1. It is important to use this book to learn, but don’t use this book to be like Warren Buffett. You can’t be Warren Buffett and, if you try, you will suffer. Use this book to understand Buffett’s ideas and then take those ideas and integrate them into your own approach to investing. It is only from your own ideas that you create greatness.
2. Buffett had learned Ben Graham’s lesson well: When stocks of a strong company are selling below their intrinsic value, act decisively.
3. It is Buffett’s preference to “buy certainties at a discount.”
“Certainties” are defined by the predictability of a company’s economics. The more predicable a company’s economics, the more certainty we might have about its valuation. The “discount” part of the statement obviously refers to the stock price.
4. We also know Buffett’s discipline of operating only within his “circle of competence.” Think of this circle of competence as the cumulative history of your experience.
5. Warren Buffett’s approach to investing is uniquely his own, yet it rests on the bedrock of philosophies absorbed from four powerful figures:
· Benjamin Graham,
· Philip Fisher,
· John Burr Williams, and
· Charles Munger.
6. BENJAMIN GRAHAM
· “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”
· “margin of safety.”
· Graham’s definition of intrinsic value was “that value which is determined by the facts.” These facts included a company’s assets, its earnings and dividends, and any future definite prospects.
· There are two rules of investing, said Graham. The first rule is don’t lose. The second rule is don’t forget rule number one.
· The first approach was buying a company for less than two-thirds of its net asset value, and the second was focusing on stocks with low price-to-earnings (P/E) ratios.
· The basic ideas of investing are to look at stocks as businesses, use market fluctuations to your advantage, and seek a margin of safety. That’s what Ben Graham taught us. A hundred years from now they will still be the cornerstones of investing. -- WARREN BUFFETT, 1994
· Graham had taught Buffett the twofold significance of emotion in investing—the mistakes it triggers for those who base irrational decisions on it, and the opportunities it thus creates for those who can avoid falling into the same traps.
7. PHILIP FISHER
· Fisher came to believe that people could make superior profits by (1) investing in companies with above-average potential and (2) aligning themselves with the most capable management.
· As to the first—companies with above-average potential—the characteristic that most impressed Fisher was a company’s ability to grow sales over the years at rates greater than the industry average. That growth, in turn, usually was a combination of two factors: a significant commitment to research and development, and an effective sales organization.
· “All the sales growth in the world won’t produce the right type of investment vehicle if, over the years, profits do not grow correspondingly,” he said. Accordingly, Fisher examined a company’s profit margins, its dedication to maintaining and improving those margins and, finally, its cost analysis and accounting controls.
· No company, said Fisher, will be able to sustain its profitability unless it is able to break down the costs of doing business while simultaneously understanding the cost of each step in the manufacturing process.
· Fisher’s sensitivity about a company’s profitability was linked with another concern: a company’s ability to grow in the future without requiring equity financing. If a company is able to grow only by selling stocks, he said, the larger number of shares outstanding will cancel out any benefit that stockholders might realize from the company’s growth.
· Fisher taught Buffett the benefits of focusing on just a few investments. He believed that it was a mistake to teach investors that putting their eggs in several baskets reduces risk. The danger in purchasing too many stocks, he felt, is that it becomes impossible to watch all the eggs in all the baskets. In his view, buying shares in a company without taking the time to develop a thorough understanding of the business was far more risky than having limited diversification.
8. JOHN BURR WILLIAMS
The Theory of Investment Value, known today as the dividend discount model, or discounted net cash-flow analysis, provides a way to put a value on a stock or a bond. Like many important ideas, it can be reduced to a very simple precept: To know what a security is worth today, estimate all the cash it will earn over its lifetime and then discount that total back to a present value.
Buffett condensed Williams’s theory as: “The value of a business is determined by the net cash f lows expected to occur over the life of the business discounted at an appropriate interest rate.”
Williams’s model is a two-step process. First it measures cash flows to determine a company’s current and future worth. How to estimate cash flows? One quick measure is dividends paid to shareholders. For companies that do not distribute dividends, Williams believed that in theory all retained earnings should eventually turn into dividends.
The second step is to discount those estimated cash flows, to allow for some uncertainty. Buffett’s measuring stick is very straightforward: He uses either the interest rate for long term (meaning ten-year)
9. CHARLES MUNGER
10. First, the very nature of the textile business made high returns on equity improbable. Textiles are commodities and commodities by definition have a difficult time differentiating their products from those of competitors. Foreign competition, which employed a cheaper labor force, was squeezing profit margins. Second, to stay competitive, the textile mills would require significant capital improvements—a prospect that is frightening in an inflationary environment and disastrous if the business returns are anemic.
11. Insurance companies sell a product that is indistinguishable from those of competitors. Policies are standardized and can be copied by anyone. There are no trademarks, no patents, no advantages in location or raw materials. It is easy to get licensed and insurance rates are an open book. Insurance, in other words, is a commodity product.
In a commodity business, a common way to gain market share is to cut prices. In periods of intense competition, other companies were willing to sell insurance policies below the cost of doing business rather than risk losing market share. Buffett held firm:
Unwilling to compete on price, Buffett instead seeks to distinguish
12. Buying stocks means buying a business and requires the same discipline. In fact, it has always been Buffett’s preference to directly own a company, for it permits him to influence what he considers the most critical issue in a business: capital allocation. But when stocks represent a better value, his choice is to own a portion of a company by purchasing its common stock.
13. In either case, Buffett follows the same strategy: He looks for companies he understands, with consistent earnings history and favorable long-term prospects, showing good return on equity with little debt, that are operated by honest and competent people, and, importantly, are available at attractive prices. This owner-oriented way of looking at potential investments is bedrock to Buffett’s approach.
His criteria are straightforward: a simple, understandable business with consistent earning power, good return on equity, little debt, and good management in place. He is interested in companies in the $5 billion to $20 billion range, the larger the better. He is not interested in turnarounds, hostile takeovers, or tentative situations where no asking price has been determined.
Buffett is often asked what types of companies he will purchase in the future. First, he says, I will avoid commodity businesses and managers that I have little confidence in. He has three touchstones: It must be the type of company that he understands, possessing good economics, and run by trustworthy managers. That’s also what he looks for in stocks— and for the same reasons.
It is one of Buffett’s most strongly held beliefs: It makes no sense to invest in a company or an industry you don’t understand, because you won’t be able to figure out what it’s worth or to track what it’s doing.
In the summation of The Intelligent Investor, Benjamin Graham wrote, “Investing is most intelligent when it is most businesslike.” Those are, says Buffett, “the nine most important words ever written about investing.” “I am a better investor because I am a businessman,” Buffett says, “and a better businessman because I am an investor.”
14. THE
Business Tenets
1. Is the business simple and understandable?
2. Does the business have a consistent operating history?
3. Does the business have favorable long-term prospects?
Management Tenets
4. Is management rational?
5. Is management candid with its shareholders?
6. Does management resist the institutional imperative?
Financial Tenets
7. What is the return on equity?
8. What are the company’s “owner earnings”?
9. What are the profit margins?
10. Has the company created at least one dollar of market value for every dollar retained?
Value Tenets
11. What is the value of the company?
12. Can it be purchased at a significant discount to its value?
“When investing,” he says, “we view ourselves as business analysts—not as market analysts, not as macroeconomic analysts, and not even as security analysts.”
15. 1. Is the business simple and understandable?
Buffett is able to maintain a high level of knowledge about
Investment success is not a matter of how much you know but how realistically you define what you don’t know. “An investor needs to do very few things right as long as he or she avoids big mistakes.”
Benjamin Moore is a classic example of a company that has turned a commodity into a franchise. Buffett’s definition of a franchise is one where the product is needed or desired, has no close substitute, and is unregulated. Most people in the building industry would agree that
16. 2. Does the business have a consistent operating history?
Warren Buffett cares very little for stocks that are “hot” at any given moment. He is far more interested in buying into companies that he believes will be successful and profitable for the long term.
As long, that is, as nothing major changes. Buffett avoids purchasing companies that are fundamentally changing direction because their previous plans were unsuccessful.
“Severe change and exceptional returns usually don’t mix.”
For some unexplained reason, says Buffett, these investors are so infatuated with the notion of what tomorrow may bring that they ignore today’s business reality. In contrast, Buffett says, his approach is “very much profiting from lack of change. That’s the kind of business I like.”
Buffett also tends to avoid businesses that are solving difficult problems. Experience has taught him that turnarounds seldom turn. It can be more profitable to expend energy purchasing good businesses at reasonable prices than difficult businesses at cheaper prices.
17. 3. Does the business have favorable long-term prospects?
According to Buffett, the economic world is divided into a small group of franchises and a much larger group of commodity businesses, most of which are not worth purchasing. He defines a franchise as a company whose product or service (1) is needed or desired, (2) has no close substitute, and (3) is not regulated.
The bigger the moat, the more sustainable, the better he likes it. “The key to investing, is determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”
A franchise that is the only source of a product people want can regularly increase prices without fear of losing market share or unit volume. Often a franchise can raise its prices even when demand is flat and capacity is not fully utilized. This pricing flexibility is one of the defining characteristics of a franchise; it allows franchises to earn above average returns on invested capital.
Another defining characteristic is that franchises possess a greater amount of economic goodwill, which enables them to better withstand the effects of inflation. Another is the ability to survive economic mishaps and still endure. In Buffett’s succinct phrase, “The definition of a great company is one that will be great for 25 to 30 years.”
Conversely, a commodity business offers a product that is virtually indistinguishable from the products of its competitors. Years ago, basic commodities included oil, gas, chemicals, wheat, copper, lumber, and orange juice. Today, computers, automobiles, airline service, banking, and insurance have become commodity-type products.
Commodity businesses, generally, are low-returning businesses and “prime candidates for profit trouble.” The most dependable way to make a commodity business profitable, then, is to be the low cost provider.
The only other time commodity businesses turn a profit is during periods of tight supply—a factor that can be extremely difficult to predict. In fact, a key to determining the long-term profitability of a commodity business, Buffett notes, is the ratio of “supply-tight to supply-ample years.” This ratio, however, is often fractional.
“The economics of a dominant newspaper,” Buffett once wrote, “are excellent, among the very best in the world.” Demand for bricks is tied to housing starts and, therefore, subject to changes in interest rates and in the overall economy. Even a run of bad weather can affect sales.
Because long-distance shipping costs are prohibitive, bricks tend to be a regional product.
18. 4. Is management rational?
The most important management act, Buffett believes, is allocation of the company’s capital. It is the most important because allocation of capital, over time, determines shareholder value. Deciding what to do with the company’s earnings—reinvest in the business, or return money to shareholders—is, in Buffett’s mind, an exercise in logic and rationality.
If the extra cash, reinvested internally, can produce an above-average return on equity—a return that is higher than the cost of capital—then the company should retain all its earnings and reinvest them.
A company that provides average or below-average investment returns but generates cash in excess of its needs has three options: (1) It can ignore the problem and continue to reinvest at below-average rates, (2) it can buy growth, or (3) it can return the money to shareholders.
If a company continually ignores this problem, cash will become an increasingly idle resource and the stock price will decline. A company with poor economic returns, a lot of cash, and a low stock price will attract corporate raiders, which often is the beginning of the end of current management tenure.
Announcing acquisition plans excites shareholders and dissuades corporate raiders. However, Buffett is skeptical of companies that need to buy growth. For one thing, it often comes at an overvalued price. For another, a company that must integrate and manage a new business is apt to make mistakes that could be costly to shareholders.
In Buffett’s mind, the only reasonable and responsible course for companies that have a growing pile of cash that cannot be reinvested at above-average rates is to return that money to the shareholders. For that, two methods are available: raising the dividend or buying back shares.
With cash in hand from their dividends, shareholders have the opportunity to look elsewhere for higher returns. It is a good deal only if investors can get more for their cash than the company could generate if it retained the earnings and reinvested in the company.
When management repurchases stock, Buffett feels that the reward is twofold. If the stock is selling below its intrinsic value, then purchasing shares makes good business sense. If a company’s stock price is $50 and its intrinsic value is $100, then each time management buys its stock, they are acquiring $2 of intrinsic value for every $1 spent. Such transactions can be highly profitable for the remaining shareholders.Furthermore, says Buffett, when executives actively buy the company’s stock in the market, they are demonstrating that they have the best interests of their owners at hand rather than a careless need to expand the corporate structure. That kind of stance sends good signals to the market, attracting other investors looking for a well-managed company that increases shareholders’ wealth. Frequently, shareholders are rewarded twice; first from the initial open market purchase and then subsequently from the positive effect of investor interest on price.
Buffett believes that management’s most important act is the allocation of capital and that this allocation, over time, will determine shareholder value. In Buffett’s mind, the issue is simple: If extra cash can be reinvested internally and produce a return higher than the cost of capital, then the company should retain its earnings and reinvest them, which is exactly what Shaw did.
He looks for a business that “has competitive barriers, does not require extensive capital expenditures, and has reasonable pricing power.” Furthermore, he notes, “we have a strong preference for businesses we know” and given the choice, “we’re more likely to invest in a handful of big bets rather than spread our investment dollars around thinly.”
19. 5. Is management candid with its shareholders?
Buffett holds in high regard managers who report their companies’ financial performance fully and genuinely, who admit mistakes as well as share successes, and who are in all ways candid with shareholders. In particular, he respects managers who are able to communicate the performance of their company without hiding behind Generally Accepted Accounting Principles (GAAP).
“What needs to be reported,” Buffett insists, “is data—whether GAAP, non-GAAP, or extra GAAP—that helps the financially literate readers answer three key questions: (1) Approximately how much is this company worth? (2) what is the likelihood that it can meet its future obligations? and (3) how good a job are its managers doing, given the hand they have been dealt?”
He also admires those with the courage to discuss failure openly. He believes that managers who confess mistakes publicly are more likely to correct them. According to Buffett, most annual reports are a sham. Over time, every company makes mistakes, both large and inconsequential. Too many managers, he believes, report with excess optimism instead of honest explanation, serving perhaps their own interests in the short term but no one’s interests in the long run.
“The CEO who misleads others in public, may eventually mislead himself in private.”
20. 6. Does management resist the institutional imperative?
“the institutional imperative”—the lemming like tendency of corporate management to imitate the behavior of other managers, no matter how silly or irrational that behavior may be.
Buffett believes that the institutional imperative is responsible for several serious, but distressingly common, conditions: “(1) [The organization] resists any change in its current direction; (2) just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) any business craving of the leader, however foolish, will quickly be supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) the behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.”
What is behind the institutional imperative that drives so many businesses? Human nature. Most managers are unwilling to look foolish and expose their company to an embarrassing quarterly loss when other “lemming” companies are still able to produce quarterly gains, even though they assuredly are heading into the sea.
Inability to resist the institutional imperative often has less to do with the owners of the company than the willingness of its managers to accept fundamental change.
Buffett isolates three factors he feels most influence management’s behavior. First, most managers cannot control their lust for activity. Such hyperactivity often finds its outlet in business takeovers. Second, most managers are constantly comparing the sales, earnings, and executive compensation of their business with other companies in and beyond their industry. These comparisons invariably invite corporate hyperactivity. Lastly, Buffett believes that most managers have an exaggerated sense of their own management capabilities.
Another common problem is poor capital allocation skills. As Buffett points out, CEOs often rise to their position by excelling in other areas of the company, including administration, engineering, marketing, or production. Because they have little experience in allocating capital, most CEOs instead turn to their staff members, consultants, or investment bankers. Here the institutional imperative begins to enter the decision-making process.
The final justification for the institutional imperative is mindless imitation. If companies A, B, and C are all doing the same thing, well then, reasons the CEO of company D, it must be all right for our company to behave the same way.
In evaluating people, you look for three qualities: integrity, intelligence, and energy. If you don’t have the first, the other two will kill you. -- WARREN BUFFETT, 1993
In addition to these lofty salaries, executives of publicly traded companies are customarily rewarded with fixed-price stock options, often tied to corporate earnings but very seldom tied to the executive’s actual job performance. This goes against the grain for Buffett.
Even when stock options are treated as a legitimate aspect of executive compensation, Buffett cautions us to watch how they are accounted for on a company’s balance sheet. He believes they should be considered an expense so that their effect on reported earnings is clear. This seems so obvious as to be unarguable; sadly, not all companies see it this way.
Warren Buffett gives us some valuable tips:
• “Beware of companies displaying weak accounting.” In particular, he cautions us to watch out for companies that do not expense stock options. It’s an obvious red f lag that other less obvious maneuvers are also present.
• Another red f lag: “unintelligible footnotes.” If you can’t understand them, he says, don’t assume it’s your shortcoming; it’s a favored tool for hiding something management doesn’t want you to know.
• “Be suspicious of companies that trumpet earnings projections and growth expectations.” No one can know the future, and any CEO who claims to do so is not worthy of your trust.
21. 7. What is the return on equity?
Buffett considers earnings per share a smoke screen. Since most companies retain a portion of their previous year’s earnings to increase their equity base, he sees no reason to get excited about record earnings per share. There is nothing spectacular about a company that increases earnings per share by 10 percent if at the same time it is growing its equity base by 10 percent. That’s no different, he explains, from putting money in a savings account and letting the interest accumulate and compound.
To measure a company’s annual performance, Buffett prefers return on equity—the ratio of operating earnings to shareholders’ equity.
To use this ratio, though, we need to make several adjustments.
First, all marketable securities should be valued at cost and not at market value, because values in the stock market as a whole can greatly influence the returns on shareholders’ equity in a particular company.
Second, we must also control the effects that unusual items may have on the numerator of this ratio. Buffett excludes all capital gains and losses as well as any extraordinary items that may increase or decrease operating earnings. He wants to know how well management accomplishes its task of generating a return on the operations of the business given the capital it employs.
Furthermore, Buffett believes that a business should achieve good returns on equity while employing little or no debt. We know that companies can increase their return on equity by increasing their debt-to-equity ratio. “Good business or investment decisions,” he says, “will produce quite satisfactory economic results with no aid from leverage.”Furthermore, highly leveraged companies are vulnerable during economic slowdowns.
22. 8. What are the company’s “owner earnings”?
Instead of cash f ow, 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. It is not a mathematically precise measure for the simple reason that calculating future capital expenditures often requires rough estimates.
Cash flow is an appropriate way to measure businesses that have large investments in the beginning and smaller outlays later on, such as real estate, gas fields, and cable companies. On the other hand, companies that require ongoing capital expenditures, such as manufacturers, are not accurately valued using only cash f low.
A company’s cash flow is customarily defined as net income after taxes plus depreciation, depletion, amortization, and other non-cash charges. The problem with this definition, Buffett explains, is that it leaves out a critical economic fact: capital expenditures. approximately 95 percent of
Popularity of cash-flow numbers heightened during the leveraged buyout period of the 1980s because the exorbitant prices paid for businesses were justified by a company’s cash f low. Buffett believes that cash-f low numbers “are frequently used by marketers of business and securities to justify the unjustifiable and thereby sell what should be unsalable. When earnings look inadequate to service debt of a junk bond or justify a foolish stock price, how convenient it becomes to focus on cash f low.” But you cannot focus on cash flow, Buffett cautions, unless you are willing to subtract the necessary capital expenditures.
23. 9. What are the profit margins?
Buffett has little patience for managers who allow costs to escalate. Frequently these same managers have to initiate a restructuring program to bring down costs in line with sales. Each time a company announces a cost-cutting program, he knows this company has not figured out what expenses can do to a company’s owners. “The really good manager,” Buffett says, “does not wake up in the morning and say, ‘This is the day I’m going to cut costs,’ any more than he wakes up and decides to practice breathing.” Good Manager “abhor having a bigger head count than is needed,” he says, “and ‘Attack costs as vigorously when profits are at record levels as when they are under pressure.’ ”
24. 10. Has the company created at least one dollar of market
Buffett’s goal is to select companies in which each dollar of retained earnings is translated into at least one dollar of market value. If retained earnings are invested in the company and produce above-average return, the proof will be a proportionally greater rise in the company’s market value.
Although the stock market will track business value reasonably well over long periods, in any one year, prices can gyrate widely for reasons other than value. The same is true for retained earnings, Buffett explains. If a company uses retained earnings unproductively over an extended period, eventually the market, justifiably, will price its shares disappointingly. Conversely, if a company has been able to achieve above-average returns on augmented capital, the increased stock price will reflect that success.
25. 11. What is the value of the company?
The increased market value should at the very least match the amount of retained earnings, dollar for dollar. If the value goes higher than the retained earnings, so much the better. All in all, it is our job to select a business with economic characteristics allowing each dollar of retained earnings to be translated into at least a dollar of market value.
It’s bad to go to bed at night thinking about the price of a stock. We think about the value and company results; The stock market is there to serve you, not instruct you. -- WARREN BUFFETT, 2003
“Price is what you pay. Value is what you get.”
In sum, then, rational investing has two components:
1. Determine the value of the business.
2. Buy only when the price is right—when the business is selling at a significant discount to its value
Paraphrasing John Burr Williams, Buffett tells us that the value of a business is the total of the net cash flows (owner earnings) expected to occur over the life of the business, discounted by an appropriate interest rate. He considers it simply the most appropriate yardstick with which to measure a basket of different investment types: government bonds, corporate bonds, common stocks, apartment buildings, oil wells, and farms.
The mathematical exercise, Buffett tells us, is similar to valuing a bond. The bond market each day adds up the future coupons of a bond and discounts those coupons at the prevailing interest rate; that determines the value of the bond. To determine the value of a business, the investor estimates the “coupons” that the business will generate for a period into the future and then discounts all these coupons back to the present.
Buffett is firm on one point: He looks for companies whose future earnings are as predictable, as certain, as the earnings of bonds. If the company has operated with consistent earnings power and if the business is simple and understandable, Buffett believes he can determine its future earnings with a high degree of certainty. If he is unable to project with confidence what the future cash f lows of a business will be, he will not attempt to value the company. He’ll simply pass.
To properly value a business, you should ideally take all the f lows of money that will be distributed between now and judgment day and discount them at an appropriate discount rate. That’s what valuing businesses is all about. Part of the equation is how confident you can be about those cash f lows occurring. Some businesses are easier to predict than others. We try to look at businesses that are predictable.
What is the appropriate discount rate? Buffett’s answer is simple: the rate that would be considered risk-free. For many years, he used the rate then current for long-term government bonds.
When interest rates are low, Buffett adjusts the discount rate upward. When bond yields dipped below 7 percent, Buffett upped his discount rate to 10 percent, and that is what he commonly uses today. If interest rates work themselves higher over time, he has successfully matched his discount rate to the long-term rate. If they do not, he has increased his margin of safety by three additional points.
When a company is able to grow owner earnings without additional capital, it is appropriate to discount owner earnings by the difference between the risk-free rate of return and the expected growth of owner earnings. When this occurs, analysts use a two-stage discount model. This model is a way of calculating future earnings when a company has extraordinary growth for a certain number of years and then a period of constant growth at a slower rate.
26. 12. Can it be purchased at a significant discount to its value?
Great investment opportunities come around when excellent companies are surrounded by unusual circumstances that cause the stock to be misappraised. -- WARREN BUFFETT, 1988
The margin-of-safety principle assists Buffett in two ways. First, it protects him from downside price risk. If he calculates that the value of a business is only slightly higher than its per share price, he will not buy the stock. He reasons that if the company’s intrinsic value were to dip even slightly, eventually the stock price would also drop, perhaps below what he paid for it. But when the margin between price and value is large enough, the risk of declining value is less. If Buffett is able to purchase a company at 75 percent of its intrinsic value (a 25 percent discount) and the value subsequently declines by 10 percent, his original purchase price will still yield an adequate return.
The margin of safety also provides opportunities for extraordinary stock returns. If Buffett correctly identifies a company with above average economic returns, the value of its stock over the long term will steadily march upward. If a company consistently earns 15 percent on equity, its share price will appreciate more each year than that of a company that earns 10 percent on equity. Additionally, if Buffett, by using the margin of safety, is able to buy this outstanding business at a significant discount to its intrinsic value,
27. When we look inside these fixed-income transactions, what we see looks familiar, for Buffett has displayed the same approach that he takes with investments in stocks. He looks for margin of safety, commitment, and low prices (bargains). He insists on strong and honest management, good allocation of capital, and a potential for profit. His decisions do not depend on hot trends or market-timing factors but instead are savvy investments based on specific opportunities where Buffett believes there are undervalued assets or securities.
28. Arbitrage, in its simplest form, involves purchasing a security in one market and simultaneously selling the same security in another market. The object is to profit from price discrepancies. Because this transaction involves no risk, it is appropriately called riskless arbitrage.
Risk arbitrage, on the other hand, is the sale or purchase of a security in hopes of profiting from some announced value. The most common type of risk arbitrage involves the purchase of a stock at a discount to some future value. This future value is usually based on a corporate merger, liquidation, tender offer, or reorganization. The risk an arbitrageur confronts is that the future announced price of the stock may not be realized.
To evaluate risk arbitrage opportunities, explains Buffett, you must answer four basic questions. “How likely is it that the promised event will indeed occur? How long will your money be tied up? What chance is there that something better will transpire—a competing takeover bid, for example? What will happen if the event does not take place because of antitrust action, financing glitches, etc.?”
Nowadays, however, he does not engage in arbitrage on a large scale but rather keeps his excess cash in Treasuries and other short-term liquid investments. Sometimes Buffett holds medium-term, tax-exempt bonds as cash alternatives. He realizes that by substituting medium-term bonds for short-term Treasury bills, he runs the risk of principal loss if he is forced to sell at disadvantageous time. But because these taxfree bonds offer higher aftertax returns than Treasury bills, Buffett figures that the potential loss is offset by the gain in income.
29. A convertible preferred stock is a hybrid security that possesses characteristics of both stocks and bonds. Generally, these stocks provide investors with higher current income than common stocks. This higher yield offers protection from downside price risk. If the common stock declines, the higher yield of the convertible preferred stock prevents it from falling as low as the common shares. In theory, the convertible stock will fall in price until its current yield approximates the value of a nonconvertible bond with a similar yield, credit, and maturity.
A convertible preferred stock also provides the investor with the opportunity to participate in the upside potential of the common shares. Since it is convertible into common shares, when the common rises, the convertible stock will rise as well. However, because the convertible stock provides high income and has the potential for capital gains, it is priced at a premium to the common stock. This premium is reflected in the rate at which the preferred is convertible into common shares. Typically, the conversion premium may be 20 percent to 30 percent. This means that the common must rise in price 20 to 30 percent before the convertible stock can be converted into common shares without losing value.
30. Focus investing means this: 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.
“We just focus on a few outstanding companies. We’re focus investors.” -- WARREN BUFFETT, 1994
31. THE FOCUS INVESTOR’S GOLDEN RULES
1. Concentrate your investments in outstanding companies run by strong management.
2. Limit yourself to the number of companies you can truly understand. Ten to twenty is good, more than twenty is asking for trouble.
3. Pick the very best of your good companies, and put the bulk of your investment there.
4. Think long-term: five to ten years, minimum.
5. Volatility happens. Carry on.
The separate elements in the process of focus investing:
32. “Find Outstanding Companies”
It rests on a notion of great common sense: If the company is doing well and is managed by smart people, eventually its stock price will reflect its inherent value. Buffett thus devotes most of his attention not to tracking share price but to analyzing the economics of the underlying business and assessing its management.
“If you are a know-something investor, able to understand business economics and to find five to ten sensibly priced companies that possess important long-term competitive advantages, conventional diversification ( broadly based active portfolios) makes no sense for you.”
If you are a know-nothing investor, stay with index funds.
33. “Less Is More”
What’s wrong with conventional diversification? For one thing, it greatly increases the chances that you will buy something you don’t know enough about.
For the average investor, ten to twenty stocks is enough for you the handle.
34. “Put Big Bets on High-Probability Events”
Phil Fisher’s influence on Buffett can also be seen in another way—his belief that the only reasonable course when you encounter a strong opportunity is to make a large investment. “With each investment you make, you should have the courage and the conviction to place at least ten percent of your net worth in that stock.”
I can’t be involved in 50 or 75 things. That’s a Noah’s
35. “Be Patient”
Focus investing is the antithesis of a broadly diversified high-turnover approach. Although focus investing stands the best chance among all active strategies of outperforming an index return over time, it requires investors to patiently hold their portfolio even when it appears that other strategies are winning. As a general rule of thumb, we should aim for a turnover rate between 20 and 10 percent, which means holding the stock for somewhere between five and ten years.
36. “Don’t Panic over Price Changes”
There can be no doubt, however, that the ride is bumpy, for price volatility is a necessary by-product of the focus approach. Focus investors tolerate the bumpiness because they know that in the long run the underlying economics of the companies will more than compensate for any short-term price fluctuations. “I knew I could handle the bumps psychologically, because I was raised by people who believe in handling bumps.”
37. Modern portfolio theory (wrong)
It is a combination of three seminal ideas about finance from three powerful minds
Markowitz concluded that investment risk is not a function of how much the price of any individual stock changes, but how much a group of stocks changes in the same direction. If they do so, there is a good chance that economic shifts will drive them all down at the same time. The only reasonable protection, he said, was diversification.
Bill Sharpe developed a mathematical process for measuring volatility that simplified Markowitz’s approach He called it the Capital Asset Pricing Model.
A third piece—the efficient market theory (EMT)—came from a young assistant professor of finance at the
In modern portfolio theory, the volatility of the share price defines risk. But throughout his career, Buffett has always perceived a drop in share prices as an opportunity to make money. In his mind, then, a dip in price actually reduces risk. He points out, “For owners of a business—and that’s the way we think of shareholders—the academics’ definition of risk is far off the mark, so much so that it produces absurdities.”
38. Buffett’s View of Risk
Buffett has a different definition of risk: the possibility of harm. And that is a factor of the intrinsic value of the business, not the price behavior of the stock. Financial harm comes from misjudging the future profits of the business, plus the uncontrollable, unpredictable effect of taxes and inflation.
Buffett sees risk as inextricably linked to an investor’s time horizon. If you buy a stock today, he explains, with the intention of selling it tomorrow, then you have entered into a risky transaction. The odds of predicting whether share prices will be up or down in a short period are the same as the odds of predicting the toss of a coin; you will lose half of the time. However, says Buffett, if you extend your time horizon out to several years (always assuming that you have made a sensible purchase), then the odds shift meaningfully in your favor.
39. Buffett’s View of Diversification
“We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort level he must feel with its economic characteristics before buying into it.”By purposely focusing on just a few select companies, you are better able to study them closely and understand their intrinsic value. The more knowledge you have about your company, the less risk you are likely taking.
“Diversification serves as protection against ignorance,” explains Buffett. “If you want to make sure that nothing bad happens to you relative to the market, you should own everything. There is nothing wrong with that. It’s a perfectly sound approach for somebody who doesn’t know how to analyze businesses.”
40. Buffett’s View of the Efficient Market Theory
Buffett’s problem with the EMT rests on a central point: It makes no provision for investors who analyze all the available information, as Buffett urges them to do, which gives them a competitive advantage.
Bill Ruane’s point of view is in many ways unique among money managers. Generally speaking, most managers begin with some preconceived notion about portfolio management and then fill in the portfolio with various stocks. At Ruane, Cuniff & Company, the partners begin with the idea of selecting the best possible stocks and then let the portfolio form around these selections.
Lou Simpson focuses his portfolio on only a few stocks. GEICO’s billion-dollar equity portfolio customarily owns fewer than ten stocks.
It is important to note that the focus strategy sometimes means enduring several weak years. Even the super-investors — undeniably skilled, undeniably successful—faced periods of short-term underperformance.
41. When Buffett considers adding an investment, he first looks at what he already owns to see whether the new purchase is any better. “What Buffett is saying is something very useful to practically any investor,” Charlie Munger stresses. “For an ordinary individual, the best thing you already have should be your measuring stick.” What happens next is one of the most critical but widely overlooked secrets to increasing the value of your portfolio. “If the new thing you are considering purchasing is not better than what you already know is available,” says Charlie, “then it hasn’t met your threshold. This screens out 99 percent of what you see.”
42. Focus investing is necessarily a long-term approach to investing. If we were to ask Buffett what he considers an ideal holding period, he would answer “forever”—so long as the company continues to generate above average economics and management allocates the earnings of the company in a rational manner. “Inactivity strikes us as intelligent behavior,” he explains
1. It works to reduce transaction costs. This is one of those common sense dynamics that is so obvious it is easily overlooked. Every time you buy or sell, you trigger brokerage costs that lower your net returns.
2. It increases after tax returns. When you sell a stock at a profit, you will be hit with capital gain taxes, eating into your profit. It is what Buffett calls an “interest-free loan from the Treasury.”
The best strategy for achieving high after-tax returns is to keep your average portfolio turnover ratio somewhere between 0 and 20 percent. Two strategies lend themselves best to low turnover rates. One is to stick with an index mutual fund; they are low turnover by definition. Those who prefer a more active style of investing will turn to the second strategy: a focus portfolio.
43. Two factors are involved: First, in very recent years, Buffett hasn’t found very many stocks that meet his price criteria. That’s a problem of the market. Second, when you’re driving a $100 billion company, it takes a significant level of economic return to move the needle. That’s a problem of size.
44. An unavoidable consequence of the focus investing approach is heightened volatility. When your portfolio is focused on just a few companies, a price change in any one of them is all the more noticeable and has greater overall impact. The ability to withstand that volatility without undue second guessing is crucial to your peace of mind, and ultimately to your financial success.
45. Anyone who hopes to participate profitably in the market, therefore, must allow for the impact of emotion. It is a two-sided issue: keeping your own emotional profile under control as much as possible and being alert for those times when other investors’ emotion-driven decisions present you with a golden opportunity.
46. Success in investing doesn’t correlate with IQ once you’re above the level of 125. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing. -- WARREN BUFFETT
47. Investors have the following characteristics:
• True investors are calm. They know that as long as the company retains the qualities that attracted them as investors in the first place, the price will come back up. In the meantime, they do not panic. True investors don’t worry about missing the party; they worry about coming to the party unprepared.
• True investors are patient. Instead of being swept along in the enthusiasm of the crowd, true investors wait for the right opportunity. They say no more often than yes.
We don’t have to be smarter than the rest; we have to be more disciplined than the rest. -- WARREN BUFFETT, 2002
• True investors are rational. They approach the market, and the world, from a base of clear thinking. They are neither unduly pessimistic nor irrationally optimistic; they are, instead, logical and rational.
48. In Buffett’s view, true investors are pleased when the rest of the world turns pessimistic, because they see it for what it really is: a perfect time to buy good companies at bargain prices. Pessimism, he says, is “the most common cause of low prices. . . . We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer.”
“We simply attempt,” he explains, “to be fearful when others are greedy and to be greedy only when others are fearful.”
To be successful, investors need good business judgment and the ability to protect themselves from the emotional whirlwind that Mr.Market unleashes. One is insufficient without the other.
49. Behavioral finance is now an accepted area of study in the economics department at major universities.
50. Overconfidence
51. Overreaction Bias
People put too much emphasis on a few chance events, thinking they spot a trend. In particular, investors tend to fix on the most recent information they received and extrapolate from it; the last earnings report thus becomes in their mind a signal of future earnings. Then, believing that they see what others do not, they make quick decisions from superficial reasoning.
The behaviorists have learned that people tend to overreact to bad news and react slowly to good news. Psychologists call this overreaction bias. Thus if the short-term earnings report is not good, the typical investor response is an abrupt, ill-considered overreaction, with its inevitable effect on stock prices.
52. asymmetrical loss aversion
The pain of a loss is far greater than the enjoyment of a gain. People need twice as much positive to overcome a negative. Applied to the stock market, it means that investors feel twice as bad about losing money as they feel good about picking a winner.
This aversion to loss makes investors unduly conservative, at great cost. We all want to believe we made good decisions, so we hold onto bad choices far too long in the vague hope that things will turn around. By not selling our losers, we never have to confront our failures. But if you don’t sell a mistake, you are potentially giving up a gain that you could earn by reinvesting smartly.
53. Mental Accounting
It refers to our habit of shifting our perspective on money as surrounding circumstances change. We tend to mentally put money into different “accounts,” and that determines how we think about using it. Like re-found the lost money, or 30 percent gain during winning and losing time.
Risk Tolerance
By using interviews and questionnaires, investment professionals could construct a risk profile for each investor. The trouble is, people’s tolerance for risk is founded in emotion, and that means it changes with changing circumstances. When the market declines drastically, even those with an aggressive profile will become very cautious. In a booming market, supposedly conservative investors add more stocks just as quickly as aggressive investors do.
Looking at personality factors, we learned that the investor with a high degree of risk tolerance will be someone who sets goals and believes he or she has control of the environment and can affect its outcome. This person sees the stock market as a contingency dilemma in which information combined with rational choices will produce winning results.
54. For investors, the implications of behavioral finance are clear: How we decide to invest, and how we choose to manage those investments, has a great deal to do with how we think about money. Mental accounting has been suggested as a further reason people don’t sell stocks that are doing badly: In their minds, the loss doesn’t become real until they act on it. Another powerful connection has to do with risk. We are far more likely to take risks with found money. On a broader scale, mental accounting emphasizes one weakness of the efficient market hypothesis: It demonstrates that market values are determined not solely by the aggregated information but also by how human beings process that information.
55. When Buffett invests, he sees a business. Most investors see only a stock price. They spend far too much time and effort watching, predicting, and anticipating price changes and far too little time understanding the business they are part owner of. Elementary as this may be, it is the root that distinguishes Buffett.
56. Often investors begin with an economic assumption and then go about selecting stocks that fit neatly within this grand design. Buffett considers this thinking to be foolish. First, no one has economic predictive powers any more than they have stock market predictive powers. Second, if you select stocks that will benefit by a particular economic environment, you inevitably invite turnover and speculation, as you continuously adjust your portfolio to benefit in the next economic scenario.
Step One: Turn off the Stock Market
Step Two: Don’t Worry about the Economy
Step Three: Buy a Business, Not a Stock
Step Four: Manage a Portfolio of Businesses
57. Now that you are managing a portfolio of businesses, many things begin to change. First, you are less likely to sell your best businesses just because they are returning a profit. Second, you will pick new businesses for purchase with much greater care. You will resist the temptation to purchase a marginal company just because you have cash reserves. If the company does not pass your tenet screen, don’t purchase it. Be patient and wait for the right business. It is wrong to assume that if you’re not buying and selling, you’re not making progress. In Buffett’s mind, it is too difficult to make hundreds of smart decisions in a lifetime. He would rather position his portfolio so he only has to make a few smart decisions.
The driving force of Warren Buffett’s investment strategy is the rational allocation of capital. Determining how to allocate a company’s earnings is the most important decision a manager will make. Rationality—displaying rational thinking when making that choice—is the quality Buffett most admires.
58. Michael Mauboussin’s finding of good fund managers:
1. Portfolio turnover. As a whole, the market-beating mutual funds had an average turnover ratio of about 30 percent. This stands in stark contrast to the turnover for all equity funds—110 percent.
2. Portfolio concentration. The long-term outperformers tend to have higher portfolio concentration than the index or other general equity funds. On average, the outperforming mutual funds placed 37 percent of their assets in their top ten names.
3. Investment style. The vast majority of the above-market performers espoused an intrinsic-value approach to selecting stocks.
4. Geographic location. Only a small fraction of the outperformers hail from the East Coast financial centers,
59. “That the S&P 500 has also beaten other active money managers is not an argument against active money management,” said Bill Miller; “it is an argument against the methods employed by most active money managers.”
