Genre: Business & Money
Author: Prem C. Jain
Title: Buffett Beyond Value: Why Warren Buffett Looks to Growth and Management W
Buffet Beyond Value seeks to systematically understand and emulate Warren Buffett’s investment philosophy. Buffett would argue that careful study of company fundamentals and management quality can allow investors to earn above-average returns.
This book takes this hypothesis and, upon comprehensive research and analysis of decades of Berkshire Hathaway’s annual reports, academic journal publications, and other foundational financial literature, seeks to test the validity of Buffett’s claims. It is written in the age-old “Socratic style” question and answer format, which aims to allow the average reader can benefit from its teachings without extensive knowledge of mathematical finance.
The book includes some well-known Buffett principles like investing in your circle of competence, understanding reported vs. true financial results, determining the holding period of investments, identifying excellent management, and practicing patience.
It also points out that the execution and implementation of these maxims is the most critical part of this approach. For example, in making his first investments in the insurance industry, Buffett was careful to start inside his “circle of competence” — at home with the companies he knew best.
Value investing as practiced by Warren Buffett tends to focus on large, well-known companies that are conservatively financed. Speaking generally, Buffett calculates the intrinsic value of a company using conservative estimates and then requires a 25-30% disparity between that figure and the current share price to be considered for investing.
This approach provides a comfortable cushion for any unforeseen problems that may occur in the future. In contrast, highly technical models often give investors a false sense of security in the price they pay, often providing an inadequate margin of safety.
Buffett views low costs and high customer satisfaction as the two key advantages of many leading companies. Indeed, the key to Buffett’s success in retailing, manufacturing, and utilities has been his ability to find companies that have a sustainable cost advantage in their line of work, which he refers to as a moat.
A compensation structure that is motivating to employees and beneficial for the company as a whole is also important. Buffett also argues that compensation plans should focus on rewarding a high return on capital employed, not just a high level of profits.
Based on quotes in the book it is quite clear that Buffett does not believe in the Efficient Market Theory where all investments are created equal. Many investors to attempt to manage portfolio risk by diversifying its funds in different assets, but if taken too far this practice can lead to purchasing stocks that bring down your overall return.
This book suggests a portfolio of 10 to 30 stocks that you know well. Between those two numbers, there will most likely be a natural cutoff where you must determine if you are letting diversification become “diworsification.”
Above all, Buffett talks in length about the importance of an investor knowing his or her own natural tendencies with respect to investing. By knowing your own abilities, inclinations, and biases while investing accordingly, you can avoid the herding mentality that surrounds significant moves in the market.
For example, by using a checklist of predetermined questions you must answer or actions you must take before buying or selling shares of stock, investors can direct attention to areas when they know themselves to be most vulnerable.
Table of Contents
About the Author
Prem C. Jain, Ph.D., C.P.A., began his academic career in 1984 at the Wharton School of the University of Pennsylvania. He received his bachelor’s degree in engineering from Birla Institute of Technology and Science in India, his MBA from the Indian Institute of Management Calcutta, his master’s degree in Applied Economics from the University of Rochester, his Ph.D. from the University of Florida, and his C.P.A. license from the State of Florida.
In 2002 he accepted his current position as the McDonough Professor of Accounting and Finance at Georgetown University’s McDonough School of Business. Over his 25 year academic career, Mr. Jain has published extensively in some of the most prestigious finance and accounting journals, including the Journal of Finance, Journal of Financial Economics, and the Journal of Accounting Research. His research subjects include stock splits, spin-offs, mutual fund advertising, the performance of Wall Street superstars, and market efficiency.
In his book Buffett Beyond Value, Mr. Jain seeks to uncover whether or not there is a systematic way of understanding and emulating Warren Buffett’s investment philosophy. Buffett would argue, “with a careful study of company fundamentals and management quality, investors definitively can earn above-average returns.”
This book takes the above hypothesis and, upon comprehensive research and analysis of decades of Berkshire Hathaway’s annual reports, academic journal publications, and other foundational financial literature, seeks to test the validity of Buffett’s claims.
How Much Background Do You Need to Follow Buffett?
Buffett Beyond Value was written in a way that the average reader can benefit from its teachings, without extensive knowledge of mathematical finance. Buffett himself is quoted saying, “to invest successfully, you need not to understand beta, efficient markets, modern portfolio theory, option pricing, or emerging markets.”
The extent of the knowledge required to follow these studies appropriately goes only to what the average stockholder probably already understands, including concepts like earnings, dividends, and return on equity. The argument behind this claim is that if stock selection were completely numbers driven, investors would simply put their money with the fund that had the brightest mathematical minds and models and let the computers do the work for them.
Yet the single greatest investor of our lifetime, Warren Buffett, primarily uses his computer to feed his bridge addiction instead of computing highly technical mathematical analysis. Conclusion? There must be more to beating Mr. Market than math.
This book was written in the “Socratic style” that follows the age-old question and answer format. For this reason, the following paper will mirror this format and discuss each of the major topics that Mr. Jain researched. The question and answer format is a style that Berkshire Hathaway leaders Warren Buffett and Charlie Munger have used with great success for over 40 years in their annual meetings and should prove effective for this summary report.
The topics to be discussed include:
- Investing, the Search for Buried Treasure
- Value + Growth = Buffett Investing
- OPM, Other People’s Money
- Success in Retailing, Manufacturing, and Utilities
- Risk, Diversification, and When to Sell
- Market Efficiency
- Profitability and Accounting
- Corporate Governance
1. INVESTING, THE SEARCH FOR BURIED TREASURE
An amateur who devotes a small amount of time to study companies in an industry he or she knows something about can outperform 95 % of the paid experts who manage the mutual funds, plus have fun doing it.” – Peter Lynch
Why Common Stocks over Mutual Funds
The main reason for choosing to invest in common stocks instead of a diversified mutual fund is to achieve a higher return, but as Peter Lynch and others point out, you can also have more fun and enjoy a sense of accomplishment by ‘winning’ on your own. Your opponent in the ‘game of investing’ is Mr. Market, and he is someone who suffers from very volatile mood swings.
Statistics show us that only one in five actively managed mutual funds beat the S&P 500 index. Therefore, an investor could improve their returns by simply choosing to invest in an S&P index fund instead of actively managed mutual funds, raising your odds of beating other managers from one in five to four in five.
However, further investigation shows that investing in a diversified group of 10-30 individual common stocks can improve returns even more and, if one is disciplined enough to hold to certain value oriented principles, can do so without a dramatic increase in risk.
If the average expected return on the market is 10%, then your average expected return from mutual fund investments should be around 8% because of the 2% that goes to the fund for expenses. Jain shows that a sum of $1,000 invested at these respective rates over a 25-year period will produce net gains of $5,848 for mutual funds and $12,585 for common stock investments that beat the market by 1%.
One factor that attributes to this added success is the tax advantage that comes from common stock investment. If you buy stocks and do not sell them for a significant amount of time, which is a key attribute to value investing, then you will pay significantly lower taxes in aggregate compared to a mutual fund investment.
A couple of years ago Buffett was quoted in the New York Times saying, “one principle that I have used throughout my career is to invest at the point of maximum pessimism.” This principle must be taken with a grain of salt, considering not all low priced securities are necessarily undervalued. Some stocks may see a significant decrease in price for reasons outside of a financial crisis like the one that took place in 2008-2009 and would be avoided by great investors like Warren Buffett whose number one rule in investing is never to lose money.
It is left up to the investor to determine if the price of a common stock is a “value” or a “value trap,” and that is where our investigation of Buffett’s teachings begins.
Lessons from Events in BRK’s History
Mr. Buffett took control of Berkshire Hathaway in 1965 and transformed it from a small textile manufacturing company into a large insurance, utility, manufacturing, and retailing conglomerate. The company’s book value rose from $19 to over $100,000 per class A share under his guidance, using principles like investing in your circle of competence, understanding reported vs. true financial results, determining the holding period of investments, identifying excellent management, and practicing patience.
Investing in your circle of competence is as simple as placing your bets on the areas you know best. Jain notes one incident from 1967 in which Berkshire made its first insurance investment in National Indemnity Company and National Fire and Marine Insurance Company, both of which are based in Omaha where Berkshire is located.
This example shows how upon entering the new investment realm of insurance, Buffett started at home with companies he knew best, or at least better than Mr. Market. This kind of wisdom is simple but very practical in its use.
Studying reported vs. true financial results is not as easy a concept to practice. The concept is to delve into the company’s history over a significant amount of time, say 5-7 years, and get a very clear picture of all revenues and expenses associated with its operation.
The story told to describe this point is about a man who was traveling while his father passed away. He could not make it home for the funeral, so he told his sister to take care of the funeral arrangements and send him the bill.
After returning home, he received a bill for several thousand dollars, which he paid. The next month he received a bill for $15, which struck him as odd, but he paid it anyway. The following month he received another bill for $15 and decided he would call his sister and get to the bottom of this mystery payment issue.
His sister answered the phone, and upon his asking replied, “oh I forgot to tell you, we buried Dad in a rented suit!” The moral of the story is to take the time to understand a company’s true financial results before making a hasty purchase because you can learn a lot about a company from its spending practices.
When asked what an ideal holding period for investments would be, Buffett replied “forever.” In 1988, Berkshire bought 14.2 million shares of Coca Cola for $592 million, which he has added to and still owns to this day.
Buffett states that the reason he will hold an investment like Coca Cola forever is, “Normally the CEO of a consumer products company will cause either marketing or finance to dominate the business at the expense of the other discipline. With Coca Cola, the mesh of marketing and finance is perfect, and the result is a shareholder’s dream.” Superior investment opportunities are very rare, and if you find one, you should hold it for a very long time.
Identifying excellent management is one of two main principles that encapsulate an excellent investment. In 1993, Berkshire bought a controlling interest in Nebraska Furniture Mart, which is led by their 100-year-old CEO Mrs. B-Rose Blumkin.
This investment has shown that it is more important to put money into a company whose management has a sound track record of doing business over a long period of time than one with a fancy resume of academic titles. The idea is to let history, coupled with good character, be your guide in who you want to trust with your money.
Patience is a principle that is easy to understand but hard to practice. The analogy used to illustrate this principle is about Hall of Fame baseball player named Ted Williams. Ted wrote a book called The Science of Hitting, in which he carved baseball’s traditional strike zone into 77 cells and determined which of them would allow him to hit with maximum efficiency.
He determined that it was better to wait on a pitch to come across one of his efficient cells than to swing at a pitch in a sub-par cell. The problem in baseball, of course, is that you can only pass on so many sub-optimal pitches before you strike out. Fortunately, in the game of investing there is no pitch count, which gives you the freedom as an investor to wait until you see an opportunity that comes into your ‘best cells’ and swing only at those “fat pitches.”
2. BUFFETT INVESTING = VALUE + GROWTH
Most analysts feel they must choose between two approaches customarily thought to be in opposition: value and growth. In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value. -Warren Buffett
Value Investing-It’s Like Buying Christmas Cards in January
The analogy of buying Christmas cards in January is an excellent example of value investing. The idea is to buy a product that you feel people will want or need in the future, at a time when there is less want or need and a discounted price that reflects that seasonal difference. A value investor’s primary goal is to preserve capital. Earning a high return is desirable, but a secondary goal.
There are two principles that Mr. Jain states are essential to value investing. The first is that price should not be high relative to a company’s average earnings over a number of years. Historical studies of the P/E ratio show that the market average rose from around 18 in the 1990s, to around 30 in the early 2000s. One lesson this book teaches is that it is wise to avoid investing in stocks when the market P/E ratio is higher than 20.
Data shows that market ratios were high during 2005-2007 and would not be a prudent time to invest in stocks. This was proven true by the crisis that followed shortly after. Another key lesson is to examine an individual company’s stock price in comparison to 5-10 years earnings, as opposed to only looking at recent price and earnings results.
The second major principle to value investing is that each company selected should be large, prominent, and conservatively financed. Ben Graham was a strong advocate of this idea because large companies tend to be more easily understood than smaller, less-known companies are.
In determining the latter part of this second principle, conservative financing will be shown by analyzing a company’s debt-to-equity ratio. One great example of this is Coca-Cola, which has a 3% debt-to-equity ratio and is both large and prominent enough to be well known and fully understood by an investor.
Other Value Elements to Consider
Jain also notes other opportunities for value investments like sharp declines in the overall market. One example of this is after the decline in mid-1973 Berkshire bought 1.9 million shares in the Washington Post Company, which had an estimated intrinsic value of $400-$500 million and a market value of $100 million. WPC has provided annualized returns in excess of 15% since this investment, outperforming the market average of 9% during this same time period.
Jain also instructs the investor that the industry suffering most from the decline is typically the first and most significant in the recovery process. However, it is important to watch out for temptations that seem bargain priced but are really value traps that will not appreciate in value.
One example is K-Mart, which declined from $27 per share in the early 1990s to $9 in the early 2000s. The problem was that K-Mart was a low-quality company in their circle of competence and could not keep up with Wal-Mart’s superior strategy. K-Mart went bankrupt in 2002. The main takeaway from this example is to avoid investing in a turnaround company unless you have strong reason to believe that the turnaround is highly probable.
A study was conducted of 10 portfolios with different P/E and Market-to-Book ratios, ranging from high to low. The results indicated that over a 5-year period, the portfolio with the highest P/E ratio achieved a 9.4% return per year and the portfolio with the highest M/B ratio achieved a 9.5% return per year.
The portfolio with the lowest P/E ratio had a 15.9% return per year, and the portfolio with the lowest M/B ratio finished with 16.0% return per year. This data strongly supports the value investing philosophy taught by Ben Graham and so many other prominent investors.
The greatest investment reward comes to those who by good luck or good sense find the occasional company that over the years can grow in sales and profits far more than the industry as a whole. –Phillip Fisher
In 1988, Berkshire purchased so many shares of Coca Cola that it accounted for 16% of Berkshire’s common stock holdings. During the time of purchase, Coca Cola’s M/B ratio was a healthy 5.32, but its P/E was around 35% higher than the market average for stocks in the S&P500.
In addition, it had gains of over 200% over the past decade, and while it had some value-oriented statistics, it also had qualities that didn’t necessarily fit the value mold. It has become conventional wisdom among many investors to view value and growth as mutually exclusive. Jain expresses his differing opinion on this, stating, “such misguided thinking has come about because of the tendency in the profession to divide a group of stocks into two categories.
This type of mechanical division of stocks into groups leads to erroneous inferences.” One example of this premeditated division can be seen in the S&P 500, where it is not uncommon to take the 250 stocks with book-to-market ratios that are higher than the median and place them in the value category, with the remaining 250 left to be labeled growth.
It is clear that this sort of division will, in fact, lead to one group outperforming the index, with the other underperforming it by a similar margin, leaving you with an average amounting to the market’s current state. Ben Graham points out that this thinking is flawed because growth investing is not based entirely on quantitative formulas like P/E and M/B ratios.
Graham lists two reasons why growth investing is more difficult, the first being that the price may already reflect the potential growth. The second is that the investor’s judgment of the future may prove to be wrong. The question left to answer then, is how do you identify growth stocks?
How to Identify Growth Stocks
Sam Walton, the founder of Wal-Mart, had a very good understanding of this process stating, “there is only one boss – the customer, and he can fire everybody in the company from the chairman on down, simply by spending his money somewhere else. The success of a business, and hence its growth, depends primarily on its customers.
To find a high growth business, you need to evaluate it from a customer’s point of view. Once you have reached an optimum level of certainty about the future growth of a company’s earnings and feel that you can invest in it at a reasonable price, you should buy it and hold it for as long as you can.
Before going into specific detail regarding growth stock identification, there are a few things the author points out as ways not to identify growth stocks. The main thing to avoid, when searching for growth companies, is the examination of financial fundamentals at the very beginning of your search.
The analysis of quantitative measures and ratios like P/E or M/B lends itself to finding value stocks and can cause one to overlook the potential growth companies. Some examples of companies that would have been overlooked in this scenario are Microsoft, Wal-Mart, and Home Depot. By looking at financial ratios alone, an investor would have steered away from these great growth companies and missed their tremendous growth.
Other investments that Jain advises avoiding are IPOs. Professors Jay Ritter and Ivo Welch show that of more than 7,000 IPOs from 1980 through 2005, the average 3-year post- IPO performance is 20% below the corresponding market returns. To put it bluntly, IPOs are just the opposite of a growth stock. As discussed, the most important driver of growth in stock is growth in earnings.
Furthermore, this is not just growth for a period of time, but over the company’s history. A solid track record of earnings is essential to successful results for earnings in the future. Furthermore, earnings growth is inherently dependent upon growth in sales, which was Sam Walton’s concept of customers being the focal point.
Here are four qualitative questions you should ask yourself before investing in growth stocks:
–Is there potential to grow sales and earnings for several years?
This is the most important question of the four to ask. The key is to search not just for growth, but for sustainable growth. One example Jain cites surrounds the fluctuating oil prices in the mid-1970’s, 1990s, and 2000s. During these periods, oil prices rose dramatically causing many oil-drilling service company’s share prices to rise along with them.
Global Marine was one of these companies, reaching prices of $35/share in 1997 before coming down to $8/share one year later. These one-time events are precisely the kind of ‘false growth’ that should be avoided when searching for sustainable growth in a company.
-How are relations with employees?
The importance of asking this question comes back to customers being the primary driver of growth. As would be expected, good employee-management relationships in a company lead to more productive and happier employees. This is important because the well-being of a company’s employees can dramatically affect its customer satisfaction with the company and its products or services.
This is another area that Wal-Mart created a sustainable competitive advantage in its area of business. The author cites one story of a trip he took in 1999 to attend Wal-Mart’s annual shareholder’s meeting in Fayetteville, Arkansas. “Joining me in attendance were more than 10,000 Wal-Mart employees who are also shareholders.
They cheered often and ended the meeting with the well-known Wal-Mart cheer that starts with Give me a W!” Having this type of enthusiasm encourages employees to be more efficient and productive. It also boosts the morale of employees and encourages customers to keep coming back, allowing for higher inventory turnover and corporate profitability.
The most attractive part of this strategy is that it requires no extra capital, only effort on both the part of the management team and the employees. The risk-reward makes it clear to the investor that a growth company worthy of investment should be practicing this structure.
-Is management quality excellent?
Phillip Fisher, regarded as one of the most influential investors of all time, created fifteen famous points to look for in a common stock and divided them up into two main categories. One of the two groups was management’s qualities. Fisher suggested, “posing questions to the company’s consumers, suppliers, and employees to get a good sense of the quality of its management.”
This philosophy is still true today and can be accessed by publications like Fortune’s Most Admired Companies in the World or Barron’s World’s best CEOs. Jain highlights that another way to determine top management’s commitment to the company is by discovering if they own company shares, and how long they have owned them.
Jain also highlights Buffett’s belief of investing in your circle of competence, stating, “When a retail company appoints a new CEO without retail experience, it raises a red flag about his or her potential effectiveness in that role.” Information released by a company about their own management is more than likely biased, whereas an outside opinion may offer more accurate results. It is important to consider multiple sources when determining the quality of management in a company.
-What is the company’s Achilles Heel, and how do they respond to challenges?
Examining the Achilles Heel of companies you are interested in is helpful from an emotional standpoint. This process of taking an alternate point of view and analyzing a company’s weaknesses can help from falling in love with an idea and missing signs of danger that forecast a troubled future. Challenges are inevitable for any successful company, as success breeds competition.
A distinguishing feature of maintaining sustainable growth through these challenges hinges on companies rediscovering themselves. IBM and Microsoft are great examples, as both have significantly altered their area focus with the changing times while still staying within their circle of competence.
Intrinsic Value and a Margin of Safety
When discussing how to calculate the intrinsic value of a company, Buffett stated, “I’d rather be approximately correct, than exactly wrong.” Buffet’s concept of intrinsic value involves conservative estimates based on a company’s balance sheet and future earnings, rather than a mathematical model that comes up with an exact figure.
He feels these highly technical models give investors a false sense of security in the price they pay, often resulting in not allowing for a proper margin of safety. The idea of a margin of safety between a stock’s current price and a conservative estimate of its worth is a world-renowned principle made famous by Ben Graham.
Speaking generally, Buffett calculates the intrinsic value of a company using conservative estimates and then requires a 25-30% disparity between that price and its current trading price to be considered for investing. This provides a comfortable cushion for any unforeseen incidents that may occur in the future.
3. OPM, OTHER PEOPLE’S MONEY
Our main business-though we have others of great importance-is insurance. To understand Berkshire, therefore, it is necessary that you understand how to evaluate an insurance company. The key determinants are: 1) the amount of float that the business generates; 2) its cost; and 3) most critical of all, the long-term outlook for both of these factors. -Warren Buffett
Insurance Companies as Other People’s Money
An insurance company makes money in two main ways, underwriting profits and float. An insurance company’s underwriting profits are essentially the difference between the total customer premiums received for the insurance, and the total claims it must pay out. In the book, the author lists a table of data showing the revenues, float, and operating profits of GEICO from 1996-2008.
He notes two things from this table. First, “GEICO’s revenues and operating profits have increased substantially over time. Even more impressive is that the percentage profitability, or profits as a percentage of revenues, has also increased.” This speaks volumes about how GEICO has been structured and managed, as most mature companies see a decline in their percentage profits as they grow by taking market share from others.
Second, “operating profits can change dramatically from year to year.” Jain cites the 1999-2000 insurance market, where premium rates were driven down to break-even profit levels. He notes, “since operating profits are volatile, it is important for management to focus on the long run-which many companies simply cannot do.”
There are two unique advantages of float or the premiums that an insurance company receives from its customers before paying those funds out on claims, in relation to other liabilities or debt. The first is that there is no interest paid on the company’s behalf for it.
The second is that the level of capital expenditures required in the insurance industry is very low, which allows the float to grow along with the company. GEICO has been a source of tremendous returns for Berkshire Hathaway. In 1996, GEICO’s operating profits were about $100 million.
Using a multiple of 10 to value this pretax income amount gives an estimated market value around $1.0 billion. This coupled with the $3.1 billion in interest-free loans from the float, calculated its estimated intrinsic value around $4.1 billion. In 2009, using the same valuation techniques, GEICO had an estimated value of $18.8 billion, resulting in slightly over 13% annual returns since 1996.
The last major point to make is about the tax-deferment Berkshire benefits from by investing in insurance businesses. Charlie Munger stated, “So long as Wesco [a Berkshire subsidiary] does not liquidate, and does not sell any appreciated securities, it has, in effect, an interest-free loan from the government equal to its deferred incomes taxes on the unrealized gains, subtracted in determining its net worth.”
The tax-deferment is created by holding purchases for a long time, as opposed to buying and selling frequently and paying the 35% annual short- term capital gains tax. A hypothetical situation created to illustrate the disparity between the two styles, shows the different gains from the same investment of $10,000 in the S&P 500 from 1984 to 2008, with and without the tax advantage.
A mutual fund investment $10,000, where a yearly 35% tax rate would be applied to all gains, would have amounted to $46,800. The $10,000 investment that was held for 25 years and then charged the long-term tax rate of 20% would have amounted to $84,800 or nearly double.
4. SUCCESS IN RETAILING, MANUFACTURING, AND UTILITIES
Just as Wal-Mart sells at prices that high-cost competitors can’t touch and thereby constantly increases its market share, so does Borsheim’s [jewelry store in Omaha]. What works with diapers works with diamonds. -Warren Buffett
Buying Businesses with a Moat Around Them
The key to Buffett’s success in retailing, manufacturing, and utilities is his ability to find companies that have a sustainable cost advantage in their line of work. Berkshire’s purchase of Borsheim’s Jewelry Store is also an excellent example of how investors can diversify their portfolio within the same industry.
Ownership in Wal-Mart and Borsheim’s would give exposure to high-cost and low-cost companies while remaining in the retailing industry. This type of diversification is healthier than, for example, owning shares of both Exxon Mobil and Chevron to gain diversification within the energy industry.
Simply put, a business’ moat is its sustainable competitive advantage. Two main advantages created the moat around Borsheim’s Jewelry Store that Buffett found so attractive. First is the advantage in location that they had to the majority of jewelry retailers in the country. Overhead costs are far less significant in a place like Omaha than New York City and other major cities.
This allowed them to build a reputation for low prices for high-quality goods. Once a company has built a strong reputation, the second major advantage comes into play. Having a good reputation allowed them to spend less money on marketing and advertising, bringing down costs and increasing profit margins.
Also, reputation and good leadership created trust in Borsheim’s customers. Buffett described the importance of good management in retailing by saying, “buying a retailer without good management is like buying the Eiffel Tower without an elevator.” This is especially important in the jewelry business, where studies show that people would rather pay 10% more to ensure that the diamonds and precious metals they purchase are of the highest quality.
5. RISK, DIVERSIFICATION, AND WHEN TO SELL
Don’t put all your eggs in one basket. -Proverb
The Interaction of Risk and Holding Period
For a long-term investor, volatility of returns in the short run should not be the main criterion for assessing risk. Risk should be considered over the life of the investment, not on its quarter-to-quarter share price fluctuations. The example used in the book describes Berkshire’s insurance holdings. In years when there are no disasters, and insurance claims are low, returns should be high, and the stock price should rise accordingly.
But, when a natural disaster strikes and insurance companies are hit with claims, profits will decrease, and the stock price could be bid down significantly. Buffett writes, “Berkshire’s management is willing to accept volatility in reported results, provided there is a reasonable prospect of long-term profitability.” The point is that all too often investors are scared into selling from one-time events, even when the long-run risk profile of a company is healthy.
In these situations, the prudent investor would simply buy more shares of this great company at a discount. It is also wise to keep a portion of your portfolio in cash or cash equivalents to be in the position to take advantage of opportunities when they occur.
Diversification becoming Diworsification
It is common practice to attempt to manage portfolio risk by diversifying its funds in different assets. The theory of not keeping all of one’s eggs in one basket. However, if taken too far, this practice can lead to purchasing stocks that bring down your overall return.
Philip Fisher writes, “investors have been so oversold on diversification that fear of having too many eggs in one basket has caused them to put far too little into companies they thoroughly know and far too much in other about which they know nothing at all. It never seems to occur to them, much less to their advisors, that buying a company without having sufficient knowledge of it may be even more dangerous than having inadequate diversification.”
This book suggests a portfolio of 10 to 30 stocks you know best. There will most likely be a natural cut off between those two numbers, and that is where you must determine if you are letting diversification become diworsification.
6. MARKET EFFICIENCY
Essentially, it [Efficient Market Theory] said that analyzing stocks was useless because all public information about them was appropriately reflected in their stock prices. In other words, the market always knew everything. -Warren Buffett
Winning a Losing Game
Based on the above quote, it is clear that Buffett does not believe in the Efficient Market Theory. It has been said that investing is like winning a losing game, where the victor is the one who makes the least amount of unforced errors. Take, for example, a tennis match between two beginner level players.
Considering the difficulty of the game and the deficiency of skill of the players, the goal should not be to make incredible shots but rather to not make unforced mistakes. Reverse engineering the equation would suggest the way to win is not to lose. If the opponents are less skilled and consistently trying to hit winners, one can do quite well by simply keeping the ball in play.
7. PROFITABILITY AND ACCOUNTING
Our [GEICO’s] competitive advantages are sustainable. Others may copy our model, but they will be unable to replicate our economies. -Warren Buffett
M = Monopoly = Money
“A monopoly exists when a company controls the entire market for a specified product or service and when there are significant barriers to entry in that market.” Monopolies have a competitive advantage, or moat, that allows them to make sustainable profits year after year. The endurance of their advantage is what distinguishes a good monopoly investment from a bad one.
It is important to note that when companies begin to enter the same market as a monopoly, it doesn’t necessarily lead to a decline in market share, due to embedded customer loyalty which often cannot be easily swayed. A company intending to capture market share from the monopoly must be able to win on price, service, and product for an extended period of time.
Many companies do not have the financial strength to last while competing for customer market share. Another reason to retain an investment in a monopoly, even when new competitors appear, is the current monopolies ability to rediscover itself as a company.
A company that has earned its customer’s satisfaction over years of business can shift their core competency to a similar but different line of work. IBM is a great example of this, as they switched their focus from selling personal computers to selling computer hardware, software, and services, taking the majority of their customer base along with them.
Low Cost and Customer Satisfaction
Low cost and customer satisfaction are described as the two key principles a leading company has. McDonald’s is a great example of a company that markets itself as having the lowest costs and a product and environment that makes its customers smile.
Competitors like Burger King and Wendy’s have had trouble competing with them because of their dominance in these two areas in the fast food industry. Another example is Amazon, who has emerged as the leader in books sales over the internet. Their success has dealt a significant blow to leading book companies like Barnes and Noble because of the ease, availability, and low costs with which books can now be purchased online.
Amazon also offers a wide variety of satisfaction guarantees and shipping discounts that keep its customer base happy and eager to return. By taking advantage of economies of scale and emerging technology, these two companies have built low- cost structures that are difficult to compete with. In addition, they have established good management that thinks of their customer’s needs first, earning them a satisfied and loyal customer base.
The dumbest reason in the world to buy a stock is because it’s going up. -Warren Buffett
Buffett talks in length about the importance of an investor knowing his or her self, and your natural tendencies in relation to investing. There is a herding mentality that surrounds significant moves in the market. This mentality stems from one of two things, either greed or fear. The important question to ask yourself is whether you have the herding instinct or not?
This human reaction can offer great opportunities if you do not blindly follow the herd, but instead, allow reason to trump emotion. There are a few ways to stay away from herding, but it starts with being honest and knowing yourself. You must know your own abilities, tendencies, and biases, and invest accordingly. Are you prone to panic? Can you part with a good thing at the appropriate time, or does greed drive you to want more?
One concrete way to combat investing with emotions is to have a checklist. This checklist is a set of predetermined questions you must answer or actions you must take, before buying or selling shares of stock. It can be as technical or simple as you like but should direct attention to areas you know you are emotionally vulnerable.
In the same way, a seasoned pilot still goes through his checklist before every take-off and landing, it is important that you adhere to your list no matter how much experience you might have as an investor, and this will remind you to have a healthy level of respect for the volatility of human emotions.
9. CORPORATE GOVERNANCE
When a manager with a reputation for brilliance tackles a business with a reputation for bad economies, the reputation of the business remains intact. -Warren Buffett
MIT professor and Goldman Sachs partner Fischer Black argued that “because of the U.S. double-taxation structure where corporations first pay taxes on earnings and then individuals again pay taxes on dividends, both corporations and individuals should prefer no dividends.”
If a company does have excess cash and no reasonably profitable projects to undertake, they should, assuming their stock price was low, repurchase their own shares. This is effectively the same as paying out dividends to its shareholders, but without the added tax burden.
When a company repurchases its own shares, it speaks volumes about where the company feels the market price for its stock is in relation to its intrinsic value. All companies will make a marketing effort, through company websites and shareholder letters, to explain how undervalued the market price of their stock currently is.
It is another thing entirely to act on these statements by increasing the stake the company has in its own success. Lastly, if the company stock price is high and they have no reasonably profitable projects to pour their excess cash flows into, they should pay dividends. This policy towards dividend payments indicates self- disciplined corporate governance.
Employees, Directors, and CEOs
Motivating a company’s employees, directors, and CEOs is vital to its future success and growth. While compensation is not always the primary motivating factor, evidenced by facts like Warren Buffet’s $175,000 compensation in 2008, it certainly is for the majority.
Therefore, having a payment structure that is motivating to the employee and beneficial for the company as a whole, is key. Buffett argues that compensation plans should focus on rewarding a high return on capital employed, not just a high level of profits. One example of this is the bonus plan for Ralph Schey, manager of Berkshire subsidiary Scott Fetzer Company. Buffett writes, “If Ralph can employ incremental funds at good returns, it pays him to do so.
His bonus increases when earnings on additional capital exceed a meaningful hurdle charge. But our bonus calculation is symmetrical: If incremental investment yields substandard returns, the shortfall is costly to Ralph as well as to Berkshire.
The consequence of this two-way arrangement is that it pays Ralph, and pays him well, to send to Omaha any cash he can’t advantageously use in his business.” This type of strategy employs both the principle of motivating your employees and doing what is best for the company as a whole. In summation, Berkshire lists three inventive compensation principles that they feel are worth employing.
Goals should be (1) tailored to the economies of the specific operating system; (2) simple in character so that the degree to which they are being realized can be easily measured; and (3) directly related to the daily activities of plan participants.
The book Buffett Beyond Value contained an enjoyable combination of insightful stories and financial data. Prem C. Jain did an excellent job switching back and forth between the two, keeping me eager and engaged to learn. I highly encourage the reading of this book to fully understand the depth of each of the nine sections that are summarized in this paper. It is safe to conclude that Buffett’s investing style goes well beyond value.
Britt always taught us Titans that Wisdom is Cheap, and principal can find treasure troves of the good stuff in books. We hope only will also express their thanks to the Titans if the book review brought wisdom into their lives.
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