Sunday, November 24, 2013

The Warren Buffett Way (3rd Edition)



I'm in the process of reading The Warren Buffett Way (Third Edition). Unfortunately I ran out of time to completely finish it before having to return it to the library. So, here's a partial synopsis of what the book is about.

Born in Omaha on August 30th, 1930, Warren Edward Buffett is considered to be one of the most successful, if not the most successful investor in history. As of 2013, his career managing money has spanned nearly 60 years. It has been divided between the time he managed Buffett Investment Partnership, Ltd. (1956 to 1969) and the much longer period of managing Berkshire Hathaway, starting in 1965, the year he took control of the company. From 1965-2012 his company earned a compounded annual gain of 19.7% compared to 9.4% of the S&P 500 (with dividends included). His overall gain over that period of time was 586,817% while the S&P 500 was at 7,433%. Astounding.

His philosophy flies in the face of convention compared to that of financial advisors today. While they preach diversified portfolios and quick turnover, Mr. Buffett says one should pick a limited number of high quality stocks and hold them long term. He calls it Focus Investing - Choose a few stocks that are likely to produce above average returns over the long haul, concentrate the bulk of your investments in those stocks , and have the fortitude to hold steady during any short term market gyrations.

Chapter 3: Buying a Business: The Twelve Immutable Tenets

Also, Mr. Buffett has what he calls the Twelve Immutable Tenets (of investing). These are things you should look for when considering investing in a company.

Business Tenets:

Is the business simple and understandable? Mr. Buffett is able to maintain a high level of knowledge about the businesses he choses to invest in because he limits his selections to companies that are within his area of financial and intellectual understanding. He is acutely award of how these businesses operate in all aspects. 

Does the business have a consistent operating history? It has been Buffett's experience that the best returns are achieved by companies that have been producing the same product or service for several years. Undergoing major business changes increases the likelihood of committing major business errors.

Does the business have favorable long-term prospects? Mr. Buffett looks for companies that provide a product or service that is (1) needed or desired, (2) has no close substitute and (3) is not regulated. These traits allow the company to hold its prices, and occasionally raise them, without the fear of losing market share or unit volume. It allows the company to earn above average returns on capital.

Management Tenets:

Is management rational? When considering a new investment of business acquisition, Buffett looks very hard at the quality of management. They must be operated by honest and competent managers whom he can admire and trust. The most important management act is the allocation of the company's capital. Because, over time, it determines shareholder value. Deciding what to do with the company's earnings - reinvest in the business or return money to shareholders - is an exercise in logic and rationality.

Is management candid with its shareholders? Buffett holds in high regard managers who report their company's financial performance fully and genuinely, who admit mistakes as well as share successes, and are in all ways candid with shareholders.

Does management resist the institutional imperative? Buffett looks for managers who resist what he calls "the institutional imperative" - the lemming-like tendency of corporate managers to imitate the behavior of others, no matter how silly or irrational it may be.

Financial Tenets:

Focus on return on equity, not earnings per share. Mr. Buffett considers earnings per share (EPS) a smokescreen. To measure a company's performance, he prefers return on equity - the ratio of operating earnings to shareholders' equity.
Calculate "owner earnings." Instead of cash flow Buffett prefers to use what he calls "owner earnings" a  company's net income plus depreciation, depletion, and amortization, less the amount of capital expenditures and any additional working capital that might be needed.

Look for companies with high profit margins. According to Buffett there is no big secret to profitability: It all comes down to controlling costs. In his experience, managers of high cost operations tend to find ways to contunually add to overhead, wheres managers of low cost operations are always finding ways to cut expenses. That's what he looks for.

For every dollar retained, make sure the company has created at least one dollar of market value. Buffett looks to select businesses with economic characteristics allowing each dollar of retained earnings to be translated eventually into at least a dollar of market value. 

Market Tenets:

What is the value of the business? Paraphrasing John Burr Williams, Buffett tells us that the value of a business is determined by the net cash flow expected to occur over the life of the business discounted at an appropriate interest rate. Buffett uses the long-term U.S. Treasury rate as his discount factor.

Can the business be purchased at a significant discount to its value? Focusing on good businesses by itself is not enough to guarantee success, Buffett notes. You have to buy at sensible prices and then the company has to perform to your expectations. It is Buffett's intention not only to identify businesses that earn above average returns, but to purchase them at below their indicated value. That difference between price and its value represents a margin of safety. If the margin between purchase price and intrinsic value is large enough, the risk of declining intrinsic value is less.

Chapter 4: It discusses Common Stock purchases. It is a case study of nine companies Berkshire Hathaway decided to invest in - The Washington Post, GEICO Corporation, Capital Cities/ABC, The Coca-Cola Company, General Dynamics, Wells Fargo & Company, American Express Company, International Business Machines (IBM), and H. J. Heinz Company.

Chapter 5: Portfolio Management

1. Calculate probabilities. This is the probability you are concerned with: What are the chances this stock I am considering will, over time, achieve an economic return greater than the stock market?

2. Wait for the best odds. The odds of success tip in your favor when you have a margin of safety; the more uncertain the situation, the greater the margin you need. In the stock market, the margin of safety is provided by a discounted price. When the company you like is selling at a price that is below its intrinsic value, that is your signal to act.

3. Adjust for new information. Knowing that you are going to wait until the odds turn in your favor, pay scrupulous attention in the meantime to whatever the company does. Has management begun to act irresponsibly? Have the financial decisions begun to change? Has something happened to alter the competitive landscape in which the business operates? If so, the probabilities will likely change.

4. Decide how much to invest. Off all the money you have available for investing in the market, what proportion should go into a particular purchase? Start with the Kelly formula then adjust downward. 2p - 1 = x where 2 times the probability of winning (p) minus 1 equals the percentage of your total bankroll you should invest (x).

Here's a list of the first two chapters.

Chapter 1: A Five-Sigma Event talks introduces us to Warren Buffett

Chapter 2: The Education of Warren Buffett tells of his education and the people who influenced him, namely Benjamin Graham, Philip Fisher and his partner at Berkshire Hathaway, Charlie Munger.

Here's a list of the last three chapters which I didn't get much of a chance to go through.

Chapter 6: The Psychology of Investing

Chatper 7: The Value of Patience

Chapter 8: The World's Greatest Investor

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