Buffettology The Previously Unexplained Techniques That Have Made Warren Buffett the World's Most Famous Investor $ Mary Buffett David Clark Rawson. “The Warren Buffett Way outlines his career and presents examples of how his investment techniques and methods evolved and the important individu- als in the. new PDF The Buffettology Workbook: Value Investing The Warren Buffett Way Full Online, new PDF The Buffettology Workbook.
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The new Buffettology: the proven techniques for investing successfully in made Warren Buffett the world's most famous investor / Mary Buffett and David Clark. PDF Buffettology by Mary Buffett? ebook download for mobile, ebooks download novels, ebooks. The Buffettology Workbook Warren Buffett BUFFETTOLO. (This is true, but is intended as abuse so that the hearer will be more sympathetic . invest it with a significance and The Warren Buffett Way: The World's.
For our purposes, any common stock that represents an ownership interest in a company is called equity. Some of them may want out of the business at some future date. He was simply looking for the right deal. The characteristics of the businesses that he is investing in will vary according to the nature of his investment. SlideShare Explore Search You. Warren is an extremely intelligent and competitive individual. True, the judgment may take all the company's capital, but the plaintiff can't come after the shareholders.
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Kathleen de Jesus. Merrill Lynch then calls its clients and sells them Katie's stock. This is called an IPO, or initial public offering. With an IPO a large chunk of the ownership of Katie's stock ends up in the hands of thousands of people. Katie's has thousands of different individual owners, each owning a small portion of Katie's Baking Company. An odd thing happens when you end up with a lot of owners. Some of them may want out of the business at some future date.
Maybe they need the money or maybe they no longer think that the baking business is the place to have their money. Whatever the reason, they want to sell. The shareholders who want to sell call their stockbrokers and tell them that they want to sell one hundred shares of Katie's Baking Company.
Those who want to buy call their brokers and tell them they want to buy one hundred shares of Katie's Baking Company. These two orders meet on the floor of the New York Stock Exchange, one of many stock exchanges found around the world. Buyers and sellers come together, one bidding to buy, the other asking to sell. When the bid and ask prices meet, a sale occurs.
It is basically an auction pricing method. All of this is facilitated by people called specialists who sit on the exchange floor and act as market makers. These market makers have a fixed place on the floor where buyers and sellers of a particular stock meet. The agent goes over to the market maker for Katie's stock and puts in the order. Someone who wants to sell does the same thing.
And the market maker acts as the matchmaker, bringing the two agents together for the sale. Sometimes when the market is slow for a particular stock the market maker will buy the stock forhis own account. This stock becomes part of his inventory, which he will sell when a buyer finally shows up. The market maker always keeps a small inventory of the stocks he deals in so he can fill buy orders when there are no sellers.
For our purposes, any common stock that represents an ownership interest in a company is called equity. And bonds are called debt. The companies that we will be discussing in this book all went public years ago and have thousands of shareholders and are traded at various stock exchanges. Let's start with a simple business and value it to determine at what price it would be an attractive acquisition.
The business will be uncomplicated and straightforward, and we will forgo the effects of inflation and taxation on the valuation process. This will also give us a chance to explain balance sheets and income statements and the process of incorporation. The wise investor should have some understanding of these things, but many do not.
Those of you with MBAs may be bored to death by this exercise, so I'll throw some Warren tidbits into the pot as we go along. Let's say that young Warren develops a childhood dream of becoming the richest man in America and at the age of seventeen decides to start a business. As with all young business tycoons, the money is burning a hole in his pocket.
What should he do with it? Spend it on girls? No, he hasn't yet met Susie, his wife and the mother of his children. Maybe he should spend it on some candy and a soda. No, they rot your teeth, which will mean paying a dentist, which means capital expenditures with no return.
No, by golly, young Warren is going to go out and start a business and make some more money. If he wants to take full advantage of the wonders of compounding interest, he knows that the younger he starts, the better. As we all know, death is what stops the compounding of money and brings the tax collector to your door. Now that he has the first asset of his business, he realizes he needs to put it someplace where people will use it.
The guy at the local pool hall says he's got four pinball machines of his own and he does not want Warren in there taking his customers away. Realizing that the pool hall has a sort of monopoly on pinball-playing types, young Warren becomes depressed at having been cut out of the action. As they say in the retail business, "Location, location, and location.
A trip to Sarge's barbershop indicates two things: Sarge, always keen on making a dollar, says, "Yeah," and promptly goes into business with young Warren. Walking out of the barbershop, young Warren realizes that this is going to be a very profitable business venture. Good question. But the answer isn't exactly clear. Let's look at some of the economics of the business. So his balance sheet, a thing that accountants use to determine a business's financial position on a particular day, looks like this at the end of his first day of business: Let's go through the balance sheet.
Note that you can do a balance sheet for any day of the year, but most businesses only do it at the end of a fiscal quarter and the fiscal year. The income statement is another document that shows how much money a business earned during a particular period of time. For Warren's pinball business the income statement for the first day would look like this: Income equals the amount young Warren can stick in his pocket. So what is Warren's business enterprise worth? We know also that Sarge keeps his business open seven days a week and takes particular pride in staying open on holidays, which means that he is open days a year.
Okay, Sarge is a little weird.
Not a bad return on your investment. Feeling a bit miffed, you respond, "Well, if you're so smart, young Warren, just what is your pinball business worth?
Present value? And he says, "Present value. That is, if you don't spend any of the money you take in, effectively retaining all the earnings. So, Mr. You whip out your BA Solar supercalculator, which can compute present and future values with the flick of a wrist. What does this do to our evaluation? The equation for the calculator goes like this: Remember, it is this annual compounding rate of return that we are interested in. Thus, whatever your return requirements are, it is possible to calculate the amount you have to pay to get that return.
Pay above that amount, and you are speculating that the business will do better than projected by past results. Pay less, and you will be getting a greater return on your money. You have taken a business perspective. You realize the realities of the business and the return that is offered, and are willing only to pay a price that makes economic sense. More on this later. You are not caught up predicting that young Warren is going to become the pinball baron of North America with a chain of barbershop pinball machines crisscrossing the United States.
No, you will leave that one to the folks on Wall Street. What you are interested in is the certainty of the investment's annual rate of return.
Let's think about this from another perspective. Before he spends a dime, the cabdriver who buys a new cab figures out what the cab is going to cost versus what it is going to earn. The cabdriver has taken a business perspective to analyze the merits of his investment.
The Corvette buyer is speculating and letting greed and hopeful thinking dictate his actions. His ability to calculate his future return blows freely in the winds of fashion and greed. Another real-life example is the individual who buys commercial real estate, such as an office building.
Commercial property is almost always bought and sold on a business perspective basis. Residential real estate, however, has a more speculative nature, with people buying apartment buildings and paying more for them than they can possibly carry with their rental earnings. Thus, any investor will have to put up a huge down payment to cover the excess speculative price in order to make the bank comfortable and give the bank a margin of safety. Banks try to lend money with a business perspective.
They keep a sharp eye on what the property can earn, and care little about the rise in real estate values. What banks care about is the property's ability to generate income to cover the interest charges.
The speculator, on the other hand, is hoping that real estate values will increase and that in the future he will be able to sell the building at a higher price than he paid.
He is not unlike the Corvette buyer, caring little about what the property can realistically earn compared to what it might sell for in the future. And such is the stock market, where fractional interests in individual businesses are auctioned daily on the motivation of both business perspective investment and greedy speculation.
On the business perspective side are the large corporations seeking to buy whole companies so that they can add to their earnings base. On the speculative side are the individual investors and many mutual funds buying not on the basis of sound business reasoning but on the basis of hope and greed. Understand that the price at which a security is being sold is not always indicative of what the company is worth. Sometimes the true value of the company is more and sometimes it is less.
The stock market is made up of people and entities, like corporations and mutual funds, that are motivated by two contrary strategies. Described in their polar extremes, these two strategies encompass investment from a strictly business perspective and rank speculation motivated by fear and greed. It is this speculation that can send securities to spectacular heights and then to depressingly fear- motivated lows.
It is the business perspective that calls them to a medium, down from the greedy heights and up from the fear-motivated lows.
It had a long history of spectacular earnings growth, which was made possible by the profits generated by the tobacco business. However, the public had labeled the company a pariah because of the lawsuits against it by people who claimed they had cancer, caused by smoking. The stock market saw this and responded by keeping the price of the stock low.
The management of RJR Nabisco saw the low price and realized that they could borrow the billions of dollars they needed to buy out the existing shareholders, thus taking total control of the company, and then use the company's free cash flow to pay off the billions they had borrowed.
Seeing this opportunity, the management formed a group of investors that arranged for billions of dollars of financing from a Wall Street investment bank. This is somewhat like buying a commercial piece of real estate, paying the seller out of the proceeds from the new mortgage you obtained from the bank, and then paying off the bank with the proceeds from the rents. It was a very clever game, made possible because the speculative public, motivated by fear, oversold the stock and forced the stock's price downward.
After the buyout, KKR used RJR's free cash flow, along with the proceeds from the sale of several of its subsidiaries, to pay down the debt, and as of the writing of this book, the company is profitable and has paid off a large portion of the debt incurred from the buyout.
Think of leverage-buyout firms such as KKR as a group of investors who go out and buy a building that doesn't have a mortgage on it, then use the rents the building generates to pay off the bank.
But instead of buildings, groups like KKR do it with companies that don't have much debt and that the stock market has undervalued. Graham wrote in his edition of Security Analysis that "in general, the market undervalues a litigated claim as an asset and overvalues it as a liability.
Hence the students of these situations often have an opportunity to buy into them at less than their true value, and to realize attractive profits— on the average— when the litigation is disposed of. Please note, this is not to say that the business world is not capable of being caught up in speculative greed and then spending too much for an acquisition. It is something that usually happens when management's ego gets wrapped up in the game and the greed of increasing its empire goes to its head, replacing the sound business logic that investing from a business perspective dictates.
What to Buy— and at What Price That's right. If you can answer these two questions, you've got it made. What to buy, and at what price?
Seems simple, doesn't it? The problem is that Wall Street, with its investment bankers and brokers, functions basically as salesmen working for a commission. Obviously they want to get the highest price possible for the goods they are selling. The buyer is almost ensured of never getting a bargain. New issues are priced at their maximum to allow the issuing company to receive the most money for its shares and the investment bank to receive the biggest commission.
The stockbroker who calls you on the phone is a commission broker, and like all commission brokers, he is interested only in selling the priciest items that he can. If the stockbroker is selling you a new issue, then you know immediately that it has been fully priced by the investment bank and you are not getting any bargain. If the stockbroker is selling you an issue that his research department is backing, then you know that you are following the herd mentality.
For, as the stock price rises, the enthusiasm of the stockbroker will increase as well. Interesting, isn't it, that the man who has made the most money in this game has a strategy opposite to that of the guy who calls you on the phone and is trying to sell you something!
For the oddest of reasons, Wall Street and the individual investor have jumbled the questions of what to buy and at what price into a myriad of financial pyrotechnics that befuddle the imagination. They screw it up by focusing entirely on the question of what to buy and totally ignoring the question of price. Like jewelry or art salesmen, they let the aesthetics of the form take precedence over the question of function. The Wall Street broker treats the financial economics of an enterprise as though they were aesthetic qualities and, almost without fail, separates the price entirely from the picture.
Remember, the stockbroker is trying to sell you on the prospects of the stock rising in price, and this is where the aesthetic qualities of the economics of the business come into play. The broker creates the excitement with the economics, and you, the investor, salivating like Pavlov's dog, give him your money.
In all that time no one ever said boo about whether or not you have received any true value for your money. But what does value have to do with aesthetics? However, if function had been your first question, you would view any investment as Warren does— from a business perspective. The nagging question should not be about the rising price of the stock but about whether or not the underlying business is going to make any money. And if so, how much? Once that figure has been determined, the return given for the price asked can be calculated.
It never ceases to amaze me that Wall Street can sell to investors, at wildly ridiculous prices, companies that are just starting out and won't have any earnings for some time. This happens while companies that show a long history of earnings and growth go for a fraction of the price of their speculative cousins.
For Graham the questions of what to buy and at what price were mutually dependent. However, Graham placed a greater emphasis on letting price dictate the what-to-buy decision than does Warren. As long as the company had stable earnings, the per share asking price would determine what could be bought, and Graham had little concern about the nature of the business.
Graham didn't care if it manufactured or sold cars, batteries, airplanes, rail cars, or insurance, as long as the price of the company's stock was comfortably below what he thought it was worth. For Graham a low enough price compensated for poor inherent business economics.
Graham developed an arsenal of different techniques to determine the worth of the business in question. Everything from asset values to earning power found its way into his calculation of intrinsic value.
Graham calculated the value of a company and then determined if the asking price was low enough for him to make a sufficient profit.
Sufficient profit potential afforded him what he called the "margin of safety. As we know, first he discovers what to buy and then he decides if the price is right. A real-life analogy would be if Graham went to the discount store to shop for a bargain, any bargain, as long as it's a bargain.
You have to know the feeling. Even though you live in Florida and will probably never use a snowblower, the price is so low that you can't pass it up.
That is the essence of who Graham was and how he chose his investments. Thus, the only time he can be found in a discount store is when he's checking it out to see if anything he needs is selling cheap. Warren functions in the securities market the same way. He already knows what companies he would like to own. All he is waiting for is the right price. With Warren the what-to-buy question is separate from the at-what-price question. He answers the what-to-buy question first, then determines if it is selling at the right price.
Now go back and read it one more time! How Warren determines which are the right businesses to own at what price will be the focus of the rest of this book. The Magic of Compounding Understanding both the power of compound return and the difficulty of getting it is the heart and soul of understanding a lot of things.
Charlie Munger Forbes, January 22, Before I take you any further, I would like to explain how the magic of compounding sums of money fits into Warren's philosophy and is often overlooked by those who are trying to understand his strategies. Maybe as a child you were told that if you had one penny and doubled it in a year, you would have two pennies.
Now, if you had two pennies in Year 2 and you doubled that amount, you would have four pennies. If you kept this process up for a period of twenty-seven years—. Sounds financially magical, doesn't it? In the early days of Warren's investment partnership, he was fanatical in his letters and memos to his limited partners about explaining the virtues of compounding sums of money.
The reason for this is that compounding is one of the wonders of the world and Warren has used it to dramatic effect in getting the value of his investments to grow at spectacular rates.
But his real trick is getting a high annual compounding rate of return that is not subject to personal income taxes. It is probably his greatest secret and the one that eludes the majority of students of Buffettology.
We will address this brilliant bit of Buffettology later in this chapter, but for right now let's focus on the basics of compounding. Warren believes that compounding is the secret to getting really rich. Let me show you why. Here's how compounding can make you rich. It's amazing, isn't it? A difference of just 5 to 10 percentage points can have a tremendous effect on your total gains. The difference that just a few percentage points can make over a long period of time is astonishing.
Warren is seeking to get the highest annual compounding rate of return possible for the longest period of time possible. At Berkshire Hathaway, Warren has been able to increase the underlying net worth of his company at an average annual compounding rate of Which is phenomenal.
I cannot stress enough that the concept of compounding is a key to understanding Warren. It is simple and easy to understand, but for some strange reason its importance in investment theory is grossly understated.
For Warren the theory of compounding reigns supreme. Lets look closer at why. After taxes this works out to a Charlie Munger Forbes, January 22, The first thing you must understand is that a compounding return is different from what is normally paid on passive investments, such as your basic corporate bond. It also allows the investor to skip the personal income tax levy until the very end, when bonds come due and General Motors pays him back the principal plus interest.
Instead of paying the money out, GM keeps it and buys more bonds for the investor. This process continues through to the end of the fifth year. The following table shows the results of compounding tax free: Sounds great, doesn't it? Too bad the IRS won't let the investor get away with this. They long ago figured this trick out and will send him a tax bill in the year the interest is earned, even though he won't see a check until the end of year 5.
But for Warren the IRS missed one very important point. In Warren's world, buying a company's equity common stock is the same as buying its debt. Understand that the net earnings reported by a company in its annual report or by the investment surveys, such as Standard and Poor's or Value Line, are an after-corporate-income-tax figure.
This means that those earnings will be subject to no further taxation unless the company pays out the earnings to you as a dividend. If the company pays out the earnings as a dividend, then you have to pay personal income taxes on the dividends received.
Warren saw that the income earned on corporate and government bonds was being taxed at personal-income-tax rates.
Think of it: And if the company doesn't pay the earnings out to Warren as a dividend, but instead chooses to retain them, Warren is protected from personal income taxes until he sells his investment, which could be never. The earnings that are retained by the company will compound at the effective rate of return at which the company can profitably reinvest them.
Compounding earnings and no personal income taxation. Sounds great to me. Remember, Warren's investment objective is to get the highest compounding rate of return possible for the longest period of time possible. So it is better that you leave your money in Berkshire and let the increase Berkshire's net worth be reflected by an increase in the price of its stock.
Of course, when you sell your investment in Berkshire the tax collector demands a cut of your capital gain. This gives you a compounding after-capital-gains-tax annual rate of return of To get an after-personal-income-tax compounding annual rate of return of A return of If I offered you a ten-year bond paying a yearly rate of return of You bet you would.
In fact, you would take all of it you could, and then set up a partnership to get your friends' money into it. You could have done the equivalent by investing in Berkshire Hathaway in the early eighties. In fact, all of Wall Street could have— but did they?
And people wonder why the majority of Wall Street customers aren't the ones who own the yachts. Nothing could be more wrong. Consider this: Which is a lot of money! To perform the above equation on your BA Solar financial calculator, first make sure the calculator is in its financial mode hit the MODE key until you see a small FIN on the screen.
A final thought on the wonders of compounding. Warren is famous for driving older-model cars. In the early days of his partnership he drove a VW Beetle. People observing this attribute it to a general lack of interest in acquiring material items.
What they fail to see is how his compounding influences his spending habits. In Warren's world this is the key question that sets the stage. Warren has always maintained that identifying what to invest in is a mind-challenging event. In Warren's case, after spending his early years following Graham's philosophy, which often led to his buying mediocre businesses, he rebelled against his mentor and embraced the philosophies of Philip Fisher and Charles Munger.
Fisher and Munger, through experience, developed an investment philosophy that advocated investing only in businesses that have superior economics working in their favor and are selling for the right price. Fisher and Munger agreed with Graham that the price you pay determines the return on your investment.
But they differed from Graham on what was a desirable purchase. Graham believed that most businesses were possible candidates for investment as long as he perceived them to be selling at a bargain price.
For Graham, the possibilities were endless, and his investment portfolio reflected this thinking.
On any given day he might own positions in a hundred or more different stocks. He thought that most businesses had an intrinsic value and that when they sold well below that value they were candidates for acquisition.
The investor merely had to determine the intrinsic value of the business, which Graham said was more of a "range of value" than a single price.
He liked to say that if a man was fat you didn't have to know his exact weight to know he was fat. The problem with this approach is determining what is fat. To most British people, the Germans seem fat, while most Germans think the British skinny.
The same is true in business. What appears to be skinny may be fat, and what may appear fat may be really skinny. Graham wasn't all that concerned with the nature of the business he was buying. He couldn't be. He was involved in too many businesses. What Graham did to try and solve this problem was set up standards for determining if a business was fat or not.
One method he used over the thirty-odd years he was managing money was to purchase a group of common stocks at less than their working-capital value, or net- current-assets value, giving no weight to plant and other fixed assets, and deducting all liabilities in full from the current assets. Another method he used was to buy a group of stocks at less than seven times reported earnings for the past twelve months.
Graham warned that these methods were to be used for the purchase of a group of companies and not single stocks. Graham's philosophy failed, however, with the central problem of buying below intrinsic value.
That is, in order for the investor to profit from the transaction, the price of the business he bought below its intrinsic value must someday rise to or above the stock's intrinsic value. Thus we have the realization of-value-problem of intrinsic-value-oriented investing. To put it more bluntly, what do you do with those companies you bought at a price below their intrinsic value if they continue to sell below their intrinsic value?
Let's play with an example. But here is the problem: If the company doesn't become fully priced until the third year, Graham's return drops to 7. In the fourth year it drops to 5. Thus, the realization-of-value problem. If the realization of value doesn't occur, every year that you wait, your projected annual compounding rate of return substantially diminishes. And if it takes longer than a few years, you end up with an annual compounding rate of return that may be less than what you would have received if you had put your money into a savings account at the local bank.
Graham's solution to this problem was to require what he called a margin of safety a concept he adapted from bond analysis. The projected return is the difference between the stock market price and Graham's determination of the stock's intrinsic value.
This way Graham ensured himself an adequate return even if he had to wait several years for the company to reach its full intrinsic value. To protect against those companies that never reached full price he diversified his holdings, sometimes— as noted— owning up to one hundred or more different companies.
He also instigated a program that called for selling any holding that had not reached its full value within two to three years. Graham was not a real long-term player. For Graham, the longer the investment took to reach full intrinsic value, the lower his annual compounding rate of return would be. Graham eventually concluded that many companies were incapable of being analyzed and their intrinsic value could not be determined.
He developed a standard that required the company to have stable earnings before a security analyst should venture in and determine its intrinsic value.
Stable earnings for Graham equated to predictable earnings, which would allow for a more exact calculation of intrinsic value. Thus, the requirement of stable earnings started Graham in a direction that allowed for exclusion of some businesses that didn't have stable earnings from the evaluation process.
Graham, by using this limited point of view, began to restrict his field of possible investments. Quantitative reasoning, though reflective of the qualitative side of a business, does not fully articulate what is happening in a business. Stable earnings may allow one to place an intrinsic value on a business, but they will not always indicate the nature of the business's underlying economics. Stable earnings merely allow for a perceived sound base from which to perform mathematical calculations.
Warren found that, effective as Graham's methods were, they lacked certainty and often left him holding on to investments that never performed. In addition, Grahamian philosophy dictated that an investment be sold when it reached its intrinsic value or after holding it for two to three years.
But Warren found that every time he sold a Grahamian-type investment and it worked positively, taxes would erode his profit. Warren discovered the solution to this problem in the philosophies of Charlie Munger and Philip Fisher, who advocated investing only in excellent businesses that have an expanding value.
A perfect example of this is the General Foods play, which we discussed in Chapter 7. General Foods' per share earnings continued to rise from the year , when Warren started buying the stock, through , when Philip Morris bought out the company. As the earnings of General Foods rose, the intrinsic value of the company rose as well. But even with this increase in stock price the market continued to value the company just at or below its intrinsic value relative to the return on government bonds.
Let me show you. Using classical Graham, Warren might have sold the General Foods position in as the market price started to reflect the intrinsic value of the company relative to the return on government bonds. And again using Graham, Warren might have sold the stock after holding it for two or three years because there had been no significant increase in the stock's price. But because General Foods is the kind of business that has an expanding value, Warren held on to the position.
Even though the company continued at times to sell below its intrinsic value, the market price continued to rise. Warren knew that the market price would rise eventually because the economics of the business would allow the company to experience long-term economic growth, which would be reflected by increasing per share earnings.
And the stock market would eventually increase the market price of the stock to reflect the increase in per share earnings. Warren, using the rationale of Fisher and Munger, realized that eventually the stock market would fully value General Foods stock, and if it didn't, the stock would still rise in price as the market value of the stock followed up the increasing intrinsic value of the company.
To paraphrase Graham: Short term, the market is a voting machine, letting whim, fear, and greed dictate how it votes. But long term, the market is a weighing machine that values a company according to the weight of its intrinsic value.
Remember, Warren considers the per share earnings retained by the company to be his return. Warren's only concern was whether the business nature of General Foods was such that the earnings of the company would continue to grow, thus protecting and expanding his estimated rate of return. Thus, during the seventies, Warren began to realize that the Grahamian approach to investing— purchasing anything and everything that was defined as a bargain— was not the ideal strategy.
Warren found that mediocre businesses really didn't have predictable earnings. An enterprise with poor inherent economics more often than not would remain that way. And though the company may have a period of hopeful results, the extreme competitiveness of commerce would in the end rule out any long-term profitability that would increase the value of the company.
He also found that the average or mediocre business would, in effect, forever tread water and the stock market, seeing lackluster results, would never become enthusiastic about the enterprise.