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Issue VI

January 1996


Sharp Investing


Playing Monopoly for Keeps

Did you know that there is an investor with the potential for owning every stock in the world within the next 25 years? Warren Buffett, worth nearly 16 billion dollars, has compounded money at 30% per year for 40 years. Continuing that track record for another 25 years would yield an astonishing 11.3 trillion dollars, more than the current value (7 trillion) of the world stock market.
Of course, this idea is ridiculous but illustrates the incredible success of the world's best investor. Warren Buffett is obviously a special person, gifted with a focused genius and the perfect mentality for long term investing. While few of us can hope to duplicate his record, a study of what has made him successful may be useful in aiding the average investor to claim their own modest successes. A good place to start is with two recent books on Mr. Buffett. The Warren Buffett Way (Robert Hagstrom Jr.) and Buffett-The Making of An American Capitalist (Roger Lowenstein), are both excellent looks into what makes Warren tick. The books each manage to cover different ground, the Hagstrom book gives more of a number crunching analysis of Buffett's investment style, while the Lowenstein book spends more time exploring Buffett's business network and management style.
In my humble opinion, there are seven main reasons for Buffett's investing success. In no particular order, they are:
1. Limiting investments to a handful of opportunities, rather than trying to own a piece of everything. As I have shown, owning 10 properly picked stocks reduces 98% of the diversifiable risk, the next 1000 stocks in a mutual fund reduce less risk than the 10th stock and are the fund manager's way of trying to own a piece of everything. In some years, Buffett owned as few as 3 major holdings. Currently he has about 8 major holdings. When asked why he didn't subscribe to traditional diversification, Buffett responded that diversification is for investors who don't know what they are doing. Indeed, if you think of owning stocks as owning a business, there aren't many business owners who buy additional businesses to diversify the risk of their main business. They certainly don't buy 1000 additional businesses.


2. Evaluating the probability of every potential investment and only biting when the odds are in his favor. You won't find Buffett shorting stocks, playing options, speculating on IPO's, or any of the popular strategies that are short on odds. He doesn't take on mediocre investments in order to be constantly participating in the markets. He encourages the management of each company he owns to look at each project under consideration and evaluate whether it has a greater than 50% chance to increase shareholder wealth.
3. Looking for growth of shareholder's wealth rather than buying traditional "growth" companies. Increasing shareholder wealth is the goal of all for-profit businesses. Growth of shareholder wealth is the ultimate measure of an excellent business. Buffett looks for investment opportunities that provide the highest odds of reaching that goal. Buffett studied under Benjamin Graham, and as a result uses fundamental analysis of businesses to ferret out undervalued investment opportunities. It is very rare that traditional "growth" companies become undervalued, and indeed there are 44 academic studies that conclude that traditional "value" investing provides much greater shareholder growth than traditional "growth" investing. Buffett takes value investing a step further however, and places much emphasis on the quality of the management of a particular business. For example, many U.S. businesses operate in dying industries because of overseas competition such as textiles and other types of manufacturing.


Most investors avoid these no-growth industries, but Buffett looks for undervalued companies that are purchasing back their own shares. This provides growth to their shareholders' wealth in a way that diminishing sales cannot. Most corporate management is more concerned with growing the size of the company rather than the size of the shareholder's wealth. Buffett buys businesses in which management understands their obligation to the owners.
4. Invests with the idea of owning businesses rather than "playing" the stock market. Buffett only buys businesses he understands completely, and indeed has had to step in and run various companies in which he has had a major interest. Imagine if you were asked to run any of the businesses in which you are invested. Buffett is probably the only investor that could run each of his investments. When Buffett decides to invest in a business, he does it with a very long term perspective. There is no buying and selling on a short term basis, and he could care less what the daily stock quote is on his business. He equates the stock market to an interested buyer that comes around each day to your storefront and offers you a price for your business. The price offered varies from day to day depending on the mood of the buyer. But just as most owners would pay no attention to the offers, Buffett pays no attention to stock quotes confident that the intrinsic value of his business will rise substantially by the time he wishes to sell his business.

In an extreme case, Buffett has been buying Geico Insurance for 40 years with no intention of selling. Buffett has had no concern for the stock price as it has appreciated over 160 fold in the last 20 years.

5. Makes decisions independent from Wall Street consensus. Lowenstein's book chronicles about a dozen times over the last 20 years when the financial press exclaimed that "Warren's really blown it this time". Hindsight provides us with the fact that Warren was right each and every time and Wall Street was wrong.

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Buffett has always exhibited a strong confidence in his business decisions, and unlike most human beings, does not need the comfort of consensus to be confident in his beliefs. He regards bear markets as buying opportunities as the rest of the investment community waits for the world to end.
Consider the other areas in which Buffett differs from his peers. He doesn't diversify, he doesn't reside in New York, he doesn't use computers. He eats his own cooking (he and his wife own a majority of his holding company, Berkshire Hathaway), he has personal relationships with the management of the businesses he invests in, his favorite holding period for an investment is forever. He cares nothing about money, he's lived in the same home for 40 years, and he has never, ever sold a single share of Berkshire Hathaway. And he never will.
6. Constantly monitoring the bottom line. One fact sums it up - Although Buffett employs thousands through the companies he owns, Berkshire Hathaway, the 17th largest corporation in America, has only 14 employees in the parent company. No large organizational structure, no opulent offices, no advisors, attorneys, marketing, or any other trappings befitting a Fortune 20 company. He pays himself a salary of $100,000

management tightly controls expenses as if they are spending their own money. This goes back to the idea that expenses come directly from the shareholders pocket, and one way to increase shareholder growth is to curb the growth of expenses. Minimizing expenses is such an ingrained principal that this multi-billionaire once spent time looking for change for a quarter in Manhattan rather than waste a quarter on a 10 cent public phone.
7. Not confusing activity with productivity. Most investment professionals feel that they must always be active in the market, buying and selling on an almost continual basis. Buffett has never felt this pressure, sometimes going years without buying anything (he sells investments even less frequently). Good ideas and good opportunities only come along once in a while. Buffett believes that markets are mostly efficient, but that there are occasional pockets of inefficiency that present the rare opportunity of a truly great investment. In fact, Buffett has said that most investors would be much better off if they had a ticket of decisions that could only be punched 20 times in an investment career.
Academians, such as Paul Samuelson and other economists and financial researchers, all publicly state that markets are efficient all the time. Yet, while avoiding traditional money managers, these investment intellectuals shoveled money hand over fist into Buffett's Berkshire Hathaway. Whether the discrepancy between what they practiced and what they preached was an elaborate ruse to keep other investors from discovering the Buffett magic, or was simply a way to save face in the intellectual investment world while growing rich in the real investment world, their faith in Buffett made them all extremely wealthy. Berkshire Hathaway, first purchased by Buffett in 1962 for under $8 per share, today trades for $32,700 per share.
So, how does all this help us? Obviously, there is only one Warren Buffett, and he does have advantages in terms of intellect, experience, and a huge network of business leaders. However, there are some basic lessons that anyone can capitalize on when looking at the Warren Buffett case study.
The first is value investing. Buffett points out that nine of his professional peers, direct disciples of Benjamin Graham and value investing, have long term superior records dating back to the mid-fifties. The odds of this occurring due to a "lucky event" are even less than that of finding a second person who's DNA matches OJ Simpson. Human nature being what it is, investors prefer to invest in companies with an outstanding history and bright expectations for the future because it is
comfortable and exciting and goes with the consensus. To invest in companies with a depressed stock price is uncomfortable and requires the investor to leave the consensus of the investing world. But the phenomenon of regression to the mean, as it applies to company economic performance, gives value investors a handsome reward for making the uncomfortable decisions. In terms of corporate profitability, all companies over time tend to regress toward an average level of profitability. That means that companies with superior returns tend to reduce to average returns over time (growth companies), and companies with sub-par returns tend to increase back to average returns over time. This gives the value investor a positive bias if they restrict investments to below average performers.
The genius of Buffett is in determining which companies have a depressed share price due to an overreaction to what later turns out to be a temporary problem. If you understand the playing field that gives you the best edge and then can choose investments with temporary problems you will have conquered the most difficult aspect of investing.
Finally, although there is no way to duplicate Buffett's methods from a few formulas, there are some major screens that he uses to search for a good investment. They are:

1. Average long term debt over last 5 years < 35%

2. Average Return on Equity over last 5 yrs > 20%

3. Average Gross Profit over last 5 years > 15%

4. $1 of retained earnings < $1 market value in the last 5 years (has management created more market value than they have kept in retained earnings?)

Just for fun I ran these screens through my stock database and found nine candidates that fit this criteria.
Coca Cola Mattel
Gillette Hanson PLC
Intel Abbott Laboratories
Pepsico Johnson & Johnson
Pfizer  

Of course, Buffett owns a huge chunk of Coca Cola and Gillette. All of these companies are consumer

products companies with the exception of Intel. I don't know that there is any significance to that fact but it is interesting. While most of these stocks are currently quite highly priced, in the event of a major correction they might provide an opportunity to pick up an excellent company at a discounted price. However, I would put more emphasis on the seven reasons listed for Buffett's success than in his particular stock screens.

Of course, the easiest way to profit from the Buffett bandwagon is to buy shares of Berkshire Hathaway. However, at $32,700 per share, it seems quite pricey at this point in time. But then again, that's what I thought at $15,000, and at $8000, and at $3000, and at $1200............ $$$
 
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