhat, but he insisted that neither allocation ever exceed 75%. He also insisted on the wisdom of diversification--owning at least 10 stocks and preferably 30. In light of the larger number of issues available today, 100 is not too many. The first index fund was just being cranked up when Graham died, but we can surmise that he would have approved of it for investors without the time to do meticulous research.
5. Base your expectations not on optimism but on arithmetic. In 1934 Graham summarized the kind of investing that leads sooner or later to capital losses: the view that a company's assets are irrelevant and that past earnings don't mean anything because values are only a function of the future. He was criticizing the prevailing frame of mind just before the 1929 crash. He could just as well have been describing today's day traders. Graham would have found the Internet sector problematic, to put it mildly. Collectively the companies in this sector have no dividends, earnings or tangible assets to speak of. A favored alternative is revenues. But even this measure raises the eyebrows of no less an investor than Warren Buffett. In a series of recent speeches he warned against valuing stocks based merely on how much money they churn through.
Graham wanted an investment that could benefit from an economic expansion but also survive a real crunch. For all investors but the ones willing to do the most extensive spadework, he recommended companies with strong balance sheets, a record of earnings for seven years and a dividend.
Dividends? True, they make no sense to taxable investors, and Buffett's own Berkshire Hathaway refuses to pay one. But for the majority of U.S. businesses, dividends remain the most convincing evidence that the reported earnings are real. The inflation-adjusted return on U.S. stocks over most of this century has been 7%, with more than half of that from dividends. Take a look at the returns of the Massachusetts Investors Trust from a $15 monthly investment beginning at the eve of the 1929 crash. Principal of $37,000 would have been transformed by now into a $3 million portfolio. One third of that return came from income, far more because it was reinvested.
6. Buy OPOs, not IPOs. That is, buy old public offerings--not new ones. The problem with initial public offerings is that you're buying what someone is trying too hard to sell. That should make you suspicious. Nowadays technology firms allow underwriters to deliberately under price their shares so that the shares will pop up on the first day of trading. But note that you usually can't participate in the first-day run-up unless you are a favored customer of the broker.
7. Buy cold industries. A new study by Ibbotson Associates going back to the depth of the Depression shows that with very few exceptions buying companies selling at a low P/E provided significantly higher returns. The 1990s were a stunning counterexample to this long-term principle. Okay, you wish you had bought Dell ten years ago. But what now?
Graham was skeptical of technology companies because the "experts do not have dependable ways of selecting and concentrating on the most promising companies in the most promising industries." Does that mean that companies on the forefront of developments are bad investments? Absolutely not. "In investment theory there is no reason why carefully estimated future earnings should be a less reliable guide than the bare record of the past," he wrote.
The problem arose, he said, because, typically, projections have been too optimistic for winners, too dire for losers. "The better a company's record and prospects, the less relationship the price of its shares will have to book value," he wrote, but that comes at a cost. "The greater the premium above book value, the more this 'value' will depend on the changing moods and measurements of the stock market."
Do you sincerely want to be rich? Don't stake your future on a narrow bet. Invest with a view to underlying business values, and with plenty of diversification. But also invest like that exuberant bull John Raskob, with steady additions to your portfolio. If you do, you will survive a crash--and even prosper from it.
8. Hang in there. Poor John J. Raskob. In his infamous, ill-timed interview in the August 1929 Ladies' Home Journal, he declared: "Everybody ought to be rich." And the way to do it was to invest $15 a month in the market--on margin. He wasn't an idiot: Raskob was the financier who helped create General Motors and DuPont. His fatal error was overconfidence. Minus the leverage, Raskob's advice was sound.
"The common stocks of this country have in the past ten years increased enormously in value because the business of the country has increased," he said. "It may be said that this is a phenomenal increase and that conditions are going to be different in the next ten years," he continued. "In my opinion, the wealth of the country is bound to increase at a very rapid rate." Sound familiar?
But there was a very important kernel of wisdom in Raskob's plan. Today we call it dollar-cost averaging: a steady investment, month after month, year after year. Although the system is of dubious value in accumulating a single stock, it makes perfect sense as a formula for investing in a diversified portfolio
2. Don't think it's easy to beat the market. You have to approach stock picking with a certain humility. It's pretty hard to beat a broad-based index fund over a long period of time. After a lifetime of analyzing investment results, he wrote, "A creditable, if unspectacular, result can be achieved by the lay investor with a minimum of effort and capability; but to improve this easily attainable standard requires much application and more than a trace of wisdom."
3. Trend-following works over short periods, not long ones. Momentum investing--buying the stocks that have already had good runs in the past few months or so--has worked well recently. It can't keep working. At some point the stocks that are already expensive become absurdly expensive. And then they crash.
What's the opposite of trend-following? The philosophy that price matters. Your objective as an investor is to pay less than a company is intrinsically worth as a business concern--worth being defined in terms of earnings, liquidating value or (perhaps) future prospects. Norfolk Southern is worth something because it owns tracks and has demonstrated an ability to collect more cash from these assets than it consumes. Microsoft is worth a lot because it generates far more revenue than it needs to pay in salaries to keep that revenue coming in. The software firm may be worth a higher multiple of its earnings than the railroad because its prospects are better, but it is not worth infinitely more.
4. You can't time the market. As someone with a mathematical bent, Graham spent much of his career trying to devise a good formula for when to get into--and out of--the stock market. All formulas, he concluded, failed. Stocks should be bought when they are available for comfortably less than your best estimate of their intrinsic value, and sold when you can collect comfortably more than that sum. But the broad direction of the market is impossible to gauge.
In Graham's view it was acceptable to let the apportionment of your wealth between stocks and bonds fluctuate somewhat, but he insisted that neither allocation ever exceed 75%. He also insisted on the wisdom of diversification--owning at least 10 stocks and preferably 30. In light of the larger number of issues available today, 100 is not too many. The first index fund was just being cranked up when Graham died, but we can surmise that he would have approved of it for investors without the time to do meticulous research.
5. Base your expectations not on optimism but on arithmetic. In 1934 Graham summarized the kind of investing that leads sooner or later to capital losses: the view that a company's assets are irrelevant and that past earnings don't mean anything because values are only a function of the future. He was criticizing the prevailing frame of mind just before the 1929 crash. He could just as well have been describing today's day traders. Graham would have found the Internet sector problematic, to put it mildly. Collectively the companies in this sector have no dividends, earnings or tangible assets to speak of. A favored alternative is revenues. But even this measure raises the eyebrows of no less an investor than Warren Buffett. In a series of recent speeches he warned against valuing stocks based merely on how much money they churn through.
Graham wanted an investment that could benefit from an economic expansion but also survive a real crunch. For all investors but the ones willing to do the most extensive spadework, he recommended companies with strong balance sheets, a record of earnings for seven years and a dividend.
Dividends? True, they make no sense to taxable investors, and Buffett's own Berkshire Hathaway refuses to pay one. But for the majority of U.S. businesses, dividends remain the most convincing evidence that the reported earnings are real. The inflation-adjusted return on U.S. stocks over most of this century has been 7%, with more than half of that from dividends. Take a look at the returns of the Massachusetts Investors Trust from a $15 monthly investment beginning at the eve of the 1929 crash. Principal of $37,000 would have been transformed by now into a $3 million portfolio. One third of that return came from income, far more because it was reinvested.
6. Buy OPOs, not IPOs. That is, buy old public offerings--not new ones. The problem with initial public offerings is that you're buying what someone is trying too hard to sell. That should make you suspicious. Nowadays technology firms allow underwriters to deliberately under price their shares so that the shares will pop up on the first day of trading. But note that you usually can't participate in the first-day run-up unless you are a favored customer of the broker.
7. Buy cold industries. A new study by Ibbotson Associates going back to the depth of the Depression shows that with very few exceptions buying companies selling at a low P/E provided significantly higher returns. The 1990s were a stunning counterexample to this long-term principle. Okay, you wish you had bought Dell ten years ago. But what now?
Graham was skeptical of technology companies because the "experts do not have dependable ways of selecting and concentrating on the most promising companies in the most promising industries." Does that mean that companies on the forefront of developments are bad investments? Absolutely not. "In investment theory there is no reason why carefully estimated future earnings should be a less reliable guide than the bare record of the past," he wrote.
The problem arose, he said, because, typically, projections have been too optimistic for winners, too dire for losers. "The better a company's record and prospects, the less relationship the price of its shares will have to book value," he wrote, but that comes at a cost. "The greater the premium above book value, the more this 'value' will depend on the changing moods and measurements of the stock market."
Do you sincerely want to be rich? Don't stake your future on a narrow bet. Invest with a view to underlying business values, and with plenty of diversification. But also invest like that exuberant bull John Raskob, with steady additions to your portfolio. If you do, you will survive a crash--and even prosper from it.
8. Hang in there. Poor John J. Raskob. In his infamous, ill-timed interview in the August 1929 Ladies' Home Journal, he declared: "Everybody ought to be rich." And the way to do it was to invest $15 a month in the market--on margin. He wasn't an idiot: Raskob was the financier who helped create General Motors and DuPont. His fatal error was overconfidence. Minus the leverage, Raskob's advice was sound.
"The common stocks of this country have in the past ten years increased enormously in value because the business of the country has increased," he said. "It may be said that this is a phenomenal increase and that conditions are going to be different in the next ten years," he continued. "In my opinion, the wealth of the country is bound to increase at a very rapid rate." Sound familiar?
But there was a very important kernel of wisdom in Raskob's plan. Today we call it dollar-cost averaging: a steady investment, month after month, year after year. Although the system is of dubious value in accumulating a single stock, it makes perfect sense as a formula for investing in a diversified portfolio
Sir John Templeton's list for investment success
1. If you begin with a prayer, you can think more clearly and make fewer mistakes.
Templeton was, and is, a devout Christian. His foundation that he has set up is one of the leading Christian philanthropic groups and advances a number of Christian causes. Some may find this may be off-topic for an investment FAQ, but nevertheless it is Sir John Templeton's first rule.
2. Outperforming the market is a difficult task.
The Challenge is not simply making better investment decisions than the average investor. The real challenge is making investment decisions that are better than those of professionals who manage the big institutions.
3. Invest - don't trade or speculate.
The stock market is not a casino but if you move in or out of stocks every time they move a point or two, the market will be your casino and you may lose eventually or frequently.
4. Buy value, not market trends or economic outlook.
Ultimately, it is the individual stocks that determine the market, not vice versa. Individual stocks can rise in a bear market and fall in in bull market. So buy individual stocks, not the market trend or economic outlook.
5. When buying stocks search for bargains among quality stocks.
Determining quality in stock is like reviewing a restaurant. You don't expect it to be 100% perfect, but before it gets three or four stars you want to be superior.
6. Buy Low.
So simple in concept. So difficult in execution. When prices are high, a lot of investors are buying a lot of stocks. Prices are low when demand is low. Investors have pulled back, people are discouraged and pessimistic. But, if you buy the same securities everyone else is buying, you will have the same results as everyone else. By definition, you cant outperform the market.
7. There's no free lunch. Never invest on sentiment. Never invest solely on a tip.
You would be surprised how many investors do exactly this. Unfortunately there is something compelling about a tip. Its very nature suggests inside information, a way to turn a fast profit.
8. Do Your homework or hire wise experts to help you.
People will tell you: investigate before you invest. Listen them. Study companies to learn what makes them successful.
9. Diversify - by company, by industry. In stocks and bonds, there is safety in numbers.
No matter how careful you are, you can neither predict or neither control the future. So you must diversify.
10. Invest for maximum total return.
This means the return after taxes and inflation. This is only rational objective for most long-term investors.
11. Learn from your mistakes.
The only way to avoid mistakes is not to invest- which is the biggest mistake of all. So forgive yourself for your errors and certainly don't try to recoup your losses by taking bigger risks. Instead turn each mistake into a leaning experience.
12. Aggressively monitor your investments.
Remember no investment is forever. Expect and react to change. And there are no stocks that you can buy and forget. Being relaxed doesn't mean being complacent.
13. An investor who has all the answers doesn't even understand all the questions.
A cocksure approach to investing will lead, probably sooner than later to disappointment if not outright disaster.
14. Remain flexible and open minded about types of investment.
There are times to buy blue chip stock, cyclical stocks, convertible bonds and there are times to sit on cash. The fact is there is no one kind of investment that is always best.
15. Don't panic.
Sometimes you won't have sold when everyone else is buying and you will be caught in a market crash. Don't rush to sell the next day. Instead study your portfolio. If you can't find more attractive stocks, hold on to what you have.
16. Do not be fearful or negative too often.
There will, of course, be corrections, perhaps even crashes. But over time our studies indicate, stocks go up. It always "buy low, sell high".
Templeton was, and is, a devout Christian. His foundation that he has set up is one of the leading Christian philanthropic groups and advances a number of Christian causes. Some may find this may be off-topic for an investment FAQ, but nevertheless it is Sir John Templeton's first rule.
2. Outperforming the market is a difficult task.
The Challenge is not simply making better investment decisions than the average investor. The real challenge is making investment decisions that are better than those of professionals who manage the big institutions.
3. Invest - don't trade or speculate.
The stock market is not a casino but if you move in or out of stocks every time they move a point or two, the market will be your casino and you may lose eventually or frequently.
4. Buy value, not market trends or economic outlook.
Ultimately, it is the individual stocks that determine the market, not vice versa. Individual stocks can rise in a bear market and fall in in bull market. So buy individual stocks, not the market trend or economic outlook.
5. When buying stocks search for bargains among quality stocks.
Determining quality in stock is like reviewing a restaurant. You don't expect it to be 100% perfect, but before it gets three or four stars you want to be superior.
6. Buy Low.
So simple in concept. So difficult in execution. When prices are high, a lot of investors are buying a lot of stocks. Prices are low when demand is low. Investors have pulled back, people are discouraged and pessimistic. But, if you buy the same securities everyone else is buying, you will have the same results as everyone else. By definition, you cant outperform the market.
7. There's no free lunch. Never invest on sentiment. Never invest solely on a tip.
You would be surprised how many investors do exactly this. Unfortunately there is something compelling about a tip. Its very nature suggests inside information, a way to turn a fast profit.
8. Do Your homework or hire wise experts to help you.
People will tell you: investigate before you invest. Listen them. Study companies to learn what makes them successful.
9. Diversify - by company, by industry. In stocks and bonds, there is safety in numbers.
No matter how careful you are, you can neither predict or neither control the future. So you must diversify.
10. Invest for maximum total return.
This means the return after taxes and inflation. This is only rational objective for most long-term investors.
11. Learn from your mistakes.
The only way to avoid mistakes is not to invest- which is the biggest mistake of all. So forgive yourself for your errors and certainly don't try to recoup your losses by taking bigger risks. Instead turn each mistake into a leaning experience.
12. Aggressively monitor your investments.
Remember no investment is forever. Expect and react to change. And there are no stocks that you can buy and forget. Being relaxed doesn't mean being complacent.
13. An investor who has all the answers doesn't even understand all the questions.
A cocksure approach to investing will lead, probably sooner than later to disappointment if not outright disaster.
14. Remain flexible and open minded about types of investment.
There are times to buy blue chip stock, cyclical stocks, convertible bonds and there are times to sit on cash. The fact is there is no one kind of investment that is always best.
15. Don't panic.
Sometimes you won't have sold when everyone else is buying and you will be caught in a market crash. Don't rush to sell the next day. Instead study your portfolio. If you can't find more attractive stocks, hold on to what you have.
16. Do not be fearful or negative too often.
There will, of course, be corrections, perhaps even crashes. But over time our studies indicate, stocks go up. It always "buy low, sell high".
Finding Undervalued Stocks - The Graham's Number Technique
Benjamin Graham
(1894-1976) is considered by many to be the architect of Fundamental
Analysis and Value Investing. Graham liked to find discrepancies between
a stock's price and its value and would buy large portfolios of
undervalued stocks, holding them until they became fully valued. In his
1949 book "The Intelligent Investor, Graham describes a stock selection
technique that identifies stocks that are trading at a deep discount to a
calculated value termed the Net Current Asset Value or NCAV.
Calculation of a stock's NCAV is a fairly simple endeavor and is somewhat different from the calculation of Book Value. Whereas Book Value is purely a per share measure of Assets - Liabilities, the NCAV is a little more rigorous. In calculating NCAV, Graham only considered Current Assets, i.e. cash, cash equivalents, accounts receivable, inventories. However, from this value he still subtracted Total Liabilities. The result would then be divided by the number of shares outstanding to give the NCAV per share. This value would be considered by Graham to be a fair value for the stock.
You might think he would buy at this price, but no. In most cases, Graham only bought stocks that were trading under two-thirds or 66% of their NCAV.
Consider as an example G-III Apparel Group Ltd, ticker symbol GIII.
Current Assets are $130.25M, Total Liabilities are $68.3M, and there are 7.22M shares outstanding.
NCAV = (130.25 - 68.3) / 7.22 = $8.58. Two-thirds of this price would be $5.66.
At the time of writing (03/07/05), GIII is trading at $7.67, so may not be a buy candidate at present.
It is important to note that Graham would consider the NCAV to be a first step in further analysis of the stock. A sensible investor would investigate the balance sheet further to check for a sound business with other desirable factors such as good earnings, revenue growth, low debt-to-equity, and good operational cash flow per share.
Stocks trading at such a deep discount are few and far between, and have usually been beaten down by a combination of bad news and emotional reactions from the investing public. These stocks were Graham's bread and butter. He repeatedly insisted that the time to buy stocks was when everyone else was selling and the time to sell was when everyone else was buying. Had he been alive, he certainly would have been out of stocks before the dot com bubble burst and would surely have been picking up bargains soon after. It is no secret that one of Graham's most famous disciples is Warren Buffett who has consistently beaten the market by a large margin with his investments.
One study has shown that Graham's NCAV strategy works well; in this particular study, portfolios picked using the strategy at the beginning of each year between 1970 and 1983 would have returned an average annual gain of over 29% when held for only the duration of each year in this 13 year period.
Van Tharp mentions an actual investing strategy based on the NCAV or Graham's Number as it is sometimes called, in his book "Safe Strategies for Financial Freedom". The strategy as mentioned by Tharp involves buying stocks at two-thirds of their NCAV, and selling a third of your holding when a 50% profit is achieved. If the price continues upwards to 100% profit, you sell a number of shares to make up half your original holding.
You now have your original investment back and have a holding of "free" shares. This strategy can be performed in an IRA using a large portfolio of perhaps 30 similarly undervalued stocks. If the market has been declining for several months, there will be several such stocks to choose from. In an up trending market, however, it will be much harder to find good value candidates but diligent investors who do their homework will more often than not be well rewarded for their efforts.
Such a wide diversification may seem excessive for most investors, butwith such low-priced stock there were evidently going to be a few bankruptcycandidates. Graham considered this strategy to be suitable for what he called "defensive" investors. He did acknowledge, however, that there were some"enterprising" investors who could afford to be more aggressive from the pointof view of risk. To this end, he suggested a series of less onerous criteriafor selecting stocks which is outlined below.
First, list all stocks with Price/Earnings ratios below 9. Note: Graham was writing in 1970 when P/E's as a whole were not as elevated by technology stocks as they are today. Readers who are less risk-averse or who just want to consider a wider range of stocks may wish to vary the P/E in order to see what comes up -- perhaps up to 80 percent of the average P/E of the S&P 500 would be a good start. Currently the operating average is around 18 and 85 percent of that figure is just over 15. Graham did not state if he was using a Trailing or Forward P/E ratio, but most likely he was using Trailing P/Es. I personally prefer to use Forward P/E ratios, especially if they are significantly lower than the Trailing P/E as this implies expected earnings growth and therefore possible increase in the stock price.
Once we have a list of stocks meeting the P/E criterion, we consider the financialcondition of each stock, referring to the most recent balance sheet:Initially, Current Assets must be at least 1.5 times Current Liabilities. This can also be gleaned via a stock screener by displaying stocks with "Current Ratio" >= 1.5. Total Debt must not be greater than 110% of Net Current Assets (i.e. the sum of Cash & Cash Equivalents, Inventory, Accounts Receivable).
Looking further back, we need to find evidence of Earnings Stability, with nodeficit in the last five years, i.e. no evidence of an annual loss. Additionally,evidence of earnings growth over a five-year period is a must. This can simplybe the consideration, for example, that 2004 earnings were greater than 2000 earnings.
There should be some current dividend payout. Finally, the current price of thestock should be less than 120% of the NCAV per share or Graham's Number.Where to find this number? From the balance sheet, subtract Total Liabilitiesfrom Current Assets, and divide the result by the number of shares outstanding.Assuming you have a positive number that is greater than zero, the stock's priceshould not be greater than 120% of this number.
Graham did not set any lower limit on market capitalization. "Small companiesmay afford enough safety if bought carefully and on a group basis." He meantthat a well diversified portfolio with a fair number of such companies stock would protect the enterprising investor from the bankruptcy of one or two companies
Calculation of a stock's NCAV is a fairly simple endeavor and is somewhat different from the calculation of Book Value. Whereas Book Value is purely a per share measure of Assets - Liabilities, the NCAV is a little more rigorous. In calculating NCAV, Graham only considered Current Assets, i.e. cash, cash equivalents, accounts receivable, inventories. However, from this value he still subtracted Total Liabilities. The result would then be divided by the number of shares outstanding to give the NCAV per share. This value would be considered by Graham to be a fair value for the stock.
You might think he would buy at this price, but no. In most cases, Graham only bought stocks that were trading under two-thirds or 66% of their NCAV.
Consider as an example G-III Apparel Group Ltd, ticker symbol GIII.
Current Assets are $130.25M, Total Liabilities are $68.3M, and there are 7.22M shares outstanding.
NCAV = (130.25 - 68.3) / 7.22 = $8.58. Two-thirds of this price would be $5.66.
At the time of writing (03/07/05), GIII is trading at $7.67, so may not be a buy candidate at present.
It is important to note that Graham would consider the NCAV to be a first step in further analysis of the stock. A sensible investor would investigate the balance sheet further to check for a sound business with other desirable factors such as good earnings, revenue growth, low debt-to-equity, and good operational cash flow per share.
Stocks trading at such a deep discount are few and far between, and have usually been beaten down by a combination of bad news and emotional reactions from the investing public. These stocks were Graham's bread and butter. He repeatedly insisted that the time to buy stocks was when everyone else was selling and the time to sell was when everyone else was buying. Had he been alive, he certainly would have been out of stocks before the dot com bubble burst and would surely have been picking up bargains soon after. It is no secret that one of Graham's most famous disciples is Warren Buffett who has consistently beaten the market by a large margin with his investments.
One study has shown that Graham's NCAV strategy works well; in this particular study, portfolios picked using the strategy at the beginning of each year between 1970 and 1983 would have returned an average annual gain of over 29% when held for only the duration of each year in this 13 year period.
Van Tharp mentions an actual investing strategy based on the NCAV or Graham's Number as it is sometimes called, in his book "Safe Strategies for Financial Freedom". The strategy as mentioned by Tharp involves buying stocks at two-thirds of their NCAV, and selling a third of your holding when a 50% profit is achieved. If the price continues upwards to 100% profit, you sell a number of shares to make up half your original holding.
You now have your original investment back and have a holding of "free" shares. This strategy can be performed in an IRA using a large portfolio of perhaps 30 similarly undervalued stocks. If the market has been declining for several months, there will be several such stocks to choose from. In an up trending market, however, it will be much harder to find good value candidates but diligent investors who do their homework will more often than not be well rewarded for their efforts.
Such a wide diversification may seem excessive for most investors, butwith such low-priced stock there were evidently going to be a few bankruptcycandidates. Graham considered this strategy to be suitable for what he called "defensive" investors. He did acknowledge, however, that there were some"enterprising" investors who could afford to be more aggressive from the pointof view of risk. To this end, he suggested a series of less onerous criteriafor selecting stocks which is outlined below.
First, list all stocks with Price/Earnings ratios below 9. Note: Graham was writing in 1970 when P/E's as a whole were not as elevated by technology stocks as they are today. Readers who are less risk-averse or who just want to consider a wider range of stocks may wish to vary the P/E in order to see what comes up -- perhaps up to 80 percent of the average P/E of the S&P 500 would be a good start. Currently the operating average is around 18 and 85 percent of that figure is just over 15. Graham did not state if he was using a Trailing or Forward P/E ratio, but most likely he was using Trailing P/Es. I personally prefer to use Forward P/E ratios, especially if they are significantly lower than the Trailing P/E as this implies expected earnings growth and therefore possible increase in the stock price.
Once we have a list of stocks meeting the P/E criterion, we consider the financialcondition of each stock, referring to the most recent balance sheet:Initially, Current Assets must be at least 1.5 times Current Liabilities. This can also be gleaned via a stock screener by displaying stocks with "Current Ratio" >= 1.5. Total Debt must not be greater than 110% of Net Current Assets (i.e. the sum of Cash & Cash Equivalents, Inventory, Accounts Receivable).
Looking further back, we need to find evidence of Earnings Stability, with nodeficit in the last five years, i.e. no evidence of an annual loss. Additionally,evidence of earnings growth over a five-year period is a must. This can simplybe the consideration, for example, that 2004 earnings were greater than 2000 earnings.
There should be some current dividend payout. Finally, the current price of thestock should be less than 120% of the NCAV per share or Graham's Number.Where to find this number? From the balance sheet, subtract Total Liabilitiesfrom Current Assets, and divide the result by the number of shares outstanding.Assuming you have a positive number that is greater than zero, the stock's priceshould not be greater than 120% of this number.
Graham did not set any lower limit on market capitalization. "Small companiesmay afford enough safety if bought carefully and on a group basis." He meantthat a well diversified portfolio with a fair number of such companies stock would protect the enterprising investor from the bankruptcy of one or two companies
What Is Value Investing?
Different
sources define value investing differently. Some say value investing is
the investment philosophy that favors the purchase of stocks that are
currently selling at low price-to-book ratios and have high dividend
yields. Others say value investing is all about buying stocks with low
P/E ratios. You will even sometimes hear that value investing has more
to do with the balance sheet than the income statement. In his 1992
letter to Berkshire Hathaway shareholders, Warren Buffet wrote:
We think the very term "value investing" is redundant. What is "investing" if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value - in the hope that it can soon be sold for a still-higher price - should be labeled speculation (which is neither illegal, immoral nor - in our view - financially fattening).
Whether appropriate or not, the term "value investing" is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics - a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield - are in no way inconsistent with a "value" purchase.
Buffett’s definition of “investing” is the best definition of value investing there is. Value investing is purchasing a stock for less than its calculated value.
Tenets of Value Investing
1) Each share of stock is an ownership interest in the underlying business. A stock is not simply a piece of paper that can be sold at a higher price on some future date. Stocks represent more than just the right to receive future cash distributions from the business. Economically, each share is an undivided interest in all corporate assets (both tangible and intangible) – and ought to be valued as such.
2) A stock has an intrinsic value. A stock’s intrinsic value is derived from the economic value of the underlying business.
3) The stock market is inefficient. Value investors do not subscribe to the Efficient Market Hypothesis. They believe shares frequently trade hands at prices above or below their intrinsic values. Occasionally, the difference between the market price of a share and the intrinsic value of that share is wide enough to permit profitable investments. Benjamin Graham, the father of value investing, explained the stock market’s inefficiency by employing a metaphor. His Mr. Market metaphor is still referenced by value investors today:
Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.
4) Investing is most intelligent when it is most businesslike. This is a quote from Benjamin Graham’s “The Intelligent Investor”. Warren Buffett believes it is the single most important investing lesson he was ever taught. Investors ought to treat investing with the seriousness and studiousness they treat their chosen profession. An investor should treat the shares he buys and sells as a shopkeeper would treat the merchandise he deals in. He must not make commitments where his knowledge of the “merchandise” is inadequate. Furthermore, he must not engage in any investment operation unless “a reliable calculation shows that it has a fair chance to yield a reasonable profit”.
5) A true investment requires a margin of safety. A margin of safety may be provided by a firm’s working capital position, past earnings performance, land assets, economic goodwill, or (most commonly) a combination of some or all of the above. The margin of safety is manifested in the difference between the quoted price and the intrinsic value of the business. It absorbs all the damage caused by the investor’s inevitable miscalculations. For this reason, the margin of safety must be as wide as we humans are stupid (which is to say it ought to be a veritable chasm). Buying dollar bills for ninety-five cents only works if you know what you’re doing; buying dollar bills for forty-five cents is likely to prove profitable even for mere mortals like us.
We think the very term "value investing" is redundant. What is "investing" if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value - in the hope that it can soon be sold for a still-higher price - should be labeled speculation (which is neither illegal, immoral nor - in our view - financially fattening).
Whether appropriate or not, the term "value investing" is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics - a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield - are in no way inconsistent with a "value" purchase.
Buffett’s definition of “investing” is the best definition of value investing there is. Value investing is purchasing a stock for less than its calculated value.
Tenets of Value Investing
1) Each share of stock is an ownership interest in the underlying business. A stock is not simply a piece of paper that can be sold at a higher price on some future date. Stocks represent more than just the right to receive future cash distributions from the business. Economically, each share is an undivided interest in all corporate assets (both tangible and intangible) – and ought to be valued as such.
2) A stock has an intrinsic value. A stock’s intrinsic value is derived from the economic value of the underlying business.
3) The stock market is inefficient. Value investors do not subscribe to the Efficient Market Hypothesis. They believe shares frequently trade hands at prices above or below their intrinsic values. Occasionally, the difference between the market price of a share and the intrinsic value of that share is wide enough to permit profitable investments. Benjamin Graham, the father of value investing, explained the stock market’s inefficiency by employing a metaphor. His Mr. Market metaphor is still referenced by value investors today:
Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.
4) Investing is most intelligent when it is most businesslike. This is a quote from Benjamin Graham’s “The Intelligent Investor”. Warren Buffett believes it is the single most important investing lesson he was ever taught. Investors ought to treat investing with the seriousness and studiousness they treat their chosen profession. An investor should treat the shares he buys and sells as a shopkeeper would treat the merchandise he deals in. He must not make commitments where his knowledge of the “merchandise” is inadequate. Furthermore, he must not engage in any investment operation unless “a reliable calculation shows that it has a fair chance to yield a reasonable profit”.
5) A true investment requires a margin of safety. A margin of safety may be provided by a firm’s working capital position, past earnings performance, land assets, economic goodwill, or (most commonly) a combination of some or all of the above. The margin of safety is manifested in the difference between the quoted price and the intrinsic value of the business. It absorbs all the damage caused by the investor’s inevitable miscalculations. For this reason, the margin of safety must be as wide as we humans are stupid (which is to say it ought to be a veritable chasm). Buying dollar bills for ninety-five cents only works if you know what you’re doing; buying dollar bills for forty-five cents is likely to prove profitable even for mere mortals like us.
Commonly Referred Sayings of Warren Buffett
o The critical investment factor is determining the intrinsic value of a business and paying a fair or bargain price.
o Never invest in a business you cannot understand.
o Risk can be greatly reduced by concentrating on only a few holdings.
o Stop trying to predict the direction of the stock market, the economy, interest rates, or elections.
o Buy companies with strong histories of profitability and with a dominant business franchise.
o You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.
o Be fearful when others are greedy and greedy only when others are fearful.
o Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market.
o It is optimism that is the enemy of the rational buyer.
o As far as you are concerned, the stock market does not exist. Ignore it.
o The ability to say "no" is a tremendous advantage for an investor.
o Much success can be attributed to inactivity. Most investors cannot resist the temptation to constantly buy and sell.
o Lethargy, bordering on sloth should remain the cornerstone of an investment style.
o An investor should act as though he had a lifetime decision card with just twenty punches on it.
o Wild swings in share prices have more to do with the "lemming- like" behaviour of institutional investors than with the aggregate returns of the company they own.
o As a group, lemmings have a rotten image, but no individual lemming has ever received bad press.
o An investor needs to do very few things right as long as he or she avoids big mistakes.
o "Turn-arounds" seldom turn.
o Is management rational?
o Is management candid with the shareholders?
o Does management resist the institutional imperative?
o Do not take yearly results too seriously. Instead, focus on four or five-year averages.
o Focus on return on equity, not earnings per share.
o Calculate "owner earnings" to get a true reflection of value.
o Look for companies with high profit margins.
o Growth and value investing are joined at the hip.
o The advice "you never go broke taking a profit" is foolish.
o It is more important to say "no" to an opportunity, than to say "yes".
o Always invest for the long term.
o Does the business have favourable long term prospects?
o It is not necessary to do extraordinary things to get extraordinary results.
o Remember that the stock market is manic-depressive.
o Buy a business, don't rent stocks.
o Does the business have a consistent operating history?
o Wide diversification is only required when investors do not understand what they are doing.
o An investor should ordinarily hold a small piece of an outstanding business with the same tenacity that an owner would exhibit if he owned all of that business.
(extracted from various books on Buffett including "Buffett: the Making of an American Capitalist", "Buffettology", "The Warren Buffett Way" and "Of Permanent Value", "Thoughts of Chairman Buffett : Thirty Years of Unconventional Wisdom from the Sage of Omaha")
o Never invest in a business you cannot understand.
o Risk can be greatly reduced by concentrating on only a few holdings.
o Stop trying to predict the direction of the stock market, the economy, interest rates, or elections.
o Buy companies with strong histories of profitability and with a dominant business franchise.
o You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.
o Be fearful when others are greedy and greedy only when others are fearful.
o Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market.
o It is optimism that is the enemy of the rational buyer.
o As far as you are concerned, the stock market does not exist. Ignore it.
o The ability to say "no" is a tremendous advantage for an investor.
o Much success can be attributed to inactivity. Most investors cannot resist the temptation to constantly buy and sell.
o Lethargy, bordering on sloth should remain the cornerstone of an investment style.
o An investor should act as though he had a lifetime decision card with just twenty punches on it.
o Wild swings in share prices have more to do with the "lemming- like" behaviour of institutional investors than with the aggregate returns of the company they own.
o As a group, lemmings have a rotten image, but no individual lemming has ever received bad press.
o An investor needs to do very few things right as long as he or she avoids big mistakes.
o "Turn-arounds" seldom turn.
o Is management rational?
o Is management candid with the shareholders?
o Does management resist the institutional imperative?
o Do not take yearly results too seriously. Instead, focus on four or five-year averages.
o Focus on return on equity, not earnings per share.
o Calculate "owner earnings" to get a true reflection of value.
o Look for companies with high profit margins.
o Growth and value investing are joined at the hip.
o The advice "you never go broke taking a profit" is foolish.
o It is more important to say "no" to an opportunity, than to say "yes".
o Always invest for the long term.
o Does the business have favourable long term prospects?
o It is not necessary to do extraordinary things to get extraordinary results.
o Remember that the stock market is manic-depressive.
o Buy a business, don't rent stocks.
o Does the business have a consistent operating history?
o Wide diversification is only required when investors do not understand what they are doing.
o An investor should ordinarily hold a small piece of an outstanding business with the same tenacity that an owner would exhibit if he owned all of that business.
(extracted from various books on Buffett including "Buffett: the Making of an American Capitalist", "Buffettology", "The Warren Buffett Way" and "Of Permanent Value", "Thoughts of Chairman Buffett : Thirty Years of Unconventional Wisdom from the Sage of Omaha")
The Warren Buffett You Don't Know - Part 2
Has there ever
been a less pompous billionaire than Warren Edward Buffett? Hollywood
might cast him in the role of an amiable teacher at a Midwestern college
or a sweet-tempered, wisecracking inventor who eventually wins a Nobel
prize and gets the girl besides. To hear Buffett sing his beautifully
artless rendition of Ain't She Sweet to his own ukulele accompaniment is
to wonder not only how such a man came to measure his net worth in
billions but also whether he might not be a time-traveler from a more
innocent age.
If Buffett had a business card, it would identify him as chairman and chief executive of Berkshire Hathaway Inc. (BRK.A)
But he is far better known--indeed, world-famous--as the greatest stock
market investor of modern times. The figures, though often cited, still
astound: Had you put $10,000 into Berkshire when Buffett bought control
of it in 1965, you'd have $51 million now, vs. just $497,431 if the
money were invested in the Standard & Poor's 500-stock index.
The
numbers don't lie, but the story they tell is out of date. Buffett has
not added a major position to Berkshire's bulging stock portfolio since
amassing 4.3% of McDonald's Corp. (MCD)
in 1995. In the meantime, he has transformed what long has been a
sideline at Berkshire--the acquisition of entire companies--into the
main event. Over the past three years, Berkshire has spent $27.3 billion
to buy seven companies in industries as disparate as aviation, fast
food, and home furnishings. The $22 billion purchase of reinsurer
General Re Corp., which closed late last year, was Buffett's largest
ever.
The
effect has been dramatic: In short order, Berkshire has been
transformed from a closed-end fund in corporate drag to a bona fide
operating company. At the start of 1996, the company's famous stock
portfolio accounted for fully 76% of Berkshire's $29.9 billion in
assets. But by the end of 1999's first quarter, the figure had plummeted
to 32% as assets quadrupled, to $124 billion. Today, Buffett's company
employs 47,566 workers, double the number in 1995.
And
he isn't done yet. ''I'd love to make a $10 billion to $15 billion
acquisition, and we could go bigger than that if I really like the
company,'' says Buffett, who holds $15 billion in cash and is sitting on
top of an additional $30 billion in unrealized gains in Berkshire's
stock portfolios.
It's
all there in black and white in Berkshire Hathaway's famously literate
annual reports, but somehow the company's transformation has gone not
just unheralded but unnoticed. Berkshire is ''possibly the most talked
about and the least understood company in the world,'' contends Alice
Schroeder, a PaineWebber Inc. insurance analyst who in January published
one of the few comprehensive studies of the company ever undertaken by a
brokerage house.
MISUNDERSTOOD.
The common view is that Berkshire shares fetch a premium because of
Buffett's reputation as a latter-day Midas. The ''Buffett premium''
undoubtedly is real in the sense that if the man died today, the stock
would plunge tomorrow. In Schroeder's view, though, Berkshire's stock is
already trading at a sizable discount to its true value, which she
estimates at $91,000 to $97,000 per A share. The A shares lately have
been trading at about $70,000. The basic problem, Schroeder says, is
that the world continues to misperceive Berkshire as little more than
the sum of the stocks it holds in its $37 billion portfolio. In other
words, the market tends to overreact to news about the seven stocks that
form the core of Berkshire's holdings (table). Over the past 12 months,
Berkshire has fallen by about 17%, from a high of $84,000 in June,
1998. In Schroeder's view, the main cause of this decline is the
plunging value of Buffett's colossal stakes in Coca-Cola Co. (KO) and Gillette Co (G).
The
radical recent shift in Berkshire's corporate profile does not reflect a
radical change in Buffett's thinking. In most ways, he remains true to
the conservative precepts of value investing. In essence, Buffett
continues to prefer today's sure thing to the next big thing, no matter
how spectacular its potential. Forget Internet stocks: Buffett still
will not invest in even such well-seasoned high-tech companies as
Microsoft Corp. (MSFT) or Hewlett-Packard Co. (HWP)
because he doesn't believe that anyone can predict how much they will
earn over the next decade or two. ''I can't do it myself,'' he says.
''And if I don't know, I don't invest.
''Even
in his stock-picking heyday, Buffett preferred owning businesses to
passive minority investment. Until recently, though, Berkshire's
acquisitions have been few and far between because Buffett insisted on
buying top-quality businesses at discount prices. What has changed is
that he is now willing to pay a premium for one-of-a-kind businesses.
Why
this is so is not completely clear. The Buffett psyche is notoriously
labyrinthine. ''I could easily spend a lot of time trying to analyze
Warren if I didn't consciously try not to,'' says Olza M. Nicely, CEO of
auto insurer GEICO Corp., one of Berkshire's largest subsidiaries.
''There are certain mysteries you just have to accept.''
In
Buffett's view, he is putting the finishing touches on his masterpiece.
''Berkshire is my painting, so it should look the way I want it to when
it's done,'' he says.
In
an era in which most CEOs at least mouth the platitudes of good
corporate governance and shareholder rights, Buffett, in his
good-natured way, is a throwback to a time when a mogul was a mogul and
did as he damn well pleased. ''Berkshire is the company I wanted to
create. It's not the company Alfred P. Sloan wanted to create. It fits
me,'' he says. ''I run it with our investors and managers in mind, but
it is designed to fit me.'' To be blunt, Buffett stands revealed as a
driven, even monomaniacal corporate empire-builder.
For
all his offhand charm, Buffett is pretty much all business all the
time. Aside from an addiction to luxury air travel, he is a man of
simple tastes and frugal habits. He neither spends his money nor gives
much of it away. Philanthropy, the renascent vogue of America's
superrich, interests him peripherally at most. Buffett intends to take
his fortune to the grave--and to keep adding to it until the day he
dies. ''The problem I've got with doing anything else except what I'm
doing is that there is nothing remotely as fun as running Berkshire,''
he says. ''I'm selfish that way.''
So
far, Berkshire's legendarily devoted shareholders would not have it any
other way. In May, some 15,000 of them flocked to Omaha to sit at the
feet of the master during Berkshire's three-day festival of an annual
meeting, which Buffett calls ''Woodstock for Capitalists.'' Of course,
Buffett and his wife, Susan T. Buffett, are the largest Berkshire
shareholders by far: Their 38.4% stake is worth about $40 billion.
The
highest circle of management power at Berkshire has always been tight,
but it has shrunk in recent years--to Buffett alone. Charles T. Munger,
Buffett's longtime vice-chairman and business alter ego, continues to
enliven the annual meeting by playing the part of drolly laconic
sidekick to Buffett's ebullient master of ceremonies. Behind the scenes,
though, his influence has waned. ''Charlie and I don't talk a lot
anymore,'' acknowledges Buffett, who says he did not even bother to
consult his vice-chairman before making the epochal Gen Re acquisition.
By
all accounts, including their own, Munger and Buffett have not fallen
out. But while Buffett is wholly devoted to building Berkshire, Munger,
75, now spends his time chairing a not-for-profit hospital and serving
as a trustee of a private high school. ''Charlie is broader in his
interests than I am,'' Buffett says. ''He doesn't have the same
intensity for Berkshire that I have. It's not his baby.'' Munger
concurs: ''Warren's whole ego is poured into Berkshire.''
The Warren Buffett You Don't Know - Part 1
Warren Buffett
is returning to the U.S. from Europe in a private jet. As his plane
nears its destination, the flight attendant gives out landing cards and a
warning to all eight passengers aboard. ''The customs inspector here is
utterly humorless,'' she says, ''so no wisecracks or he will tear the
plane apart from fore to aft.'' Buffett, who quips as reflexively as he
breathes, takes his card without comment.
In the terminal, a surly looking man with a crewcut and a pistol on his hip sits behind a small table. Buffett hands over his passport and landing card to the inspector, who does not seem to realize that the professorial-looking 68-year-old standing before him is America's second-richest man. Or perhaps he just gets a kick out of trying to take the high and mighty down a peg. ''You left some things blank,'' the inspector says peevishly. ''Do you have $10,000?''
The question could have launched a dozen snappy retorts, but Buffett restrains himself. ''I have what I left with,'' he says carefully. The inspector furrows his brow--was that some kind of joke?--but does not press the issue. He asks Buffett if he has any anything to declare. ''I was given two books,'' Buffett says. ''Well, you have to put it down, then,'' snaps the agent, who fills in the blank himself.
Buffett shows not a flicker of annoyance at being treated like a misbehaving child. He stands mute and impassive before the inspector, who, after a few more curt remarks, can think of nothing else to do but let ''the Oracle of Omaha'' be on his way.
In the terminal, a surly looking man with a crewcut and a pistol on his hip sits behind a small table. Buffett hands over his passport and landing card to the inspector, who does not seem to realize that the professorial-looking 68-year-old standing before him is America's second-richest man. Or perhaps he just gets a kick out of trying to take the high and mighty down a peg. ''You left some things blank,'' the inspector says peevishly. ''Do you have $10,000?''
The question could have launched a dozen snappy retorts, but Buffett restrains himself. ''I have what I left with,'' he says carefully. The inspector furrows his brow--was that some kind of joke?--but does not press the issue. He asks Buffett if he has any anything to declare. ''I was given two books,'' Buffett says. ''Well, you have to put it down, then,'' snaps the agent, who fills in the blank himself.
Buffett shows not a flicker of annoyance at being treated like a misbehaving child. He stands mute and impassive before the inspector, who, after a few more curt remarks, can think of nothing else to do but let ''the Oracle of Omaha'' be on his way.
Warren Buffett on the dividend policy
Dividend policy
is often reported to shareholders, but seldom explained. A company
will say something like, "Our goal is to pay out 40% to 50% of earnings
and to increase dividends at a rate at least equal to the rise in the
CPI". And that's it - no analysis will be supplied as to why that
particular policy is best for the owners of the business. Yet,
allocation of capital is crucial to business and investment management.
Because it is, we believe managers and owners should think hard about
the circumstances under which earnings should be retained and under
which they should be distributed.
The first point to understand is that all earnings are not created equal. In many businesses particularly those that have high asset/profit ratios - inflation causes some or all of the reported earnings to become ersatz. The ersatz portion - let's call these earnings "restricted" - cannot, if the business is to retain its economic position, be distributed as dividends. Were these earnings to be paid out, the business would lose ground in one or more of the following areas: its ability to maintain its unit volume of sales, its long-term competitive position, its financial strength. No matter how conservative its payout ratio, a company that consistently distributes restricted earnings is destined for oblivion unless equity capital is otherwise infused.
Restricted earnings are seldom valueless to owners, but they often must be discounted heavily. In effect, they are conscripted by the business, no matter how poor its economic potential. (This retention-no-matter-how-unattractive-the-return situation was communicated unwittingly in a marvelously ironic way by Consolidated Edison a decade ago. At the time, a punitive regulatory policy was a major factor causing the company's stock to sell as low as one-fourth of book value; i.e., every time a dollar of earnings was retained for reinvestment in the business, that dollar was transformed into only 25 cents of market value. But, despite this gold-into-lead process, most earnings were reinvested in the business rather than paid to owners. Restricted earnings need not concern us further in this dividend discussion.
Let's turn to the much-more-valued unrestricted variety. These earnings may, with equal feasibility, be retained or distributed. In our opinion, management should choose whichever course makes greater sense for the owners of the business. This principle is not universally accepted. For a number of reasons managers like to withhold unrestricted, readily distributable earnings from shareholders - to expand the corporate empire over which the managers rule, to operate from a position of exceptional financial comfort, etc. But we believe there is only one valid reason for retention. Unrestricted earnings should be retained only when there is a reasonable prospect - backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future - that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.
To illustrate, let's assume that an investor owns a risk-free 10% perpetual bond with one very unusual feature. Each year the investor can elect either to take his 10% coupon in cash, or to reinvest the coupon in more 10% bonds with identical terms; i.e., a perpetual life and coupons offering the same cash-or-reinvest option. If, in any given year, the prevailing interest rate on long-term, risk-free bonds is 5%, it would be foolish for the investor to take his coupon in cash since the 10% bonds he could instead choose would be worth considerably more than 100 cents on the dollar. Under these circumstances, the investor wanting to get his hands on cash should take his coupon in additional bonds and then immediately sell them. By doing that, he would realize more cash than if he had taken his coupon directly in cash. Assuming all bonds were held by rational investors, no one would opt for cash in an era of 5% interest rates, not even those bondholders needing cash for living purposes.
If, however, interest rates were 15%, no rational investor would want his money invested for him at 10%. Instead, the investor would choose to take his coupon in cash, even if his personal cash needs were nil. The opposite course - reinvestment of the coupon - would give an investor additional bonds with market value far less than the cash he could have elected. If he should want 10% bonds, he can simply take the cash received and buy them in the market, where they will be available at a large discount.
Think about whether a company's unrestricted earnings should be retained or paid out. The analysis is much more difficult and subject to error because the rate earned on reinvested earnings is not a contractual figure, as in our bond case, but rather a fluctuating figure. Owners must guess as to what the rate will average over the intermediate future. However, once an informed guess is made, the rest of the analysis is simple: you should wish your earnings to be reinvested if they can be expected to earn high returns, and you should wish them paid to you if low returns are the likely outcome of reinvestment.
Many corporate managers reason very much along these lines in determining whether subsidiaries should distribute earnings to their parent company. At that level,. the managers have no trouble thinking like intelligent owners. But payout decisions at the parent company level often are a different story. Here managers frequently have trouble putting themselves in the shoes of their shareholder-owners.
With this schizoid approach, the CEO of a multi-divisional company will instruct Subsidiary A, whose earnings on incremental capital may be expected to average 5%, to distribute all available earnings in order that they may be invested in Subsidiary B, whose earnings on incremental capital are expected to be 15%. The CEO's business school oath will allow no lesser behavior. But if his own long-term record with incremental capital is 5% - and market rates are 10% - he is likely to impose a dividend policy on shareholders of the parent company that merely follows some historical or industry-wide payout pattern. Furthermore, he will expect managers of subsidiaries to give him a full account as to why it makes sense for earnings to be retained in their operations rather than distributed to the parent-owner. But seldom will he supply his owners with a similar analysis pertaining to the whole company.
In judging whether managers should retain earnings, shareholders should not simply compare total incremental earnings in recent years to total incremental capital because that relationship may be distorted by what is going on in a core business. During an inflationary period, companies with a core business characterized by extraordinary economics can use small amounts of incremental capital in that business at very high rates of return. But, unless they are experiencing tremendous unit growth, outstanding businesses by definition generate large amounts of excess cash. If a company sinks most of this money in other businesses that earn low returns, the company's overall return on retained capital may nevertheless appear excellent because of the extraordinary returns being earned by the portion of earnings incrementally invested in the core business. The situation is analogous to a Pro-Am golf event: even if all of the amateurs are hopeless duffers, the team's best-ball score will be respectable because of the dominating skills of the professional.
Many corporations that consistently show good returns both on equity and on overall incremental capital have, indeed, employed a large portion of their retained earnings on an economically unattractive, even disastrous, basis. Their marvelous core businesses, however, whose earnings grow year after year, camouflage repeated failures in capital allocation elsewhere (usually involving high-priced acquisitions of businesses that have inherently mediocre economics). The managers at fault periodically report on the lessons they have learned from the latest disappointment. They then usually seek out future lessons. (Failure seems to go to their heads.)
In such cases, shareholders would be far better off if earnings were retained only to expand the high-return business, with the balance paid in dividends or used to repurchase stock (an action that increases the owners' interest in the exceptional business while sparing them participation in subpar businesses). Managers of high-return businesses who consistently employ much of the cash thrown off by those businesses in other ventures with low returns should be held to account for those allocation decisions, regardless of how profitable the overall enterprise is.
Nothing in this discussion is intended to argue for dividends that bounce around from quarter to quarter with each wiggle in earnings or in investment opportunities. Shareholders of public corporations understandably prefer that dividends be consistent and predictable. Payments, therefore, should reflect long-term expectations for both earnings and returns on incremental capital. Since the long-term corporate outlook changes only infrequently, dividend patterns should change no more often. But over time distributable earnings that have been withheld by managers should earn their keep. If earnings have been unwisely retained, it is likely that managers, too, have been unwisely retained.
Historically, Berkshire has earned well over market rates on retained earnings, thereby creating over one dollar of market value for every dollar retained. Under such circumstances, any distribution would have been contrary to the financial interest of shareholders, large or small.
The first point to understand is that all earnings are not created equal. In many businesses particularly those that have high asset/profit ratios - inflation causes some or all of the reported earnings to become ersatz. The ersatz portion - let's call these earnings "restricted" - cannot, if the business is to retain its economic position, be distributed as dividends. Were these earnings to be paid out, the business would lose ground in one or more of the following areas: its ability to maintain its unit volume of sales, its long-term competitive position, its financial strength. No matter how conservative its payout ratio, a company that consistently distributes restricted earnings is destined for oblivion unless equity capital is otherwise infused.
Restricted earnings are seldom valueless to owners, but they often must be discounted heavily. In effect, they are conscripted by the business, no matter how poor its economic potential. (This retention-no-matter-how-unattractive-the-return situation was communicated unwittingly in a marvelously ironic way by Consolidated Edison a decade ago. At the time, a punitive regulatory policy was a major factor causing the company's stock to sell as low as one-fourth of book value; i.e., every time a dollar of earnings was retained for reinvestment in the business, that dollar was transformed into only 25 cents of market value. But, despite this gold-into-lead process, most earnings were reinvested in the business rather than paid to owners. Restricted earnings need not concern us further in this dividend discussion.
Let's turn to the much-more-valued unrestricted variety. These earnings may, with equal feasibility, be retained or distributed. In our opinion, management should choose whichever course makes greater sense for the owners of the business. This principle is not universally accepted. For a number of reasons managers like to withhold unrestricted, readily distributable earnings from shareholders - to expand the corporate empire over which the managers rule, to operate from a position of exceptional financial comfort, etc. But we believe there is only one valid reason for retention. Unrestricted earnings should be retained only when there is a reasonable prospect - backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future - that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.
To illustrate, let's assume that an investor owns a risk-free 10% perpetual bond with one very unusual feature. Each year the investor can elect either to take his 10% coupon in cash, or to reinvest the coupon in more 10% bonds with identical terms; i.e., a perpetual life and coupons offering the same cash-or-reinvest option. If, in any given year, the prevailing interest rate on long-term, risk-free bonds is 5%, it would be foolish for the investor to take his coupon in cash since the 10% bonds he could instead choose would be worth considerably more than 100 cents on the dollar. Under these circumstances, the investor wanting to get his hands on cash should take his coupon in additional bonds and then immediately sell them. By doing that, he would realize more cash than if he had taken his coupon directly in cash. Assuming all bonds were held by rational investors, no one would opt for cash in an era of 5% interest rates, not even those bondholders needing cash for living purposes.
If, however, interest rates were 15%, no rational investor would want his money invested for him at 10%. Instead, the investor would choose to take his coupon in cash, even if his personal cash needs were nil. The opposite course - reinvestment of the coupon - would give an investor additional bonds with market value far less than the cash he could have elected. If he should want 10% bonds, he can simply take the cash received and buy them in the market, where they will be available at a large discount.
Think about whether a company's unrestricted earnings should be retained or paid out. The analysis is much more difficult and subject to error because the rate earned on reinvested earnings is not a contractual figure, as in our bond case, but rather a fluctuating figure. Owners must guess as to what the rate will average over the intermediate future. However, once an informed guess is made, the rest of the analysis is simple: you should wish your earnings to be reinvested if they can be expected to earn high returns, and you should wish them paid to you if low returns are the likely outcome of reinvestment.
Many corporate managers reason very much along these lines in determining whether subsidiaries should distribute earnings to their parent company. At that level,. the managers have no trouble thinking like intelligent owners. But payout decisions at the parent company level often are a different story. Here managers frequently have trouble putting themselves in the shoes of their shareholder-owners.
With this schizoid approach, the CEO of a multi-divisional company will instruct Subsidiary A, whose earnings on incremental capital may be expected to average 5%, to distribute all available earnings in order that they may be invested in Subsidiary B, whose earnings on incremental capital are expected to be 15%. The CEO's business school oath will allow no lesser behavior. But if his own long-term record with incremental capital is 5% - and market rates are 10% - he is likely to impose a dividend policy on shareholders of the parent company that merely follows some historical or industry-wide payout pattern. Furthermore, he will expect managers of subsidiaries to give him a full account as to why it makes sense for earnings to be retained in their operations rather than distributed to the parent-owner. But seldom will he supply his owners with a similar analysis pertaining to the whole company.
In judging whether managers should retain earnings, shareholders should not simply compare total incremental earnings in recent years to total incremental capital because that relationship may be distorted by what is going on in a core business. During an inflationary period, companies with a core business characterized by extraordinary economics can use small amounts of incremental capital in that business at very high rates of return. But, unless they are experiencing tremendous unit growth, outstanding businesses by definition generate large amounts of excess cash. If a company sinks most of this money in other businesses that earn low returns, the company's overall return on retained capital may nevertheless appear excellent because of the extraordinary returns being earned by the portion of earnings incrementally invested in the core business. The situation is analogous to a Pro-Am golf event: even if all of the amateurs are hopeless duffers, the team's best-ball score will be respectable because of the dominating skills of the professional.
Many corporations that consistently show good returns both on equity and on overall incremental capital have, indeed, employed a large portion of their retained earnings on an economically unattractive, even disastrous, basis. Their marvelous core businesses, however, whose earnings grow year after year, camouflage repeated failures in capital allocation elsewhere (usually involving high-priced acquisitions of businesses that have inherently mediocre economics). The managers at fault periodically report on the lessons they have learned from the latest disappointment. They then usually seek out future lessons. (Failure seems to go to their heads.)
In such cases, shareholders would be far better off if earnings were retained only to expand the high-return business, with the balance paid in dividends or used to repurchase stock (an action that increases the owners' interest in the exceptional business while sparing them participation in subpar businesses). Managers of high-return businesses who consistently employ much of the cash thrown off by those businesses in other ventures with low returns should be held to account for those allocation decisions, regardless of how profitable the overall enterprise is.
Nothing in this discussion is intended to argue for dividends that bounce around from quarter to quarter with each wiggle in earnings or in investment opportunities. Shareholders of public corporations understandably prefer that dividends be consistent and predictable. Payments, therefore, should reflect long-term expectations for both earnings and returns on incremental capital. Since the long-term corporate outlook changes only infrequently, dividend patterns should change no more often. But over time distributable earnings that have been withheld by managers should earn their keep. If earnings have been unwisely retained, it is likely that managers, too, have been unwisely retained.
Historically, Berkshire has earned well over market rates on retained earnings, thereby creating over one dollar of market value for every dollar retained. Under such circumstances, any distribution would have been contrary to the financial interest of shareholders, large or small.
Warren Buffett Interview - Part 3
13)
You often talk about the importance of investing only with people you
like, trust and admire. However, you've bought companies only days after
you became aware of them. How do you evaluate the owners and managers
of a company before investing?
After mentioning that he’s actually bought companies after only brief telephone conversations, Mr. Buffett admitted that "every now and then you miss", but added that "it’s better than the odds of marriage". He went on to say that "sometimes you size up people better with more time", but he didn’t sound like he needed much time to recognize the type of character he looks for.
The key question for him when evaluating the management of a potential acquisition target is "do they love the money or the business". His concern is that he monetizes the owner/manager’s wealth and that may cause the latter, if he doesn’t truly love the business, not to work as hard after he’s sold out to Berkshire. He said he looks for the "obvious cases" of owners who truly love their businesses and added that he’s mostly been successful (has had "a good batting average") in identifying them.
For those owners, their businesses are their life’s work, which Mr. Buffett compared to a painting: "You spent all your life painting this painting. You can sell it to us and see it hanging in a place of honor in a museum. Or you can sell it to an LBO operator and see it hanging in a porn shop.
"I once bought a jewelry business over the phone. I could tell that the current owner was the ‘right’ type of person. The owner’s great grandfather had started the company and I could tell that the owner really loved the business."
Mr. Buffett said that he can usually "size someone up in less than a day". The most import question he poses in buying a business and looking at management is, "do they love the business?" He phrased it in this way: "If you spend your whole life painting a picture would you rather have that painting on exhibit at the Metropolitan Museum of Art, or would you rather earn 5% more on the sale of the painting and have it hanging in a porn shop?"
He has had a great batting average in picking companies and people. But he says that "we can’t tell with everyone and once in a while we make a mistake."
14) The profits of financial companies as a % of total US corporate profits is at an all-time high (~40%) -- is this just the result of the carry trade, which will end, or perhaps bogus use of derivatives, or is there something more structural changing?
15) On his fears about US dollar weakness:
The dollar is not overvalued on a purchasing power basis. Macroeconomics is not our usual game, however if some economic facts are screaming at us, we jump on them. We don't usually do junk bonds, however if you cast your eye about, you can always find deals. I don't feel like doing macro bets as much with other people's money as my own. We work with big currencies-- eight of them. I don't have a view about which will move most against the dollar. My view is that the dollar will weaken. Countries support their own currency-- Japan wanted to keep their currency down which kept the US currency up. I don't know if China or HK will decouple their currency from the US. I like to have earnings in other currencies because they convert into more dollars, however I keep most of our cash in dollars.
16) On probabilistic thinking: while we would all love to do it, how does one distinguish between true subjective probabilistic thinking and bias induced guesswork?
Of course we try to make decisions based on probability and not guesswork. I agree strongly with the thoughts in Robert Rubin's book (In An Uncertain World). It's all probabilities. The one time when Charlie and I have trouble doing this is when it comes to firing people. I hate doing that and I avoid it as much as possible. We had one manager at one of our companies who developed Alzeimer's disease. It took us a long time to see it, and after we saw it, it took us a long time to act on it. Fortunately, the company still did well even while he had Alzeimer's, so we've developed a new rule around here: Only buy businesses that are so good that someone with Alzeimer's can manage them!
We all think we’re doing the former – probabilistic thinking.
Mr. Buffett said he tries to always use probabilistic thinking. That’s what he likes about the insurance business and investments. We try to think through every decision that comes to us. Some decisions are simple probabilities.
However, Mr. Buffett added that we’re human and probabilistic thinking is not always possible. Mr. Buffett said that when dealing with other people, such as firing someone, is a time in his case that he may stray from probabilistic thinking. An example was when Mr. Buffett denied that one employee who ran one of his businesses had Alzheimer’s for one year beyond when anyone else would have picked up on it. He said how hard it was for him to fire him, especially since he loved the person but he was just no longer good at the job. He, therefore, unintentionally postponed the decision. Mr. Buffett said he looked for countering evidence because he hates to fire a CEO he likes. He said he will tolerate a lot from someone who has been an associate. Mr. Buffett then joked that now he buys business that even a person with Alzheimer’s can run!
One thinks they know when they’re getting way from probabilistic thinking, but you can not always detect it.
Mr. Buffett recommended Bob Rubin’s book in which he recommends ways to think in the economic world
He concluded that business is all probabilistic thinking but some thinking is better not being calculated, for example in relation to people you love and humans in general.
17) You said a year or two ago that the ratio of US corporate profits as a % of GDP was historically high, at 6%, and would likely fall. Since then, the ratio has gone up (nearing 8%). Has something structurally changed, or are you confident that the ratio will still fall back?
Mr. Buffett responded that he doesn’t believe the 8% rate will be sustainable, and he views 6% as a more reasonable figure in the long-run. Moreover, he has trouble reconciling high corporate profits % (even at 6% level) with the corresponding figure of federal taxes paid by corporations, which is currently also at a very high level – 1.5% of GDP.
After a brief discussion of corporate profits and corporate taxes as a percentage of GDP, Mr. Buffett shared an interesting view on federal taxation. In a way, federal government owns a special class of stock (let’s call it Class AA stock) in every corporation. For example, last year Berkshire Hathaway paid ~ $3.4 bil. to federal government in relation to this "stock." The more the company reinvests in its business, the higher next year’s earnings and tax payments are – i.e. the higher the dividends and the value of the AA stock are). Moreover, at any point in time, the federal government can change the % of earnings to be distributed to it (i.e. change the tax rate). If the government would ever decide to "go public" with a security of future Berkshire Hathaway tax payments, that stock would be very attractive. Wall Street would love it. In fact, at 35% tax rate, that stock could be worth as much as the entire Berkshire Hathaway.
Go to Part 1 , Part 2 , Part 3
After mentioning that he’s actually bought companies after only brief telephone conversations, Mr. Buffett admitted that "every now and then you miss", but added that "it’s better than the odds of marriage". He went on to say that "sometimes you size up people better with more time", but he didn’t sound like he needed much time to recognize the type of character he looks for.
The key question for him when evaluating the management of a potential acquisition target is "do they love the money or the business". His concern is that he monetizes the owner/manager’s wealth and that may cause the latter, if he doesn’t truly love the business, not to work as hard after he’s sold out to Berkshire. He said he looks for the "obvious cases" of owners who truly love their businesses and added that he’s mostly been successful (has had "a good batting average") in identifying them.
For those owners, their businesses are their life’s work, which Mr. Buffett compared to a painting: "You spent all your life painting this painting. You can sell it to us and see it hanging in a place of honor in a museum. Or you can sell it to an LBO operator and see it hanging in a porn shop.
"I once bought a jewelry business over the phone. I could tell that the current owner was the ‘right’ type of person. The owner’s great grandfather had started the company and I could tell that the owner really loved the business."
Mr. Buffett said that he can usually "size someone up in less than a day". The most import question he poses in buying a business and looking at management is, "do they love the business?" He phrased it in this way: "If you spend your whole life painting a picture would you rather have that painting on exhibit at the Metropolitan Museum of Art, or would you rather earn 5% more on the sale of the painting and have it hanging in a porn shop?"
He has had a great batting average in picking companies and people. But he says that "we can’t tell with everyone and once in a while we make a mistake."
14) The profits of financial companies as a % of total US corporate profits is at an all-time high (~40%) -- is this just the result of the carry trade, which will end, or perhaps bogus use of derivatives, or is there something more structural changing?
15) On his fears about US dollar weakness:
The dollar is not overvalued on a purchasing power basis. Macroeconomics is not our usual game, however if some economic facts are screaming at us, we jump on them. We don't usually do junk bonds, however if you cast your eye about, you can always find deals. I don't feel like doing macro bets as much with other people's money as my own. We work with big currencies-- eight of them. I don't have a view about which will move most against the dollar. My view is that the dollar will weaken. Countries support their own currency-- Japan wanted to keep their currency down which kept the US currency up. I don't know if China or HK will decouple their currency from the US. I like to have earnings in other currencies because they convert into more dollars, however I keep most of our cash in dollars.
16) On probabilistic thinking: while we would all love to do it, how does one distinguish between true subjective probabilistic thinking and bias induced guesswork?
Of course we try to make decisions based on probability and not guesswork. I agree strongly with the thoughts in Robert Rubin's book (In An Uncertain World). It's all probabilities. The one time when Charlie and I have trouble doing this is when it comes to firing people. I hate doing that and I avoid it as much as possible. We had one manager at one of our companies who developed Alzeimer's disease. It took us a long time to see it, and after we saw it, it took us a long time to act on it. Fortunately, the company still did well even while he had Alzeimer's, so we've developed a new rule around here: Only buy businesses that are so good that someone with Alzeimer's can manage them!
We all think we’re doing the former – probabilistic thinking.
Mr. Buffett said he tries to always use probabilistic thinking. That’s what he likes about the insurance business and investments. We try to think through every decision that comes to us. Some decisions are simple probabilities.
However, Mr. Buffett added that we’re human and probabilistic thinking is not always possible. Mr. Buffett said that when dealing with other people, such as firing someone, is a time in his case that he may stray from probabilistic thinking. An example was when Mr. Buffett denied that one employee who ran one of his businesses had Alzheimer’s for one year beyond when anyone else would have picked up on it. He said how hard it was for him to fire him, especially since he loved the person but he was just no longer good at the job. He, therefore, unintentionally postponed the decision. Mr. Buffett said he looked for countering evidence because he hates to fire a CEO he likes. He said he will tolerate a lot from someone who has been an associate. Mr. Buffett then joked that now he buys business that even a person with Alzheimer’s can run!
One thinks they know when they’re getting way from probabilistic thinking, but you can not always detect it.
Mr. Buffett recommended Bob Rubin’s book in which he recommends ways to think in the economic world
He concluded that business is all probabilistic thinking but some thinking is better not being calculated, for example in relation to people you love and humans in general.
17) You said a year or two ago that the ratio of US corporate profits as a % of GDP was historically high, at 6%, and would likely fall. Since then, the ratio has gone up (nearing 8%). Has something structurally changed, or are you confident that the ratio will still fall back?
Mr. Buffett responded that he doesn’t believe the 8% rate will be sustainable, and he views 6% as a more reasonable figure in the long-run. Moreover, he has trouble reconciling high corporate profits % (even at 6% level) with the corresponding figure of federal taxes paid by corporations, which is currently also at a very high level – 1.5% of GDP.
After a brief discussion of corporate profits and corporate taxes as a percentage of GDP, Mr. Buffett shared an interesting view on federal taxation. In a way, federal government owns a special class of stock (let’s call it Class AA stock) in every corporation. For example, last year Berkshire Hathaway paid ~ $3.4 bil. to federal government in relation to this "stock." The more the company reinvests in its business, the higher next year’s earnings and tax payments are – i.e. the higher the dividends and the value of the AA stock are). Moreover, at any point in time, the federal government can change the % of earnings to be distributed to it (i.e. change the tax rate). If the government would ever decide to "go public" with a security of future Berkshire Hathaway tax payments, that stock would be very attractive. Wall Street would love it. In fact, at 35% tax rate, that stock could be worth as much as the entire Berkshire Hathaway.
Go to Part 1 , Part 2 , Part 3
Warren Buffett Interview Part 2
7)
You and Charlie Munger believe that the easiest person in the world to
fool is yourself. Have you been fooling yourself by remaining committed
to certain buy and hold doctrines, especially considering they are
alluring because you have to work less since good investments work for
you.
People believe what they want to believe. Everyone rationalizes their actions. A partner like Charlie can point it out to me. If we have a strength, it is that we think things through and we have the advantage of having each other. We are not influenced by other people. Charlie would say we are successful because we are rational and do our own work.
Paraphrasing Keynes’, "The difficulty lies not in the new ideas but in escaping from the old ones," Mr. Buffett remarked: The problem is not holding onto the new [ideas]. The problem is escaping from the old. Darwin claimed he had to write down new ideas constantly. His mind would race to find new ideas. But if he did not write down his new findings within 30 minutes his subconscious would wipe them out and revert to old beliefs.
8) What do you believe is the top thing that will affect our great country's competitiveness in the future and what would you advise be done to address it? (can follow up with health care and social security/pension gap)
One of the biggest problems facing the country is weapons of mass destruction. But there isn’t much that can be done about the problem (there will always be terrorists).
The trade deficit, of which current account deficit accounts for 90%, is the biggest economic problem facing the U.S. It is very complicated and not covered sufficiently in the debate. Social security and Healthcare are two issues tied in with the issue of the trade deficit. When there is no trade deficit, there is no net holding by foreigners. Currently government redistributes 22% of the US output to social security and healthcare. And these issues are eternal intra-family political squabbles over the redistribution between those who are producing and those who are not producing? Trade Deficit is a transfer of ownership or IOU on converted ownership, representing $1.8BN of outflow to foreign countries. It can’t be easily addressed. If the trade deficit continues at the current rate for the next 6-10 years, foreigners will have a permanent call on 3% of the output.
Can we afford this? Potentially yes. Foreign aid administered after the Marshall Plan post-WWII can be appropriate. However this is an accumulated burden to be paid by future generations because their "parents" didn’t want to pay for it. This could play a significant factor in future financial market disruption. "When someone fires in the theater on the stage" with significant amount of assets held by foreigners, along with other things happening at the same time, the trade deficit could be the #1 problem in the next financial event.
On healthcare, you have to rationalize healthcare demand when healthcare costs become higher and higher. The demand structure under the current system is not sustainable. We need to reframe some of the expectations of people and reframe what is the appropriate level of healthcare provisions. For example: Should we keep everyone alive for their last 3-6 months? Should people get the maximum amount of care to keep healthy? Government needs to ration it through government policy and people’s willingness to wait.
9) Is there a significant portion of the value you generate from the portfolio derived through active investment (e.g., influence on management decision, etc.) If so, what do you think of the role and probability of long-term success of an investment manager with little influence over management decisions, i.e, a passive investor? Has passive investing lost some of its appeal for you because you have been personally disappointed with the management of major American corporations? If so, what implications does that have for America?
In short, Charlie and I do not and should not have a significant impact on the management of our companies. You would be surprised how little impact we have on management. They [CEOs] all have different batting stances and know what style works for them. There would be no point for us to tell them to alter their stance as you can still be a good hitter even if you stand different to the next man - we hire them as they are good hitters.
In terms of our influence on the CEO's of our public holdings - we are "toothless tigers". We do not control the company and do never threaten to sell our stakes if our advice is not taken, therefore we are very much toothless tigers. We are holders of the stock for the long-term and therefore do not gain from short-term increases in the price. Moreover, we actually prefer for the price to go down in the near term so we can buy more stock and increase our stake in the company. However, the disclosure rules make it increasingly difficult for us to build up stakes in companies. For instance, we rarely invest in the UK as there is a 3% disclosure rule so we can not build a meaningful stake before it becomes public. So historically, we performed much better when the disclosure requirements were less stringent and they have been increased steadily over time. Our investment in PetroChina was another example of disclosure rules costing us hundreds of millions of dollars. We had to announce our ownership at a 1% level, after which the price shot up.
Stockholders should be able to think and behave like owners. The three things that a shareholder in a public company should focus on are: do you have the right CEO? does she/he overreach? are they too focused on acquisitions or empire building and stop thinking on a per share basis? Institutional owners need to focus on these three aspects.
Both Charlie and I say we would make a lot more money if we were anonymous. You'd be surprised how little impact we have on management. They're all different individuals with their own egos, money, and even control. You'd be surprised how much we don't steer them. We have very little influence on their investments, but it doesn't matter because we don't buy and sell. We don't gain anything from the stock price going up. Piggybacking doesn't do much.
It's a big minus to operate in a public arena where people are not likely to follow. I still have 99% of my net worth in Berkshire, but I try to buy some on my own anonymously -- I do much better that way.
We ask for confidential treatment in some areas, but the SEC doesn't allow that often. Passive investor role: big institutional owners should act and behave like owners. The big thing to worry about is whether the company has the right CEO and if it does, does the CEO overreach even if he's a good manager? The only people who can stop that are the directors and owners...and the directors will only stop it if the owners make a case. CEOs will sometimes do things uneconomic to satisfy primal urges. My instinct is that the institutional investors behave better than they did 10 years ago.
10) I am also from Omaha. When I tell people at school about your frugal financial approach, they are stunned. What is your specific philosophy about wealth? And how do you think this discipline has contributed to your success running Berkshire?
Mr. Buffett feels he was lucky to be born in the US (he won the ovarian lottery). He believes that he's wired in a way that works well in a capitalistic society: he has the innate ability to allocate money. He believes that society has enabled him to earn this money and so he believes that the money should go back to society eventually. He believes in a graduated income tax. Society has contributed to his wealth so they should benefit.
He discussed the effect wealth has on an individual and the effect it has had on his life: It means that he can do whatever he wants to do. He has the luxury to make choices. But, he has no desire to be a greenskeeper- to own a 20 acre property which requires him to devote time to organizing and maintaining it. Further, spending the next 4yrs building a house doesn't appeal to him. He won't find a house where he'd be happier than the one he's live in since '58-59. He has no interest in owning a large yacht- he views this as more of a hassle than anything else. He prefers to use his wealth to do what he wants to do with the people he wants to do it with. He likes his life. He likes the people he works with- nobody has left Berkshire voluntarily in 15 yrs. He won't buy a business owned by someone he doesn't like.
If one were to ask Charlie why they were successful, he would respond that it was due to "rational decision making" and being able to not depend and focus on what someone else thinks is important. Also stressed that he was very lucky to be born in the country that he was. Likened it to a lottery with a 1 in 50 chance. This is because he is "wired in a way to be very effective" in a large economy where capital allocation skills are needed and highly rewarded. He illustrated the counter example with a quote from Gates saying that if he were born a few thousand years earlier he "would be an animal’s lunch".
As for the trappings of wealth, he believes he already lives the life he wants to live. He cautioned against backing into certain behaviors simply because that was what other rich people do. For example, he does not want to own a large boat as he simply does not derive enough utility out of it to justify the bother that would entail from owning and maintaining one. As it stands, he does benefit from his wealth in that he has the "ultimate luxury", that is to do what he wants to do everyday and he’s having more fun than most 74 year olds. He doesn’t want to build a bigger house and he gets to work with people he likes. Apparently, they like him too as none of the 18 people who work with him at Berk HQ has left in 15 years. He also will not do a deal simply for the money as it would be as perverse as someone already very wealthy marrying for the money. What money has ultimately given him is the power to choose because the luxury to choose is what being wealthy is all about.
Mr. Buffett continued and discussed the middleweight boxing match he watched on PPV at $54.95. He didn’t think twice about the cost of it. He talked about how in the not too distant past the fight would have been limited to people at Madison Square Garden whereas the boxers there stood to gain the benefit from an audience of millions because of what society as a whole has enabled. Therefore he is, and he believes so should the boxers, be in favor of progressive taxes. That is they are able to make extraordinary incomes because of society and should be willing to contribute a greater share to maintaining it.
11) It is clear that you would never resort to earnings smoothing etc for Berkshire. But you do sell insurance products that have helped other companies smooth their earnings, or at least make their problems look less severe. Is there a contradiction in this?
The whole idea of insurance is that you pay a premium each year to protect for a disaster every 20 years. The nature of the product is smoothing earnings. You personally do this with your auto insurance. You pay $400 (or $350 if you call Geico!) to protect yourself. Sometimes companies have used it incorrectly, but this is not inherent in the insurance product. If you get into "no risk transfer" deals with insurance you can get called on it. Berkshire Hathaway has written the two biggest retroactive insurance deals. One when White Mountain bought One Beacon and the other when ACE bought Cigna. Each paid ~$1.5 billion to reduce charges for old bad cases. Berkshire Hathaway was much better equipped to handle the risk than ACE or White Mountain (who were both stretching to pay for the deals). All of our policies are finite. There have been some cases of policies with zero risk transfer in the U.S., but they were very limited in the last five years because auditors must now sign off that there is adequate risk transfer and it is not just for accounting purposes. Generally, there is an understanding and a long relationship between the primary insurer and the reinsurer. If the reinsurer gets killed, the primary does not take the business elsewhere. They just build that experience into next year’s quote. This is less prevalent now because it is less client orientated and more transaction oriented because of the introduction of brokers. There is no more relationship development, just a focus on the lowest price.
12) At our investment management conference a few weeks ago, one panel featured the CIOs from Barclays Global Investors, State Street and Vanguard, and we collectively discussed the use of derivatives in modern portfolio management. We understand you dealt with unknown exposures in a past acquisition, but wonder if you think in this environment certain institutions have the risk control and discipline to use derivatives to effectively mitigate their risks.
Berkshire uses derivatives. There is nothing evil about them per se. It is very hard to control risks without derivatives. But all mismarks on contracts are in the trader's favor, never our favor. These days, there is no money in plain vanilla stuff - the margins are too squeezed - so you get people writing very sophisticated derivatives.
Berkshire is still unwinding many of its positions. General Re had 23,000 contracts 3 yrs ago and 3000 are left. Derivatives are very tough for management. In situations like 9/11, with losses of unknown magnitude, anyone with big equity and big derivatives portfolio (when you don't know what's behind the derivatives) is in trouble. A big downgrade on the company would have followed with margin postings, etc. - trouble...
Another issue with derivatives is that the incentives of the guy writing the derivates are not aligned with the company. For example. one of the highest paid guys at Gen Re was the guy that wrote complicated contracts - and those contracts were not necessarily good for the company. Finally, the problem with large derivatives portfolios is that they tend to be directly related to equity positions that company has. This interdependence means that billions of dollars on your balance sheet are dependent on others performance (other equity performance) - not on your own company performance.
"Derivatives are like AIDS - its not who you slept with, but who they slept with"
Go to Part 1 , Part 2 , Part 3
People believe what they want to believe. Everyone rationalizes their actions. A partner like Charlie can point it out to me. If we have a strength, it is that we think things through and we have the advantage of having each other. We are not influenced by other people. Charlie would say we are successful because we are rational and do our own work.
Paraphrasing Keynes’, "The difficulty lies not in the new ideas but in escaping from the old ones," Mr. Buffett remarked: The problem is not holding onto the new [ideas]. The problem is escaping from the old. Darwin claimed he had to write down new ideas constantly. His mind would race to find new ideas. But if he did not write down his new findings within 30 minutes his subconscious would wipe them out and revert to old beliefs.
8) What do you believe is the top thing that will affect our great country's competitiveness in the future and what would you advise be done to address it? (can follow up with health care and social security/pension gap)
One of the biggest problems facing the country is weapons of mass destruction. But there isn’t much that can be done about the problem (there will always be terrorists).
The trade deficit, of which current account deficit accounts for 90%, is the biggest economic problem facing the U.S. It is very complicated and not covered sufficiently in the debate. Social security and Healthcare are two issues tied in with the issue of the trade deficit. When there is no trade deficit, there is no net holding by foreigners. Currently government redistributes 22% of the US output to social security and healthcare. And these issues are eternal intra-family political squabbles over the redistribution between those who are producing and those who are not producing? Trade Deficit is a transfer of ownership or IOU on converted ownership, representing $1.8BN of outflow to foreign countries. It can’t be easily addressed. If the trade deficit continues at the current rate for the next 6-10 years, foreigners will have a permanent call on 3% of the output.
Can we afford this? Potentially yes. Foreign aid administered after the Marshall Plan post-WWII can be appropriate. However this is an accumulated burden to be paid by future generations because their "parents" didn’t want to pay for it. This could play a significant factor in future financial market disruption. "When someone fires in the theater on the stage" with significant amount of assets held by foreigners, along with other things happening at the same time, the trade deficit could be the #1 problem in the next financial event.
On healthcare, you have to rationalize healthcare demand when healthcare costs become higher and higher. The demand structure under the current system is not sustainable. We need to reframe some of the expectations of people and reframe what is the appropriate level of healthcare provisions. For example: Should we keep everyone alive for their last 3-6 months? Should people get the maximum amount of care to keep healthy? Government needs to ration it through government policy and people’s willingness to wait.
9) Is there a significant portion of the value you generate from the portfolio derived through active investment (e.g., influence on management decision, etc.) If so, what do you think of the role and probability of long-term success of an investment manager with little influence over management decisions, i.e, a passive investor? Has passive investing lost some of its appeal for you because you have been personally disappointed with the management of major American corporations? If so, what implications does that have for America?
In short, Charlie and I do not and should not have a significant impact on the management of our companies. You would be surprised how little impact we have on management. They [CEOs] all have different batting stances and know what style works for them. There would be no point for us to tell them to alter their stance as you can still be a good hitter even if you stand different to the next man - we hire them as they are good hitters.
In terms of our influence on the CEO's of our public holdings - we are "toothless tigers". We do not control the company and do never threaten to sell our stakes if our advice is not taken, therefore we are very much toothless tigers. We are holders of the stock for the long-term and therefore do not gain from short-term increases in the price. Moreover, we actually prefer for the price to go down in the near term so we can buy more stock and increase our stake in the company. However, the disclosure rules make it increasingly difficult for us to build up stakes in companies. For instance, we rarely invest in the UK as there is a 3% disclosure rule so we can not build a meaningful stake before it becomes public. So historically, we performed much better when the disclosure requirements were less stringent and they have been increased steadily over time. Our investment in PetroChina was another example of disclosure rules costing us hundreds of millions of dollars. We had to announce our ownership at a 1% level, after which the price shot up.
Stockholders should be able to think and behave like owners. The three things that a shareholder in a public company should focus on are: do you have the right CEO? does she/he overreach? are they too focused on acquisitions or empire building and stop thinking on a per share basis? Institutional owners need to focus on these three aspects.
Both Charlie and I say we would make a lot more money if we were anonymous. You'd be surprised how little impact we have on management. They're all different individuals with their own egos, money, and even control. You'd be surprised how much we don't steer them. We have very little influence on their investments, but it doesn't matter because we don't buy and sell. We don't gain anything from the stock price going up. Piggybacking doesn't do much.
It's a big minus to operate in a public arena where people are not likely to follow. I still have 99% of my net worth in Berkshire, but I try to buy some on my own anonymously -- I do much better that way.
We ask for confidential treatment in some areas, but the SEC doesn't allow that often. Passive investor role: big institutional owners should act and behave like owners. The big thing to worry about is whether the company has the right CEO and if it does, does the CEO overreach even if he's a good manager? The only people who can stop that are the directors and owners...and the directors will only stop it if the owners make a case. CEOs will sometimes do things uneconomic to satisfy primal urges. My instinct is that the institutional investors behave better than they did 10 years ago.
10) I am also from Omaha. When I tell people at school about your frugal financial approach, they are stunned. What is your specific philosophy about wealth? And how do you think this discipline has contributed to your success running Berkshire?
Mr. Buffett feels he was lucky to be born in the US (he won the ovarian lottery). He believes that he's wired in a way that works well in a capitalistic society: he has the innate ability to allocate money. He believes that society has enabled him to earn this money and so he believes that the money should go back to society eventually. He believes in a graduated income tax. Society has contributed to his wealth so they should benefit.
He discussed the effect wealth has on an individual and the effect it has had on his life: It means that he can do whatever he wants to do. He has the luxury to make choices. But, he has no desire to be a greenskeeper- to own a 20 acre property which requires him to devote time to organizing and maintaining it. Further, spending the next 4yrs building a house doesn't appeal to him. He won't find a house where he'd be happier than the one he's live in since '58-59. He has no interest in owning a large yacht- he views this as more of a hassle than anything else. He prefers to use his wealth to do what he wants to do with the people he wants to do it with. He likes his life. He likes the people he works with- nobody has left Berkshire voluntarily in 15 yrs. He won't buy a business owned by someone he doesn't like.
If one were to ask Charlie why they were successful, he would respond that it was due to "rational decision making" and being able to not depend and focus on what someone else thinks is important. Also stressed that he was very lucky to be born in the country that he was. Likened it to a lottery with a 1 in 50 chance. This is because he is "wired in a way to be very effective" in a large economy where capital allocation skills are needed and highly rewarded. He illustrated the counter example with a quote from Gates saying that if he were born a few thousand years earlier he "would be an animal’s lunch".
As for the trappings of wealth, he believes he already lives the life he wants to live. He cautioned against backing into certain behaviors simply because that was what other rich people do. For example, he does not want to own a large boat as he simply does not derive enough utility out of it to justify the bother that would entail from owning and maintaining one. As it stands, he does benefit from his wealth in that he has the "ultimate luxury", that is to do what he wants to do everyday and he’s having more fun than most 74 year olds. He doesn’t want to build a bigger house and he gets to work with people he likes. Apparently, they like him too as none of the 18 people who work with him at Berk HQ has left in 15 years. He also will not do a deal simply for the money as it would be as perverse as someone already very wealthy marrying for the money. What money has ultimately given him is the power to choose because the luxury to choose is what being wealthy is all about.
Mr. Buffett continued and discussed the middleweight boxing match he watched on PPV at $54.95. He didn’t think twice about the cost of it. He talked about how in the not too distant past the fight would have been limited to people at Madison Square Garden whereas the boxers there stood to gain the benefit from an audience of millions because of what society as a whole has enabled. Therefore he is, and he believes so should the boxers, be in favor of progressive taxes. That is they are able to make extraordinary incomes because of society and should be willing to contribute a greater share to maintaining it.
11) It is clear that you would never resort to earnings smoothing etc for Berkshire. But you do sell insurance products that have helped other companies smooth their earnings, or at least make their problems look less severe. Is there a contradiction in this?
The whole idea of insurance is that you pay a premium each year to protect for a disaster every 20 years. The nature of the product is smoothing earnings. You personally do this with your auto insurance. You pay $400 (or $350 if you call Geico!) to protect yourself. Sometimes companies have used it incorrectly, but this is not inherent in the insurance product. If you get into "no risk transfer" deals with insurance you can get called on it. Berkshire Hathaway has written the two biggest retroactive insurance deals. One when White Mountain bought One Beacon and the other when ACE bought Cigna. Each paid ~$1.5 billion to reduce charges for old bad cases. Berkshire Hathaway was much better equipped to handle the risk than ACE or White Mountain (who were both stretching to pay for the deals). All of our policies are finite. There have been some cases of policies with zero risk transfer in the U.S., but they were very limited in the last five years because auditors must now sign off that there is adequate risk transfer and it is not just for accounting purposes. Generally, there is an understanding and a long relationship between the primary insurer and the reinsurer. If the reinsurer gets killed, the primary does not take the business elsewhere. They just build that experience into next year’s quote. This is less prevalent now because it is less client orientated and more transaction oriented because of the introduction of brokers. There is no more relationship development, just a focus on the lowest price.
12) At our investment management conference a few weeks ago, one panel featured the CIOs from Barclays Global Investors, State Street and Vanguard, and we collectively discussed the use of derivatives in modern portfolio management. We understand you dealt with unknown exposures in a past acquisition, but wonder if you think in this environment certain institutions have the risk control and discipline to use derivatives to effectively mitigate their risks.
Berkshire uses derivatives. There is nothing evil about them per se. It is very hard to control risks without derivatives. But all mismarks on contracts are in the trader's favor, never our favor. These days, there is no money in plain vanilla stuff - the margins are too squeezed - so you get people writing very sophisticated derivatives.
Berkshire is still unwinding many of its positions. General Re had 23,000 contracts 3 yrs ago and 3000 are left. Derivatives are very tough for management. In situations like 9/11, with losses of unknown magnitude, anyone with big equity and big derivatives portfolio (when you don't know what's behind the derivatives) is in trouble. A big downgrade on the company would have followed with margin postings, etc. - trouble...
Another issue with derivatives is that the incentives of the guy writing the derivates are not aligned with the company. For example. one of the highest paid guys at Gen Re was the guy that wrote complicated contracts - and those contracts were not necessarily good for the company. Finally, the problem with large derivatives portfolios is that they tend to be directly related to equity positions that company has. This interdependence means that billions of dollars on your balance sheet are dependent on others performance (other equity performance) - not on your own company performance.
"Derivatives are like AIDS - its not who you slept with, but who they slept with"
Go to Part 1 , Part 2 , Part 3
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