Buffett&#39 - AhlynewsInfo

Buffett&#39

Homepage
The Startup
Sign in Get started

Go to the profile of Manas J. Saloi
Manas J. Saloi
Product Manager @Directi

Highlights from The Essays of Warren Buffett

The book ‘The Essays of Warren Buffett: Lessons for Corporate America’ is a must read for anyone who wants to learn how one of the most celebrated money managers of last century operates. I read the 3rd edition and am sharing my favourite parts from the book here.

Golden rules of Investing

  • The most revolutionary investing ideas of the past thirty-five years were those called modern finance theory. This is an elaborate set of ideas that boil down to one simple and misleading practical implication: it is a waste of time to study individual investment opportunities. One of modern finance theory’s main tenets is modern portfolio theory. It says that you can eliminate the peculiar risk of any security by holding a diversified portfolio — that is, it formalizes the folk slogan “don’t put all your eggs in one basket.” The risk that is leftover is the only risk for which the investors would be compensated. This leftover risk can be measured by a simple mathematical term — called beta — that shows how volatile the security is compared to the market. Beta measures this volatility risk well for securities that trade on efficient markets, where information about publicly traded securities is swiftly and accurately incorporated into prices. In the modern finance story, efficient markets rule. Buffett thinks most markets are not purely efficient and that equating volatility with risk is a gross distortion.
  • As to concentration of the portfolio, Buffett reminds us that Keynes, who was not only a brilliant economist but also an astute investor, believed that an investor should put fairly large sums into two or three businesses he knows something about and whose management is trustworthy.
    Buffett jokes that calling someone who trades actively in the market an investor “is like calling someone who repeatedly engages in one-night stands a romantic.” Buffett instead thinks we should follow Mark Twain’s advice from Pudd’nhead Wilson “Put all your eggs in one basket — and watch that basket.”
  • Buffet learned the art of investing from Ben Graham who in a number of classic works, including The Intelligent Investor, introduced a character who lives on Wall Street, Mr. Market. He is your hypothetical business partner who is daily willing to buy your interest in a business or sell you his at at prevailing market prices. He is moody and the more manic-depressive he is, the greater the spread between price and value, and therefore the greater the investment opportunities he offers. Buffett reintroduces Mr. Market, emphasizing how valuable Graham’s allegory of the overall market is for disciplined investment knitting. Another leading prudential legacy from Graham is his margin-of-safety principle. This principle holds that one should not make an investment in a security unless there is a sufficient basis for believing that the price being paid is substantially lower than the value being delivered.
  • All true investing must be based on an assessment of the relationship between price and value. Strategies that do not employ this comparison of price and value do not amount to investing at all, but to speculation — the hope that price will rise, rather than the conviction that the price being paid is lower than the value being obtained.
  • The circle of competence principle is the third leg of the Graham/Buffett stool of intelligent investing, along with Mr. Market and the margin of safety. This common sense rule instructs investors to consider investments only concerning businesses they are capable of understanding with a modicum of effort.
  • Three suggestions for investors from Buffett: First, beware of companies displaying weak accounting. If a company still does not expense options, or if its pension assumptions are fanciful, watch out. Second, unintelligible footnotes usually indicate untrustworthy management. If you can’t understand a footnote or other managerial explanation, it’s usually because the CEO doesn’t want you to. Finally, be suspicious of companies that trumpet earnings projections and growth expectations.
  • What needs to be reported is data — whether GAAP, non-GAAP, or extra-GAAP — that helps 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?
  • On bonds: “The large numbers of corporations that failed in the early 1990s recession under crushing debt burdens to dispute academic research showing that higher interest rates on junk bonds more than compensated for their higher default rates.”
  • On “fallen angels” — bonds that were initially of investment grade but that were downgraded when the issuers fell on bad times:
    “A kind of bastardized fallen angel burst onto the investment scene in the 1980s — “junk bonds” that were far below investment-grade when issued. As the decade progressed, new offerings of manufactured junk became ever junkier and ultimately the predictable outcome occurred: Junk bonds lived up to their name. Thus, said the friendly salesmen, a diversified portfolio of junk bonds would produce greater net returns than would a portfolio of high-grade bonds. (Beware of past-performance “proofs” in finance: If history books were the key to riches, the Forbes 400 would consist of librarians). The manager of a fallen angel almost invariably yearned to regain investment-grade status and worked toward that goal. The junk-bond operator was usually an entirely different breed. Behaving much as a heroin user might, he devoted his energies not to finding a cure for his debt-ridden condition, but rather to finding another fix. Additionally, the fiduciary sensitivities of the executives managing the typical fallen angel were often, though not always, more finely developed than were those of the junk-bond-issuing financiopath.”
  • Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals. Should you choose, however, to construct your own portfolio, there are a few thoughts worth remembering: Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital. To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing, or emerging markets. You may, in fact, be better off knowing nothing of these. Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now.
    If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.
  • Bertrand Russell’s observation about life in general applies with unusual force in the financial world: “Most men would rather die than think. Many do.”
  • “Value is destroyed, not created, by any business that loses money over its lifetime, no matter how high its interim valuation may get. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life. Intrinsic value is an estimate rather than a precise figure.”
  • “You can gain some insight into the differences between book value and intrinsic value by looking at one form of investment, a college education. Think of the education’s cost as its “book value.” If this cost is to be accurate, it should include the earnings that were foregone by the student because he chose college rather than a job. For this exercise, we will ignore the important non-economic benefits of an education and focus strictly on its economic value. First, we must estimate the earnings that the graduate will receive over his lifetime and subtract from that figure an estimate of what he would have earned had he lacked his education. That gives us an excess earnings figure, which must then be discounted, at an appropriate interest rate, back to graduation day. The dollar result equals the intrinsic economic value of the education.
    Some graduates will find that the book value of their education exceeds its intrinsic value, which means that whoever paid for the education didn’t get his money’s worth. In other cases, the intrinsic value of an education will far exceed its book value, a result that proves capital was wisely deployed. In all cases, what is clear is that book value is meaningless as an indicator of intrinsic value.”
  • “We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen. Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8% and 17.4%. But, surprise — none of these blockbuster events made the slightest dent in Ben Graham’s investment principles. Nor did they render unsound the negotiated purchases of fine businesses at sensible prices. A different set of major shocks is sure to occur in the next 30 years. We will neither try to predict these nor to profit from them. If we can identify businesses similar to those we have purchased in the past, external surprises will have little effect on our long-term results.”
  • “People who expect to earn 10% annually from equities during this century — envisioning that 2% of that will come from dividends and 8% from price appreciation — are implicitly forecasting a level of about 24,000,000 on the Dow by 2100. Think about it”

How Buffett and Charlie Munger run Berkshire

  • Buffett and Berkshire avoid making predictions and tell their managers to do the same. They think it is a bad managerial habit that too often leads managers to make up their financial reports.
  • Buffett just gives a simple set of commands to his CEOs: to run their business as if (1) they are its sole owner, (2) it is the only asset they hold, and (3) they can never sell or merge it for a hundred years. This enables Berkshire CEOs to manage with a long-term horizon ahead of them, something alien to the CEOs of public companies whose short-term oriented shareholders obsess with meeting the latest quarterly earnings estimate. Short-term results matter, of course, but the Berkshire approach avoids any pressure to achieve them at the expense of strengthening long-term competitive advantages.
  • “When a problem exists, whether in personnel or in business operations, the time to act is now.”
  • Unlike many CEOs, who desire their company’s stock to trade at the highest possible prices in the market, Buffett prefers Berkshire stock to trade at or around its intrinsic value — neither materially higher nor lower. Such linkage means that business results during one period will benefit the people who owned the company during that period.
  • Stock splits are another common action in corporate America that Buffett points out disserve owner interests. Stock splits have three consequences: they increase transaction costs by promoting high share turnover; they attract shareholders with short-term, market-oriented views who unduly focus on stock market prices; and, as a result of both of those effects, they lead to prices that depart materially from intrinsic business value.
  • Intrinsic value: The discounted value of the cash that can be taken out of a business during its remaining life. Charlie and Berkshire are interested only in acquisitions that they believe will raise the per-share intrinsic value of Berkshire’s stock.
  • According to Buffett: Useful financial statements must enable a user to answer three basic questions about a business: approximately how much a company is worth, its likely ability to meet its future obligations, and how good a job its managers are doing in operating the business. Charlie and Buffett think that it is both deceptive and dangerous for CEOs to predict growth rates for their companies.
  • “At Berkshire, we try to be as logical about compensation as about capital allocation. For example, we compensate Ralph Schey based upon the results of Scott Fetzer rather than those of Berkshire. What could make more sense, since he’s responsible for one operation but not the other? A cash bonus or a stock option tied to the fortunes of Berkshire would provide totally capricious rewards to Ralph. He could, for example, be hitting home runs at Scott Fetzer while Charlie and I rang up
    mistakes at Berkshire, thereby negating his efforts many times over. Conversely, why should option profits or bonuses be heaped upon Ralph if good things are occurring in other parts of Berkshire but Scott Fetzer is lagging?”
  • “Charlie and I believe that a CEO must not delegate risk control. It’s simply too important. If Berkshire ever gets in trouble, it will be my fault. It will not be because of misjudgments made by a Risk Committee or Chief Risk Officer.”
  • “It has not been shareholders who have botched the operations of some of our country’s largest financial institutions. Yet they have borne the burden, with 90% or more of the value of their holdings wiped out in most cases of failure. The CEOs and directors of the failed companies, however, have largely gone unscathed. Their fortunes may have been diminished by the disasters they oversaw, but they still live in grand style. It is the behavior of these CEOs and directors that needs to be changed: If their institutions and the country are harmed by their recklessness, they should pay a heavy price-one not reimbursable by the companies”
  • “Audit committees should unequivocally put auditors on the spot, making them understand they will become liable for major monetary penalties if they don’t come forth with what they know or suspect.”
  • On why Berkshire bought Washing Post Company: “We bought all of our [Washington Post Company (“WPC”)] holdings in mid-1973 at a price of not more than one-fourth of the then per-share business value of the enterprise. Calculating the price/value ratio required no unusual insights. Most security analysts, media brokers, and media executives would have estimated WPC’s intrinsic business value at $400 to $500 million just as we did. And its $100 million stock market valuation was published daily for all to see. Our advantage was our attitude, that we had learned from Ben Graham, that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values.”
  • “Whenever Charlie and I buy common stocks for Berkshire’s insurance companies (leaving aside arbitrage purchases, discussed) we approach the transaction as if we were buying into a private business. We look at the economic prospects of the business, the people in charge of running it, and the price we must pay. We do not have in mind any time or price for sale. Indeed, we are willing to hold a stock indefinitely so long as we expect the business to increase in intrinsic value at a satisfactory rate. When investing, we view ourselves as business analysts — not as market analysts, not as macroeconomic analysts, and not even as security analysts.”
  • “Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Market appears daily and names a price at which he will either buy your interest or sell you his. Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market’s quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains.
    is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him. Rather an investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace. In my own efforts to stay insulated, I have found it highly useful to keep Ben’s Mr. Market concept firmly in mind. As Ben said: “In the short run, the market is a voting machine but in the long run it is a weighing machine.”
  • The speed at which a business’s success is recognized, furthermore, is not that important as long as the company’s intrinsic value is increasing at a satisfactory rate.
  • Buffett then explains why he is happy when the stock market is stagnant or goes down: “ A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? This question answers itself. Similarly If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the “hamburgers” they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.”
  • On arbitrage: “To evaluate arbitrage situations you must answer four questions: (1) How likely is it that the promised event will indeed occur? (2) How long will your money be tied up? (3) What chance is there that something still better will transpire — a competing takeover bid, for example? and (4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?
  • The preceding discussion about arbitrage makes a small discussion of “efficient market theory” (EMT) also seem relevant. This doctrine became highly fashionable — indeed, almost holy scripture — in academic circles during the 1970s. Essentially, it said that analyzing stocks was useless because all public information about them was appropriately reflected in their prices. In other words, the market always knew everything. As a corollary, the professors who taught EMT said that someone throwing darts at the stock tables could select a stock portfolio having prospects just as good as one selected by the brightest, most hard-working security analyst. We continue to think that it is usually foolish to part with an interest in a business that is both understandable and durably wonderful. Business interests of that kind are simply too hard to replace. The strategy we’ve adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. 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. In stating this opinion, we define risk, using dictionary terms, as “the possibility of loss or injury.” Academics, however, like to define investment “risk” differently, averring that it is the relative volatility of a stock or portfolio of stocks — that is, their volatility as compared to that of a large universe of stocks. Employing data bases and statistical skills, these academics compute with precision the “beta” of a stock — that shows how volatile the security is compared to the market. Beta measures this volatility risk well for securities that trade on efficient markets, where information about publicly traded securities is swiftly and accurately incorporated into prices. In our opinion, the real risk an investor must assess is whether his aggregate after-tax receipts from an investment (including those he receives on sale) will, over his prospective holding period, give him at least as much purchasing power as he had to begin with, plus a modest rate of interest on that initial stake. Though this risk cannot be calculated with engineering precision, it can in some cases be judged with a degree of accuracy that is useful. The primary factors bearing upon this evaluation are: (1) The certainty with which the long-term economic characteristics of the business can be evaluated; (2) The certainty with which management can be evaluated, both as to its ability to realise the full potential of the business and to wisely employ its cash flows; (3) The certainty with which management can be counted on to channel the reward from the business to the shareholders rather than to itself; (4) The purchase price of the business; (5) The levels of taxation and inflation that will be experienced and that will determine the degree by which an investor’s purchasing-power return is reduced from his gross return.
  • It is better to be approximately right than precisely wrong.
  • “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 makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices — the businesses he understands best and that present the least risk, along with the greatest profit potential. In the words of the prophet Mae West: “Too much of a good thing can be wonderful.”
  • “We continually search for large businesses with understandable, enduring and mouth-watering economics that are run by able and shareholder-oriented managements.”
  • “Our equity-investing strategy remains little changed from what it was when we said in the 1977 annual report: We select our marketable equity securities in much the way we would evaluate a business for acquisition in its entirety. We want the business to be one (a) that we can understand; (b) with favourable long-term prospects; operated by honest and competent people; and (d) available at a very attractive price.” We have seen cause to make only one change in this creed: Because of both market conditions and our size, we now substitute “an attractive price” for “a very attractive price.”
  • “Consciously paying more for a stock than its calculated value — in the hope that it can soon be sold for a still-higher price — should be labeled speculation (which is neither illegal, immoral nor — in our view — financially fattening). Growth benefits investors only when the business in point can invest at incremental returns that are enticing — in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor.”
  • Value investing typically connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield.
  • “Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite — that is, consistently employ ever-greater amounts of capital at very low rates of return.”
  • “In studying the investments we have made in both subsidiary companies and common stocks, you will see that we favour businesses and industries unlikely to experience major change.”
  • If we have a strength, it is in recognising when we are operating well within our circle of competence and when we are approaching the perimeter. Predicting the long-term economics of companies that operate in fast-changing industries is simply far beyond our perimeter. A further related lesson: Easy does it. After 25 years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them.
  • On Cigar butt investing philosophy which Buffett followed earlier in his career “If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the “cigar butt” approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the “bargain purchase” will make that puff all profit.”
  • Time is the friend of the wonderful business, the enemy of the mediocre. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realise a high return. But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost.
  • On institutional imperative: “I learned over time that rationality wilts when institutional imperative comes into play. Example: (1) As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialise to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behaviour of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated. Institutional dynamics, not venality or stupidity, set businesses on these courses, which are too often misguided.”
  • “After some other mistakes, I learned to go into business only with people whom I like, trust, and admire.”
  • “It’s no sin to miss a great opportunity outside one’s area of competence. But I have passed on a couple of really big purchases that were served up to me on a platter and that I was fully capable of understanding.”
  • “Over the years, a number of very smart people have learned the hard way that a long string of impressive numbers multiplied by a single zero always equals zero.”
  • On paying dividends: “Not a dime of cash has left Berkshire for dividends share repurchases during the past 40 years. Instead, we have retained all of our earnings to strengthen our business, a reinforcement now running about $1 billion per month.”
  • “ Our net worth has increased from $48 million to $157 billion during the last four decades. No other corporation has come to building its financial strength in this unrelenting way. By being so cautious in respect to leverage, we penalise our returns by a minor amount. Having loads of liquidity, though, lets us sleep well. Moreover, during the episodes of financial chaos that occasionally erupt in our economy, we will be equipped both financially and emotionally to play offense while others scramble for survival. That’s what allowed us to invest $15.6 billion in 25 days of panic following the Lehman bankruptcy in 2008.”

On alternative investments

  • “Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as “safe.” In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge. Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as the holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur.”
  • “Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such policies spin out of control. Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time. Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power. For tax-paying investors, the picture has been far worse. During the same 47-year period, continuous rolling of U.S. Treasury bills produced 5.7% annually. That sounds satisfactory. But if an individual investor paid personal income taxes at a rate averaging 25%, this 5.7% return would have yielded nothing in the way of real income. This investor’s visible income tax would have stripped him of 1.4 points of the stated yield, and the invisible inflation tax would have devoured the remaining 4.3 points. Under today’s conditions, therefore, I do not like currency-based investments. Even so, Berkshire holds significant amounts of them, primarily of the short-term variety. We primarily hold U.S. Treasury bills, the only investment that can be counted on for liquidity under the most chaotic of economic conditions. Our working level for liquidity is $20 billion; $10 billion is our absolute minimum.”
  • “Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end. Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce — gold’s price as I write this — its value would be $9.6 trillion. Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B? My own preference is investment in productive assets, whether businesses, farms, or real estate.
  • “Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system. Essentially, these instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices or currency values.”
  • “Indeed, recent events demonstrate that certain big-name CEOs (or former CEOs) at major financial institutions were simply incapable of managing a business with a huge, complex book of derivatives. Include Charlie and me in this hapless group: When Berkshire purchased General Re in 1998, we knew we could not get our minds around its book of 23,218 derivatives contracts, made with 884 counterparties (many of which we had never heard of). So we decided to close up shop. Though we were under no pressure and were operating in benign markets as we exited, it took us five years and more than $400 million in losses to largely complete minds around its book of 23,218 derivatives contracts, made with 884 counterparties (many of which we had never heard of). So we decided to close up shop. Though we were under no pressure and were operating in benign markets as we exited, it took us five years and more than $400 million in losses to largely complete”

On owning a Bank

  • “Month by month the foolish loan decisions of once well-regarded banks were put on public display. As one huge loss after another was unveiled — often on the heels of managerial assurances that all was well — investors understandably concluded that no bank’s numbers were to be trusted. Aided by their flight from bank stocks, we purchased our 10% interest in Wells Fargo for $290 million, less than five times after-tax earnings, and less than three times pre-tax earnings.
    Our purchase of one-tenth of the bank may be thought of as roughly equivalent to our buying 100% of a $5 billion bank with identical financial characteristics. Wells Fargo is big — it has $56 billion in assets — and has been earning more than 20% on equity and 1.25% on assets. Of course, ownership of a bank — or about any other business — is far from riskless. California banks face the specific risk of a major earthquake, which might wreak enough havoc on borrowers to in turn destroy the banks lending to them. A second risk is systemic — the possibility of a business contraction or financial panic so severe that it would endanger almost every highly-leveraged institution, no matter how intelligently run. Finally, the market’s major fear of the moment is that West Coast real estate values will tumble because of overbuilding and deliver huge losses to banks that have financed the expansion. Because it is a leading real estate lender, Wells Fargo is thought to be particularly vulnerable. Consider some mathematics: Wells Fargo currently earns well over $1 billion pre-tax annually after expensing more than $300 million for loan losses. If 10% of all $48 billion of the bank’s loans — not just its real estate loans — were hit by problems in 1991, and these produced losses (including foregone interest) averaging 30% of principal, the company would roughly break even. A year like that — which we consider only a low-level possibility, not a likelihood — would not distress us.”

On owning an Airline

  • “The day of reckoning for these airlines could be delayed by infusions of capital (such as ours into USAir), but eventually a fundamental rule of economics prevailed: In an unregulated commodity business, a company must lower its costs to competitive levels or face extinction. When Richard Branson, the wealthy owner of Virgin Atlantic Airways, was asked how to become a millionaire, he had a quick answer: “There’s really nothing to it. Start as a billionaire and then buy an airline.” Unwilling to accept Branson’s proposition on faith, your Chairman decided in 1989 to test it by investing $358 million in a 9¼% preferred stock of USAir. I liked and admired Ed Colodny, the company’s then-CEO, and I still do. But my analysis of USAir’s business was both superficial and wrong. I was so beguiled by the company’s long history of profitable operations, and by the protection that ownership of a senior security seemingly offered me, that I overlooked the crucial point: USAir’s revenues would increasingly feel the effects of an unregulated, fiercely competitive market whereas its cost structure was a holdover from the days when regulation protected profits. These costs, if left unchecked, portended disaster, however reassuring the airline’s past record might be. Since our purchase, the economics of the airline industry have deteriorated at an alarming pace, accelerated by the kamikaze pricing tactics of certain carriers. The trouble this pricing has produced for all carriers illustrates an important truth: In a business selling a commodity-type product, it’s impossible to be a lot smarter than your dumbest competitor.”

On stock repurchases

  • “We will never make purchases with the intention of stemming a decline in Berkshire’s price. Charlie and I favour repurchases when two conditions are met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated. We have witnessed at a material discount to the company’s intrinsic business value, conservatively calculated. Today, IBM has 1.16 billion shares outstanding, of which we own about 63.9 million or 5.5%. Naturally, what happens to the company’s earnings over the next five years is of enormous importance to us. Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for the day: What should a long-term billion shares outstanding, of which we own about 63.9 million or 5.5%. Naturally, what happens to the company’s earnings over the next five years is of enormous importance to us. Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for the day: What should a long-term shareholder, such as Berkshire, cheer for during that period? I won’t keep you in suspense. We should wish for IBM’s stock price to languish throughout the five years. Let’s do the math. If IBM’s stock price averages, say, $200 during the period, the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%.

    The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon.”

On splitting Berkshire stock

  • “Were we to split the stock or take other actions focusing on stock price rather than business value, we would attract an entering class of buyers inferior to the exiting class of sellers.”
  • “A hyperactive stock market is the pickpocket of enterprise.
    For example, consider a typical company earning, say, 12% on equity. Assume a very high turnover rate in its shares of 100% per year. If a purchase and sale of the stock trades at book value, the owners of our hypothetical company will pay, in aggregate, 2% of the company’s net worth annually for the privilege of transferring ownership. This activity does nothing for the earnings of the business, and means that 1/6 of them are lost to the owners through the “frictional” cost of transfer. Consequently, our stock consistently trades in a price range that is sensibly related to intrinsic value.”
  • On issuing Class B common stock later: “We made two good-sized offerings through Salomon [during 1996], both with interesting aspects. The first was our sale in May of 517,500 shares of Class B Common, which generated net proceeds of $565 million. As I have told you before, we made this sale in response to the threatened
    creation of unit trusts that would have marketed themselves as Berkshire look-alikes. In the process, they would have used our past, and definitely non repeatable, record to entice naive small investors and would have charged these innocents high fees and commissions. The trusts would have meanwhile indiscriminately poured the proceeds of their offerings into a supply of Berkshire shares that is fixed and limited. The likely result: a speculative bubble in our stock.”

Why Buffet hates to part with Berkshire stock

  • “Our problem has been that we own a truly marvelous collection of businesses, which means that trading away a portion of them for something new almost never makes sense. If we issue shares in a merger, we reduce your ownership in all of our businesses — partly-owned companies such as Coca-Cola, Gillette and American Express, and all of our terrific operating companies as well.”
  • “The oracle Aesop and his enduring, though somewhat incomplete, investment insight was “a bird in the hand is worth
    two in the bush.”
    To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush — and the maximum number of the birds you now possess that should be offered for it.”

On acquisitions

  • “Over time, the skill with which a company’s managers allocate capital has an enormous impact on the enterprise’s value.
  • “Almost by definition, a really good business generates far more money (at least after its early years) than it can use internally. The company could, of course, distribute the money to shareholders by way of dividends or share repurchases. But often the CEO asks a strategic planning staff,
    consultants or investment bankers whether an acquisition or two might make sense. That’s like asking your interior decorator whether you need a $50,000 rug. We believe most deals do damage to the shareholders of the acquiring company. In any case, why potential buyers even look at projections prepared by sellers baffles me. Charlie and I never give them a glance, We would love to see an intermediary earn its fee by thinking of us — and therefore repeat here what we’re looking for: (1) Large purchases, (2) Demonstrated consistent earning power (future projections are of no interest to us, nor are “turnaround” situations), (3) Businesses earning good returns on equity while employing little or no debt, (4) Management in place (we can’t supply it), (5) Simple businesses (if there’s lots of technology, we won’t understand it), (6) An offering price (we don’t want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown).”
  • “Berkshire is another kind of buyer — a rather unusual one. We buy to keep, but we don’t have, and don’t expect to have, operating people in our parent organisation. All of the businesses we own are run autonomously to an extraordinary degree. The areas I get involved in are capital allocation and selection and compensation of the top man. Other personnel decisions, operating strategies, etc. are his bailiwick.”

Note: I ignored highlights from a few chapters related to Accounting. Not being an accounting nerd, I had a hard time grasping all the concepts. I also mostly focussed on stocks and bonds and ignored other money instruments.

Links: Goodreads , Amazon

Liked this summary? Read Lessons from Managing Oneself , On Writing Well , Deepwork and So good they can’t ignore you

Stay up to date with my latest posts/tweets here: @manas_saloi


This story is published in The Startup , Medium’s largest entrepreneurship publication followed by 320,924+ people.

Subscribe to receive our top stories here .

The Startup
Never miss a story from The Startup, when you sign up for Medium. Learn more
Never miss a story from The Startup

Homepage
The Startup
Sign in Get started

Go to the profile of Manas J. Saloi
Manas J. Saloi
Product Manager @Directi

Highlights from The Essays of Warren Buffett

The book ‘The Essays of Warren Buffett: Lessons for Corporate America’ is a must read for anyone who wants to learn how one of the most celebrated money managers of last century operates. I read the 3rd edition and am sharing my favourite parts from the book here.

Golden rules of Investing

  • The most revolutionary investing ideas of the past thirty-five years were those called modern finance theory. This is an elaborate set of ideas that boil down to one simple and misleading practical implication: it is a waste of time to study individual investment opportunities. One of modern finance theory’s main tenets is modern portfolio theory. It says that you can eliminate the peculiar risk of any security by holding a diversified portfolio — that is, it formalizes the folk slogan “don’t put all your eggs in one basket.” The risk that is leftover is the only risk for which the investors would be compensated. This leftover risk can be measured by a simple mathematical term — called beta — that shows how volatile the security is compared to the market. Beta measures this volatility risk well for securities that trade on efficient markets, where information about publicly traded securities is swiftly and accurately incorporated into prices. In the modern finance story, efficient markets rule. Buffett thinks most markets are not purely efficient and that equating volatility with risk is a gross distortion.
  • As to concentration of the portfolio, Buffett reminds us that Keynes, who was not only a brilliant economist but also an astute investor, believed that an investor should put fairly large sums into two or three businesses he knows something about and whose management is trustworthy.
    Buffett jokes that calling someone who trades actively in the market an investor “is like calling someone who repeatedly engages in one-night stands a romantic.” Buffett instead thinks we should follow Mark Twain’s advice from Pudd’nhead Wilson “Put all your eggs in one basket — and watch that basket.”
  • Buffet learned the art of investing from Ben Graham who in a number of classic works, including The Intelligent Investor, introduced a character who lives on Wall Street, Mr. Market. He is your hypothetical business partner who is daily willing to buy your interest in a business or sell you his at at prevailing market prices. He is moody and the more manic-depressive he is, the greater the spread between price and value, and therefore the greater the investment opportunities he offers. Buffett reintroduces Mr. Market, emphasizing how valuable Graham’s allegory of the overall market is for disciplined investment knitting. Another leading prudential legacy from Graham is his margin-of-safety principle. This principle holds that one should not make an investment in a security unless there is a sufficient basis for believing that the price being paid is substantially lower than the value being delivered.
  • All true investing must be based on an assessment of the relationship between price and value. Strategies that do not employ this comparison of price and value do not amount to investing at all, but to speculation — the hope that price will rise, rather than the conviction that the price being paid is lower than the value being obtained.
  • The circle of competence principle is the third leg of the Graham/Buffett stool of intelligent investing, along with Mr. Market and the margin of safety. This common sense rule instructs investors to consider investments only concerning businesses they are capable of understanding with a modicum of effort.
  • Three suggestions for investors from Buffett: First, beware of companies displaying weak accounting. If a company still does not expense options, or if its pension assumptions are fanciful, watch out. Second, unintelligible footnotes usually indicate untrustworthy management. If you can’t understand a footnote or other managerial explanation, it’s usually because the CEO doesn’t want you to. Finally, be suspicious of companies that trumpet earnings projections and growth expectations.
  • What needs to be reported is data — whether GAAP, non-GAAP, or extra-GAAP — that helps 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?
  • On bonds: “The large numbers of corporations that failed in the early 1990s recession under crushing debt burdens to dispute academic research showing that higher interest rates on junk bonds more than compensated for their higher default rates.”
  • On “fallen angels” — bonds that were initially of investment grade but that were downgraded when the issuers fell on bad times:
    “A kind of bastardized fallen angel burst onto the investment scene in the 1980s — “junk bonds” that were far below investment-grade when issued. As the decade progressed, new offerings of manufactured junk became ever junkier and ultimately the predictable outcome occurred: Junk bonds lived up to their name. Thus, said the friendly salesmen, a diversified portfolio of junk bonds would produce greater net returns than would a portfolio of high-grade bonds. (Beware of past-performance “proofs” in finance: If history books were the key to riches, the Forbes 400 would consist of librarians). The manager of a fallen angel almost invariably yearned to regain investment-grade status and worked toward that goal. The junk-bond operator was usually an entirely different breed. Behaving much as a heroin user might, he devoted his energies not to finding a cure for his debt-ridden condition, but rather to finding another fix. Additionally, the fiduciary sensitivities of the executives managing the typical fallen angel were often, though not always, more finely developed than were those of the junk-bond-issuing financiopath.”
  • Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals. Should you choose, however, to construct your own portfolio, there are a few thoughts worth remembering: Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital. To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing, or emerging markets. You may, in fact, be better off knowing nothing of these. Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now.
    If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.
  • Bertrand Russell’s observation about life in general applies with unusual force in the financial world: “Most men would rather die than think. Many do.”
  • “Value is destroyed, not created, by any business that loses money over its lifetime, no matter how high its interim valuation may get. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life. Intrinsic value is an estimate rather than a precise figure.”
  • “You can gain some insight into the differences between book value and intrinsic value by looking at one form of investment, a college education. Think of the education’s cost as its “book value.” If this cost is to be accurate, it should include the earnings that were foregone by the student because he chose college rather than a job. For this exercise, we will ignore the important non-economic benefits of an education and focus strictly on its economic value. First, we must estimate the earnings that the graduate will receive over his lifetime and subtract from that figure an estimate of what he would have earned had he lacked his education. That gives us an excess earnings figure, which must then be discounted, at an appropriate interest rate, back to graduation day. The dollar result equals the intrinsic economic value of the education.
    Some graduates will find that the book value of their education exceeds its intrinsic value, which means that whoever paid for the education didn’t get his money’s worth. In other cases, the intrinsic value of an education will far exceed its book value, a result that proves capital was wisely deployed. In all cases, what is clear is that book value is meaningless as an indicator of intrinsic value.”
  • “We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen. Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8% and 17.4%. But, surprise — none of these blockbuster events made the slightest dent in Ben Graham’s investment principles. Nor did they render unsound the negotiated purchases of fine businesses at sensible prices. A different set of major shocks is sure to occur in the next 30 years. We will neither try to predict these nor to profit from them. If we can identify businesses similar to those we have purchased in the past, external surprises will have little effect on our long-term results.”
  • “People who expect to earn 10% annually from equities during this century — envisioning that 2% of that will come from dividends and 8% from price appreciation — are implicitly forecasting a level of about 24,000,000 on the Dow by 2100. Think about it”

How Buffett and Charlie Munger run Berkshire

  • Buffett and Berkshire avoid making predictions and tell their managers to do the same. They think it is a bad managerial habit that too often leads managers to make up their financial reports.
  • Buffett just gives a simple set of commands to his CEOs: to run their business as if (1) they are its sole owner, (2) it is the only asset they hold, and (3) they can never sell or merge it for a hundred years. This enables Berkshire CEOs to manage with a long-term horizon ahead of them, something alien to the CEOs of public companies whose short-term oriented shareholders obsess with meeting the latest quarterly earnings estimate. Short-term results matter, of course, but the Berkshire approach avoids any pressure to achieve them at the expense of strengthening long-term competitive advantages.
  • “When a problem exists, whether in personnel or in business operations, the time to act is now.”
  • Unlike many CEOs, who desire their company’s stock to trade at the highest possible prices in the market, Buffett prefers Berkshire stock to trade at or around its intrinsic value — neither materially higher nor lower. Such linkage means that business results during one period will benefit the people who owned the company during that period.
  • Stock splits are another common action in corporate America that Buffett points out disserve owner interests. Stock splits have three consequences: they increase transaction costs by promoting high share turnover; they attract shareholders with short-term, market-oriented views who unduly focus on stock market prices; and, as a result of both of those effects, they lead to prices that depart materially from intrinsic business value.
  • Intrinsic value: The discounted value of the cash that can be taken out of a business during its remaining life. Charlie and Berkshire are interested only in acquisitions that they believe will raise the per-share intrinsic value of Berkshire’s stock.
  • According to Buffett: Useful financial statements must enable a user to answer three basic questions about a business: approximately how much a company is worth, its likely ability to meet its future obligations, and how good a job its managers are doing in operating the business. Charlie and Buffett think that it is both deceptive and dangerous for CEOs to predict growth rates for their companies.
  • “At Berkshire, we try to be as logical about compensation as about capital allocation. For example, we compensate Ralph Schey based upon the results of Scott Fetzer rather than those of Berkshire. What could make more sense, since he’s responsible for one operation but not the other? A cash bonus or a stock option tied to the fortunes of Berkshire would provide totally capricious rewards to Ralph. He could, for example, be hitting home runs at Scott Fetzer while Charlie and I rang up
    mistakes at Berkshire, thereby negating his efforts many times over. Conversely, why should option profits or bonuses be heaped upon Ralph if good things are occurring in other parts of Berkshire but Scott Fetzer is lagging?”
  • “Charlie and I believe that a CEO must not delegate risk control. It’s simply too important. If Berkshire ever gets in trouble, it will be my fault. It will not be because of misjudgments made by a Risk Committee or Chief Risk Officer.”
  • “It has not been shareholders who have botched the operations of some of our country’s largest financial institutions. Yet they have borne the burden, with 90% or more of the value of their holdings wiped out in most cases of failure. The CEOs and directors of the failed companies, however, have largely gone unscathed. Their fortunes may have been diminished by the disasters they oversaw, but they still live in grand style. It is the behavior of these CEOs and directors that needs to be changed: If their institutions and the country are harmed by their recklessness, they should pay a heavy price-one not reimbursable by the companies”
  • “Audit committees should unequivocally put auditors on the spot, making them understand they will become liable for major monetary penalties if they don’t come forth with what they know or suspect.”
  • On why Berkshire bought Washing Post Company: “We bought all of our [Washington Post Company (“WPC”)] holdings in mid-1973 at a price of not more than one-fourth of the then per-share business value of the enterprise. Calculating the price/value ratio required no unusual insights. Most security analysts, media brokers, and media executives would have estimated WPC’s intrinsic business value at $400 to $500 million just as we did. And its $100 million stock market valuation was published daily for all to see. Our advantage was our attitude, that we had learned from Ben Graham, that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values.”
  • “Whenever Charlie and I buy common stocks for Berkshire’s insurance companies (leaving aside arbitrage purchases, discussed) we approach the transaction as if we were buying into a private business. We look at the economic prospects of the business, the people in charge of running it, and the price we must pay. We do not have in mind any time or price for sale. Indeed, we are willing to hold a stock indefinitely so long as we expect the business to increase in intrinsic value at a satisfactory rate. When investing, we view ourselves as business analysts — not as market analysts, not as macroeconomic analysts, and not even as security analysts.”
  • “Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Market appears daily and names a price at which he will either buy your interest or sell you his. Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market’s quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains.
    is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him. Rather an investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace. In my own efforts to stay insulated, I have found it highly useful to keep Ben’s Mr. Market concept firmly in mind. As Ben said: “In the short run, the market is a voting machine but in the long run it is a weighing machine.”
  • The speed at which a business’s success is recognized, furthermore, is not that important as long as the company’s intrinsic value is increasing at a satisfactory rate.
  • Buffett then explains why he is happy when the stock market is stagnant or goes down: “ A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? This question answers itself. Similarly If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the “hamburgers” they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.”
  • On arbitrage: “To evaluate arbitrage situations you must answer four questions: (1) How likely is it that the promised event will indeed occur? (2) How long will your money be tied up? (3) What chance is there that something still better will transpire — a competing takeover bid, for example? and (4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?
  • The preceding discussion about arbitrage makes a small discussion of “efficient market theory” (EMT) also seem relevant. This doctrine became highly fashionable — indeed, almost holy scripture — in academic circles during the 1970s. Essentially, it said that analyzing stocks was useless because all public information about them was appropriately reflected in their prices. In other words, the market always knew everything. As a corollary, the professors who taught EMT said that someone throwing darts at the stock tables could select a stock portfolio having prospects just as good as one selected by the brightest, most hard-working security analyst. We continue to think that it is usually foolish to part with an interest in a business that is both understandable and durably wonderful. Business interests of that kind are simply too hard to replace. The strategy we’ve adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. 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. In stating this opinion, we define risk, using dictionary terms, as “the possibility of loss or injury.” Academics, however, like to define investment “risk” differently, averring that it is the relative volatility of a stock or portfolio of stocks — that is, their volatility as compared to that of a large universe of stocks. Employing data bases and statistical skills, these academics compute with precision the “beta” of a stock — that shows how volatile the security is compared to the market. Beta measures this volatility risk well for securities that trade on efficient markets, where information about publicly traded securities is swiftly and accurately incorporated into prices. In our opinion, the real risk an investor must assess is whether his aggregate after-tax receipts from an investment (including those he receives on sale) will, over his prospective holding period, give him at least as much purchasing power as he had to begin with, plus a modest rate of interest on that initial stake. Though this risk cannot be calculated with engineering precision, it can in some cases be judged with a degree of accuracy that is useful. The primary factors bearing upon this evaluation are: (1) The certainty with which the long-term economic characteristics of the business can be evaluated; (2) The certainty with which management can be evaluated, both as to its ability to realise the full potential of the business and to wisely employ its cash flows; (3) The certainty with which management can be counted on to channel the reward from the business to the shareholders rather than to itself; (4) The purchase price of the business; (5) The levels of taxation and inflation that will be experienced and that will determine the degree by which an investor’s purchasing-power return is reduced from his gross return.
  • It is better to be approximately right than precisely wrong.
  • “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 makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices — the businesses he understands best and that present the least risk, along with the greatest profit potential. In the words of the prophet Mae West: “Too much of a good thing can be wonderful.”
  • “We continually search for large businesses with understandable, enduring and mouth-watering economics that are run by able and shareholder-oriented managements.”
  • “Our equity-investing strategy remains little changed from what it was when we said in the 1977 annual report: We select our marketable equity securities in much the way we would evaluate a business for acquisition in its entirety. We want the business to be one (a) that we can understand; (b) with favourable long-term prospects; operated by honest and competent people; and (d) available at a very attractive price.” We have seen cause to make only one change in this creed: Because of both market conditions and our size, we now substitute “an attractive price” for “a very attractive price.”
  • “Consciously paying more for a stock than its calculated value — in the hope that it can soon be sold for a still-higher price — should be labeled speculation (which is neither illegal, immoral nor — in our view — financially fattening). Growth benefits investors only when the business in point can invest at incremental returns that are enticing — in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor.”
  • Value investing typically connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield.
  • “Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite — that is, consistently employ ever-greater amounts of capital at very low rates of return.”
  • “In studying the investments we have made in both subsidiary companies and common stocks, you will see that we favour businesses and industries unlikely to experience major change.”
  • If we have a strength, it is in recognising when we are operating well within our circle of competence and when we are approaching the perimeter. Predicting the long-term economics of companies that operate in fast-changing industries is simply far beyond our perimeter. A further related lesson: Easy does it. After 25 years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them.
  • On Cigar butt investing philosophy which Buffett followed earlier in his career “If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the “cigar butt” approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the “bargain purchase” will make that puff all profit.”
  • Time is the friend of the wonderful business, the enemy of the mediocre. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realise a high return. But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost.
  • On institutional imperative: “I learned over time that rationality wilts when institutional imperative comes into play. Example: (1) As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialise to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behaviour of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated. Institutional dynamics, not venality or stupidity, set businesses on these courses, which are too often misguided.”
  • “After some other mistakes, I learned to go into business only with people whom I like, trust, and admire.”
  • “It’s no sin to miss a great opportunity outside one’s area of competence. But I have passed on a couple of really big purchases that were served up to me on a platter and that I was fully capable of understanding.”
  • “Over the years, a number of very smart people have learned the hard way that a long string of impressive numbers multiplied by a single zero always equals zero.”
  • On paying dividends: “Not a dime of cash has left Berkshire for dividends share repurchases during the past 40 years. Instead, we have retained all of our earnings to strengthen our business, a reinforcement now running about $1 billion per month.”
  • “ Our net worth has increased from $48 million to $157 billion during the last four decades. No other corporation has come to building its financial strength in this unrelenting way. By being so cautious in respect to leverage, we penalise our returns by a minor amount. Having loads of liquidity, though, lets us sleep well. Moreover, during the episodes of financial chaos that occasionally erupt in our economy, we will be equipped both financially and emotionally to play offense while others scramble for survival. That’s what allowed us to invest $15.6 billion in 25 days of panic following the Lehman bankruptcy in 2008.”

On alternative investments

  • “Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as “safe.” In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge. Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as the holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur.”
  • “Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such policies spin out of control. Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time. Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power. For tax-paying investors, the picture has been far worse. During the same 47-year period, continuous rolling of U.S. Treasury bills produced 5.7% annually. That sounds satisfactory. But if an individual investor paid personal income taxes at a rate averaging 25%, this 5.7% return would have yielded nothing in the way of real income. This investor’s visible income tax would have stripped him of 1.4 points of the stated yield, and the invisible inflation tax would have devoured the remaining 4.3 points. Under today’s conditions, therefore, I do not like currency-based investments. Even so, Berkshire holds significant amounts of them, primarily of the short-term variety. We primarily hold U.S. Treasury bills, the only investment that can be counted on for liquidity under the most chaotic of economic conditions. Our working level for liquidity is $20 billion; $10 billion is our absolute minimum.”
  • “Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end. Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce — gold’s price as I write this — its value would be $9.6 trillion. Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B? My own preference is investment in productive assets, whether businesses, farms, or real estate.
  • “Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system. Essentially, these instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices or currency values.”
  • “Indeed, recent events demonstrate that certain big-name CEOs (or former CEOs) at major financial institutions were simply incapable of managing a business with a huge, complex book of derivatives. Include Charlie and me in this hapless group: When Berkshire purchased General Re in 1998, we knew we could not get our minds around its book of 23,218 derivatives contracts, made with 884 counterparties (many of which we had never heard of). So we decided to close up shop. Though we were under no pressure and were operating in benign markets as we exited, it took us five years and more than $400 million in losses to largely complete minds around its book of 23,218 derivatives contracts, made with 884 counterparties (many of which we had never heard of). So we decided to close up shop. Though we were under no pressure and were operating in benign markets as we exited, it took us five years and more than $400 million in losses to largely complete”

On owning a Bank

  • “Month by month the foolish loan decisions of once well-regarded banks were put on public display. As one huge loss after another was unveiled — often on the heels of managerial assurances that all was well — investors understandably concluded that no bank’s numbers were to be trusted. Aided by their flight from bank stocks, we purchased our 10% interest in Wells Fargo for $290 million, less than five times after-tax earnings, and less than three times pre-tax earnings.
    Our purchase of one-tenth of the bank may be thought of as roughly equivalent to our buying 100% of a $5 billion bank with identical financial characteristics. Wells Fargo is big — it has $56 billion in assets — and has been earning more than 20% on equity and 1.25% on assets. Of course, ownership of a bank — or about any other business — is far from riskless. California banks face the specific risk of a major earthquake, which might wreak enough havoc on borrowers to in turn destroy the banks lending to them. A second risk is systemic — the possibility of a business contraction or financial panic so severe that it would endanger almost every highly-leveraged institution, no matter how intelligently run. Finally, the market’s major fear of the moment is that West Coast real estate values will tumble because of overbuilding and deliver huge losses to banks that have financed the expansion. Because it is a leading real estate lender, Wells Fargo is thought to be particularly vulnerable. Consider some mathematics: Wells Fargo currently earns well over $1 billion pre-tax annually after expensing more than $300 million for loan losses. If 10% of all $48 billion of the bank’s loans — not just its real estate loans — were hit by problems in 1991, and these produced losses (including foregone interest) averaging 30% of principal, the company would roughly break even. A year like that — which we consider only a low-level possibility, not a likelihood — would not distress us.”

On owning an Airline

  • “The day of reckoning for these airlines could be delayed by infusions of capital (such as ours into USAir), but eventually a fundamental rule of economics prevailed: In an unregulated commodity business, a company must lower its costs to competitive levels or face extinction. When Richard Branson, the wealthy owner of Virgin Atlantic Airways, was asked how to become a millionaire, he had a quick answer: “There’s really nothing to it. Start as a billionaire and then buy an airline.” Unwilling to accept Branson’s proposition on faith, your Chairman decided in 1989 to test it by investing $358 million in a 9¼% preferred stock of USAir. I liked and admired Ed Colodny, the company’s then-CEO, and I still do. But my analysis of USAir’s business was both superficial and wrong. I was so beguiled by the company’s long history of profitable operations, and by the protection that ownership of a senior security seemingly offered me, that I overlooked the crucial point: USAir’s revenues would increasingly feel the effects of an unregulated, fiercely competitive market whereas its cost structure was a holdover from the days when regulation protected profits. These costs, if left unchecked, portended disaster, however reassuring the airline’s past record might be. Since our purchase, the economics of the airline industry have deteriorated at an alarming pace, accelerated by the kamikaze pricing tactics of certain carriers. The trouble this pricing has produced for all carriers illustrates an important truth: In a business selling a commodity-type product, it’s impossible to be a lot smarter than your dumbest competitor.”

On stock repurchases

  • “We will never make purchases with the intention of stemming a decline in Berkshire’s price. Charlie and I favour repurchases when two conditions are met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated. We have witnessed at a material discount to the company’s intrinsic business value, conservatively calculated. Today, IBM has 1.16 billion shares outstanding, of which we own about 63.9 million or 5.5%. Naturally, what happens to the company’s earnings over the next five years is of enormous importance to us. Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for the day: What should a long-term billion shares outstanding, of which we own about 63.9 million or 5.5%. Naturally, what happens to the company’s earnings over the next five years is of enormous importance to us. Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for the day: What should a long-term shareholder, such as Berkshire, cheer for during that period? I won’t keep you in suspense. We should wish for IBM’s stock price to languish throughout the five years. Let’s do the math. If IBM’s stock price averages, say, $200 during the period, the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%.

    The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon.”

On splitting Berkshire stock

  • “Were we to split the stock or take other actions focusing on stock price rather than business value, we would attract an entering class of buyers inferior to the exiting class of sellers.”
  • “A hyperactive stock market is the pickpocket of enterprise.
    For example, consider a typical company earning, say, 12% on equity. Assume a very high turnover rate in its shares of 100% per year. If a purchase and sale of the stock trades at book value, the owners of our hypothetical company will pay, in aggregate, 2% of the company’s net worth annually for the privilege of transferring ownership. This activity does nothing for the earnings of the business, and means that 1/6 of them are lost to the owners through the “frictional” cost of transfer. Consequently, our stock consistently trades in a price range that is sensibly related to intrinsic value.”
  • On issuing Class B common stock later: “We made two good-sized offerings through Salomon [during 1996], both with interesting aspects. The first was our sale in May of 517,500 shares of Class B Common, which generated net proceeds of $565 million. As I have told you before, we made this sale in response to the threatened
    creation of unit trusts that would have marketed themselves as Berkshire look-alikes. In the process, they would have used our past, and definitely non repeatable, record to entice naive small investors and would have charged these innocents high fees and commissions. The trusts would have meanwhile indiscriminately poured the proceeds of their offerings into a supply of Berkshire shares that is fixed and limited. The likely result: a speculative bubble in our stock.”

Why Buffet hates to part with Berkshire stock

  • “Our problem has been that we own a truly marvelous collection of businesses, which means that trading away a portion of them for something new almost never makes sense. If we issue shares in a merger, we reduce your ownership in all of our businesses — partly-owned companies such as Coca-Cola, Gillette and American Express, and all of our terrific operating companies as well.”
  • “The oracle Aesop and his enduring, though somewhat incomplete, investment insight was “a bird in the hand is worth
    two in the bush.”
    To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush — and the maximum number of the birds you now possess that should be offered for it.”

On acquisitions

  • “Over time, the skill with which a company’s managers allocate capital has an enormous impact on the enterprise’s value.
  • “Almost by definition, a really good business generates far more money (at least after its early years) than it can use internally. The company could, of course, distribute the money to shareholders by way of dividends or share repurchases. But often the CEO asks a strategic planning staff,
    consultants or investment bankers whether an acquisition or two might make sense. That’s like asking your interior decorator whether you need a $50,000 rug. We believe most deals do damage to the shareholders of the acquiring company. In any case, why potential buyers even look at projections prepared by sellers baffles me. Charlie and I never give them a glance, We would love to see an intermediary earn its fee by thinking of us — and therefore repeat here what we’re looking for: (1) Large purchases, (2) Demonstrated consistent earning power (future projections are of no interest to us, nor are “turnaround” situations), (3) Businesses earning good returns on equity while employing little or no debt, (4) Management in place (we can’t supply it), (5) Simple businesses (if there’s lots of technology, we won’t understand it), (6) An offering price (we don’t want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown).”
  • “Berkshire is another kind of buyer — a rather unusual one. We buy to keep, but we don’t have, and don’t expect to have, operating people in our parent organisation. All of the businesses we own are run autonomously to an extraordinary degree. The areas I get involved in are capital allocation and selection and compensation of the top man. Other personnel decisions, operating strategies, etc. are his bailiwick.”

Note: I ignored highlights from a few chapters related to Accounting. Not being an accounting nerd, I had a hard time grasping all the concepts. I also mostly focussed on stocks and bonds and ignored other money instruments.

Links: Goodreads , Amazon

Liked this summary? Read Lessons from Managing Oneself , On Writing Well , Deepwork and So good they can’t ignore you

Stay up to date with my latest posts/tweets here: @manas_saloi


This story is published in The Startup , Medium’s largest entrepreneurship publication followed by 320,924+ people.

Subscribe to receive our top stories here .

The Startup
Never miss a story from The Startup, when you sign up for Medium. Learn more
Never miss a story from The Startup

Euclidean Technologies ®

 
 

The Essays of Warren Buffett:  Review, Quotes & Lessons

 
 Photo: Amazon

Photo: Amazon

We would like to share with you one of our favorite books – The Essays of Warren Buffett.  This book is a collection of wisdom pulled from Berkshire Hathaway’s annual letters from 1979 through 2006.  

We would be understating the case to say that these letters have had a large impact on how we think about investing.  While the Euclidean approach involves taking a view of what 50 years of company fundamentals can teach us about evaluating companies as potential investments, our findings have both validated and received context from many of the ideas found here. 

As we know you are busy and may not have time to digest this book in its entirety, please consider finding time to review a few of our favorite sections, which we have highlighted below.   

1) Mr. Market & Market Fluctuations

Buffett’s discussion of Benjamin Graham’s Mr. Market, and the mental attitude toward market fluctuations that is most conducive to market success.

“So smile when you read a headline that says ‘Investors lose as market falls.’ Edit it in your mind to ‘Disinvestors lose as market falls—but investors gain.’ Though writers often forget this truism, there is a buyer for every seller and what hurts one necessarily helps the other.”

  1997 Chairman’s Letter

2) Growth vs Value

Buffett’s perspectives that the industry’s distinction between ‘growth’ and ‘value’ investing is misguided, that growth is simply a component in the calculation of value, and that the term ‘value investing’ is redundant as what is investing if its is not the act of seeking value at least sufficient to justify the amount paid? 

“In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.” 

  1992 Chairman’s Letter

3) Valuing a Business

Buffett’s skepticism of the need to understand beta, efficient markets, modern portfolio theory and other concepts heralded by the investment community and, instead, his guidance to focus on simply how to a value business and think about market prices. 

“Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten, and twenty years from now.” 

  1996 Chairman’s Letter

4) Predictions

Buffett’s perspective that it is not worth trying to predict market fluctuations and, rather, to focus on being fearful when others are greedy and greedy only when others are fearful. 

” ‘I can calculate the movement of the stars, but not the madness of men.’ .. – Sir Isaac Newton.” 

  2005 Chairman’s Letter

 

5) Owner Earnings & Accounting Principles

While the pages here perhaps require a few attempts to fully digest, this section contains the most important insights in the entire book.  It highlights the limitations of GAAP accounting in investment analysis.  It also describes Buffett’s concept of Owner Earnings – that is, the amount of money a full owner of a business could expect to pocket from that business over time – as the relevant item to estimate when making investment decisions. 

“Questioning GAAP figures may seem impious to some. After all, what are we paying the accountants for if it is not to deliver us the “truth” about our business. But the accountant’s job is to record, not to evaluate… Managers and owners need to remember that accounting is but an aid to business thinking, never a substitute for it.”

pages 225-231 

Aesop's famed tale: A bird in the hand is worth two in the bush

6) Asset Valuation Page 243

His assessment of the oracle Aesop’s famed adage, as the basis for explaining the formula for valuing all assets that are purchased for gain. 

“His enduring, although somewhat incomplete, investment insight was ‘A bird in the hand is worth two in the bush.’ … Aesop’s investment axiom, thus expanded and turned into dollars, is immutable.”

2000 Chairman’s Letter

7) Forecasts & Behavioral Bias

Here Buffett extols the merits of ignoring political and economic forecasts and makes the comment, “we have usually made our best purchases when apprehension about some macro event were at a peak.”

“Fear is the foe of the faddest, but the friend of the fundamentalist. A different set of major shocks is sure to occur in the next 30 years. We will neither try to predict these nor to profit from them. ” 

page 274

 

We hope you enjoy this book.

Best Regards,

John & Mike


Additional resources on The Essays of Warren Buffett

What Investment – The one Warren Buffett book you need to read

The Motley Fool – Through the Years: Constant Themes in Buffett’s Letters (video)

The Motley Fool – A Money-Making Lesson Buffett Wishes He Learned Sooner

Other Best of Buffett resources:

The SuperInvestors of Graham & Doddsville

How Inflation Swindles the Equity Investor

25IQ – Best Warren Buffett quotes, by topic

 Photo: WarrenBuffettStrategies.com

Photo: WarrenBuffettStrategies.com


Learn more about Euclidean Technologies

What we do
read more on buffett

  • Fair Use Policy
  • Help Centre
  • Loading…
  • Sign In

UKEssays logo

UKEssays
Trusted by students since 2003
0115 966 7955
Today’s Opening Times 10:00 – 20:00 (BST)


Banner ad for Viper plagiarism checker

Investment Analysis Strategies Given By Warren Buffett Management Essay

Print

Reference this

Published:

Disclaimer: This essay has been submitted by a student. This is not an example of the work written by our professional essay writers. You can view samples of our professional work here .

Any opinions, findings, conclusions or recommendations expressed in this material are those of the authors and do not necessarily reflect the views of UK Essays.

Warren Edward Buffett was born on 30th August, 1930 is one of the most successful investors of America, rather most successful investors of the world. He was also a business man and humanitarian. He is a primary shareholder and along with that he is CEO of Berkshire Hathaway. Warren Buffet is known as “Oracle of Omaha” for his observance to the value of investment philosophy. In this investment analysis, we are going to highlight his strategy of investment in the shares.

If you want to follow the classical way of investment, then Warren Buffet’s investment strategies will prove to be great role model for you. In this article, we will describe various investment strategies given by Warren Buffett and their impact on the regular market. We will also encounter the reason that why Warren Buffett’s investment strategies are not successful among the small investors and the initial investors.

Body

Warren Buffett’s investment style comes from his research for various questions which arose in his mind few years back which he stated to be most important questions before investment in any company. These questions are as follows:

  • Does the company have good economic status in the industry?
  • Does the company have brand name associated with it or monopoly of the consumers?
  • Is the company loyal to the investors?
  • Is the profit margin associated with the company’s earnings to the shareholder good?
  • Does the company provide decent returns on investment to the shareholders?
  • Does the company possess high earning growth?
  • Is the debt to equity of debt ratio of the company low? [1]
  • Is the earning to debt ratio of the company high? (Green, 2008)
  • Does the company or the business incur high cost of maintenance or high cost of operations? If such is the case, then investing in such company is not good
  • Does reinvestment of earnings is done in prolific business opportunities?
  • At the time of inflation, can the company handle the adjustment of price?
  • Does the company hold a decent track record by its management in the past?

Hence, according to Warren, company should satisfy all the above mentioned questions before company in the portfolio, he had maintained.

Concentrated Purchase

Concentrated purchases were made by Buffett in his investment strategy. Warren Buffet has very few stocks in his portfolio but at the time of economic downturn in the industry, he buys lots of shares of good companies at lower price. His company, Berkshire Hathaway is considered to be one of the major players of soft drinks, insurance, shoes, steel, jewelries, energy, chocolates, etc. Berkshire Hathaway owns a huge share of small dividend paying stocks, for example,

  • Procter and Gamble
  • Coca Cola
  • Wells Fargo
  • Conoco Phillips
  • Kraft Foods

According to his strategies, long term returns available with equity shares can not beaten by any other alternative. However, there are some options in which one can invest, like real estate companies and investment in bond which provide around five percent dividends. One can also invest money in the money market which gives two percent return. (Harper)

According to him, an investor should hold a concentrated stock portfolio. According to this concentrated stock portfolio, he means that investor should own small number of stocks but investor should know all information about these stocks. Hence, in a lifetime of investment, an investor should buy and sell stocks for not more than twenty times. Buffett suggested that an investor should act in a way that he has a lifetime investment card with him in which there are just twenty buttons to punch. One should think that one investment decision makes him one step fewer towards the rest of the life of investment. This will result in some very fantastic consequences of investment. For example:

  • Twenty stocks are purchased and none sold, or
  • Tens stocks are purchased and ten sold

Warren said that patience is something very important for any investor. He said he read the financial report of Anheuser Busch Inc. twenty five years before he bought their stocks.

Warren Buffett about Value Investment

Buffett also interpreted properly the concept of value investment. He said that value investment is an important tool because it is mainly concerned with the buying of stock at a lesser price than its intrinsic value. Warren Buffett worked on the further Approach in Value Investment Strategies given by Benjamin Graham who mainly focused on discount rate of the security and thus the decision about the investment is made but Warren Buffett mainly focused upon the investment at a further level and target specific companies at rather price. He was not concerned with targeting general companies at discounted price.

Buffett investment strategies mainly focused upon return on equity rather than focus on earning per share. He understood that Return on equity can be affected by leverage which is debt to equity ratio and hence instead on evaluating leverage, he preferred companies with low leverage and having high profit margin. Buffett had twelve tenets or key considerations for investing in any company. (Warren Buffett investment strategy, 2009)

According to him, investment is not something that you know but it tells about how realistic you are in defining what you do not know. This is the prerequisite for evaluating performance of future business any company. Business tenet of Warren Buffett talked about objective of producing robust projection. It is important to analyze the business first, then economy, industry or market.

There were three investment tenets of Buffett related to the management quality of any company. According to him, evaluating the management quality of any company is the most difficult task for any investor.

Warren Buffett was mainly interested in estimating the intrinsic value of a company. He is also known as bond math. He at first forecasts the earning of the present and then calculates the present value of this forecast by discounting it to present. He forecasts future earning by historic earnings of the company. In his forecasts, he defined a term moat, according to which a company having wide economic moat should be favored. According to him, a clear advantage should be given to these companies over the other companies and protect them against raid from competition. Project earning of the company should be discounted at a risk free rate in order to have virtual elimination of risk.

Problems with Buffett Investment Strategies

There are various problems with Buffett investments strategies. Most of the problems are associated with the small investors or begging investors.

Mostly, small investors fail to implement his strategies successfully. Main reason behind this was they do not have enough access to the management quality. Buffett, from the early times was at a privileged position but most of the investors are not that big.

Buffett also focused upon learning investment through trial and error which was not acceptable in the real investing situations. (The Trouble With Warren Buffett’s Investment Strategy, 2005)

Buffett investment strategies fail for the beginning investors. Following his strategies, they usually fail because they do not have access to the information whereas Buffett had superior access to the information.

Conclusion

From the above paragraphs, it is clear that Buffet’s strategies have been very effective in the equity market. His own company Berkshire Hathaway, of which he is the CEO, has been very successful financially and has shown that under his leadership and guidance, investment can be as effective and empirical as science, rather than just a bundle of statistical estimates, which often fail in the real world. He has proved to be a king in the art of classical investment strategies, and has from time to time shown his mettle, i.e., his expertise in the field of investment into financial instruments.

As mentioned earlier, the strategies and methods introduced by Buffet in the field of investment are relatively uncomplicated yet effective. He forms a set of questions, which were listed earlier, which act as an excellent starting point for the evaluation of a company and a rough evaluation of probable returns that may be obtained through the purchase of equity shares of that company.

Buffet uses a concept of Concentrated Purchase in which he buys only a limited number of equity shares should be purchased by an investor, but this purchase must be backed with substantial knowledge of the companies to which these shares belong. This alone, he says, is the most profitable portfolio management technique, since he asserts strongly that long term equity price changes can’t be beaten by any other alternative like dividends from a large number of companies. While having said this, he does not completely discard the practice of purchasing bonds and investment in assets that take long time periods to mature to reach a certain level of profitability, since he agrees that a small amount of investment into these can provide a good stability in terms of income to an investor’s portfolio. He also mentions the advantages of purchasing a large number of shares during the economic downturn in the financial markets, since this requires very little investment owing to low prices of shares, and the fact that the equity share prices rise to very profitable values in no time, one the economic downturn gets over. 

Buffet also stresses on the advantages of the concept of value Investment. He worked further into the existing concept and modified it to use it to even greater advantage. Basically, he talks about buying shares of companies at the instant when the price reaches below the intrinsic value of the share. However, he mentions that not any company can be selected to use this strategy on. He gives a set of guidelines on the selection of a company. Along with this, the modification of the strategy from the then existing concept made by Buffet was that he focused on return on equity rather than on earning per share of a company. This means that one does not need to bother about the exact performance of a company in terms of its total profits, rather on the possible changes that the company is likely to undergo in terms of performance from its existing performance, which would determine the long term price change that would occur in the equity share of that company.

Along with the aforementioned, he mentions that the most important criterion for the evaluation of a company is the quality of management present therein, and that a thorough analysis of the management quality must be made before investment into the equity shares of the company. He also introduces a concept of moat in his analysis of economic forecasting, in which he says that companies with wide economic moat should be given higher preference over others.

Having mentioned the strategies of Warren Buffet along with the effectiveness of these, it has to be remembered that for most investors, which includes investment firms, the total available resources for investment are not large, so the option of implementing the method of trial and error in the investment into various companies is not possible. Thus it is not perfectly justified to say that the Buffet’s strategies could have been prepared and implemented by anyone with a small fund backup. Also, due to the position that Buffet held, he had excellent access to information about the management quality of various companies and other similar information, which small investors cannot have. Therefore, it is not always possible in the real world situation for small scale investors to successfully implement Buffet’s investment strategies.

LesSon learnt

Having mentioned the pros and cons of Buffet’s investment strategies along with a thorough evaluation of the applicability of the same in the real world situation for all kinds of investors, it can be understood that Buffet’s strategies are excellent on a stand-alone basis, which is proved by the fact they have put his firm on an excellent standing. However, if one wants to use his strategies, they must be modified appropriately by considering one’s own particular situation, both with respect to availability of information and more importantly, financial standing. For example, for a small investor, it would be more profitable to invest a higher portion of the total funds into bonds and other income generating financial instruments, so that a continuous return is obtained, so that there is always a certain amount of risk elimination and fund backup. Thus, the total earning would become lower on a long term basis since there would be a lower possession of number of shares, but the risk of the complete portfolio going flat would be, to a certain extent, eliminated.

Of course, the guidelines and pointers provided by Buffet related to the evaluation of a company are extremely effective for all kinds of investors, and there exists no doubt in the fact that these would work in all situations. Also, the analysis tools provided by Buffet, including both modified existing strategies and novel techniques related to forecasting etc, are excellent for any investor and can be used for investing successfully.

Recommendation

It is essential to absorb the good points introduced by Buffet, while making sure that his strategies are not followed blindly, and are appropriately modified before investing. For small scale investors, it is more advisable to use the analytical tools introduced by buffet for the analysis of various companies and financial instruments rather than follow the exact investment pattern used by him in his own situation. This is because, as mentioned earlier, Buffet was always in a very superior position with respect to finances and availability of information with respect to small investors. For large investors, Buffet’s successful strategies should be used so as to obtain satisfactory returns on various investment portfolios. Of course, the tools for analysis of the market can be used by such investors also. However, with the global market evolving perpetually and markets fluctuating at unpredictable rates, it has to be remembered that there is no guarantee of all strategies that have been successful in the past to perform in the exact manner in the future. Thus, even though Buffet has proved to be an iconic figure in the field of investment, a thorough analysis of the tools and strategies introduced and used by him in the past must be performed so that all possible fallacies that may have arisen within them due to the contingencies of time may be properly understood, which would alone allow various investors to implement them successfully in their own particular situation.

References

* Green, Alexander. (2008). Warren Buffett’s Investment Strategy: Time to Buy the Ultimate No-Brainer. Retrieved on March 23, 2010 from http://www.investmentu.com/IUEL/2008/September/warren-buffetts-investment-strategy.html

* Harper, David. (n.d.). What Is Warren Buffett’s Investing Style? Retrieved on March 23, 2010 from http://www.investopedia.com/articles/05/012705.asp

* Warren Buffett investment strategy (2009). Retrieved on March 23, 2010 from http://stockweb.blogspot.com/2009/11/warren-buffett-investment-strategy.html

* The Trouble With Warren Buffett’s Investment Strategy (2005). Retrieved on March 23, 2010 from http://www.investingator.org/the-trouble-with-warren-buffetts-investment-strategy/

[1] This statement means whether company will be able to repay the debt to the lenders even in the situation when company’s earning are lower than its standard earnings?

 


Cite This Essay

To export a reference to this article please select a referencing stye below:

  • APA
  • MLA
  • MLA-7
  • Harvard
  • Vancouver
  • Wikipedia
  • OSCOLA


Reference Copied to Clipboard.


Reference Copied to Clipboard.


Reference Copied to Clipboard.


Reference Copied to Clipboard.


Reference Copied to Clipboard.


Reference Copied to Clipboard.


Reference Copied to Clipboard.

Request Removal

If you are the original writer of this essay and no longer wish to have the essay published on the UK Essays website then please click on the link below to request removal:


More from UK Essays

Management Essay Writing Service
Essays
More Management Essays
We can help with your essay

Find out more