QUITE SIMPLY THE WORLD’S GREATEST INVESTOR:
Warren Buffett—the Sage of Omaha Talking about the world’s greatest-ever investor is rather like discussing the world’s greatest-ever batsman: only one name really rolls off the tongue. And in their determination and focus on the basics, there are plenty of similarities between Bradman and Buffett. You’ll have to get hold of The Don’s The Art of Cricket to find out how he amassed 28,067 first-class runs; here we’ll explain how Buffett has piled up US$40bn. Warren Edward Buffett was conceived approximately one month after the Wall Street crash of 1929, and his early childhood was deeply affected by the crash and the great depression that followed. Buffett’s father, Howard, was a securities broker in Omaha, but he lost his job and his savings when the bank he worked for collapsed in 1931—shortly before Warren’s first birthday. Howard responded by establishing his own stockbroking firm, but it was a tough way to earn a living in the early 1930s. For a long while, as investors shunned the market, Buffett senior’s business was little more than a sign on a door. Buffett’s mother, Leila Stahl, had been brought up in West Point, Nebraska, with a family that owned and operated a local newspaper, the Cuming County Democrat. She moved to Omaha with Howard after they married in 1925. Buffett’s tough early years probably helped to forge his parsimonious nature and his desire to ensure that he would never have to struggle for money. Combined with his early exposure to the stockmarket and investing, through his father’s work, Buffett was light years ahead of most children at money management by the time he began school at the age of six. Around this time, Buffett is said to have embarked on the first of many money-making schemes, buying six-packs of Coca-Cola for 25 cents and then selling the individual bottles for 5 cents each. According to his mother, during a severe illness at age seven, Buffett lay in a hospital bed calculating his future riches on a sheet of paper, exclaiming to a nurse: ‘I don’t have much money now, but someday I will and I’ll have my picture in the paper.’ Howard Buffett was a man of high principles and this led him into politics. The politics, in turn, led to the family
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being relocated to Washington DC in 1942, when Warren was 12, after his father won a seat in Congress. Buffett junior was very unhappy at being away from Omaha, but his time in the US capital was significant in terms of his fledgling business career. A paper round began a very profitable lifelong association with The Washington Post. When his paper round was at its peak, Buffett was making US$40 a week from it. To this could be added US$20 a week for his share of a partnership with his friend Don Danly, owning, operating and servicing pinball machines in barber shops. He filed a tax return in respect of his earnings and refused to let his father pay the taxes. In 1947, the 17-year-old Buffett went, somewhat reluctantly, to the Wharton School of Finance and Commerce at the University of Pennsylvania. He didn’t feel that he was learning very much from his university studies, however, and in 1949 he returned to Omaha, after his father lost an election, and he transferred to the University of Nebraska. In Omaha, he was rushing through his studies and, at the same time, adding to his funds with various jobs on the side, including one where he managed 50 paper boys for The Lincoln Journal. For all his business acumen and earning power, though, Buffett was still unsure about what to do with the money. Buffett’s stockmarket epiphany came in 1949 when he first read Benjamin Graham’s legendary book on investing, The Intelligent Investor, which had been published that year (and which is the inspiration behind the name of our own humble publication). C ON TE N TS This encouraged him to enrol at the PAGE University of Warren Buffett—the Sage of Omaha 1 Columbia to study Piling on the dollars 3 under Ben Graham. (For more on Ben Key influences—Graham and Munger 3 Graham see page 3.) Buffett’s investment philosophy 5 What Buffett Buffett’s bullseye—the consumer franchise 9 learnt from Graham Top-quality management 10 laid the foundations [ CONT. ON PAGE 2 ]
Hitting the fat pitch
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for his investing career by ramming home the crucial distinction between price and value. After scoring the only A+ that Graham had awarded in 22 years of teaching, Buffett had hoped to be employed by Graham’s investment firm, but he was rejected because the firm employed only Jews (who were shunned by the traditional Wall Street investment houses). Buffett even offered his services for free, for the honour of working with the Master, but his approach was rebuffed. So Buffett returned to Omaha where he took employment with his father’s firm, Buffett Falk. Asked whether the firm would be renamed Buffett & Son, he is said to have retorted: ‘No, Buffett & Father.’ At this time, Buffett courted Susan Thompson, whose parents were family friends, and the two were married in 1952. They had three children, Howard, Susan and Peter. In 1954, Ben Graham relented and Buffett completed his education by working for two years, for US$12,000 a year, at Graham’s firm in New York, until Graham retired in 1956. The firm was wound up because, as one investor said at the time, ‘Graham Newman can’t continue because the only guy they have to run it is this kid named Warren Buffett. And who’d want to ride with him?’ It turned out that plenty of people did want to ride with Buffett. When he returned to Omaha, his own investing partnership began with friends and family, but several notable clients of Graham Newman were directed his way, and word of mouth spread. Soon, Buffett was managing many millions of dollars. His rule was that his partners were not to know anything about how their money was invested, but they would be given a simple annual statement of returns. In addition to this, and so that he wouldn’t be at the whim of fickle investors, he would allow partners to withdraw or add money on only one day a year. The results of the Buffett Partnership were spectacular. Between 1957 and 1970, he never lost money in a single year and always beat the stockmarket index, compounding his investments at an average of 28% and turning US$1 into US$32 (see page 3). A notable investment success was American Express, whose stock price was hammered by a fraud in New Jersey but whose business franchise and intrinsic value, Buffett famously surmised by watching the tills at his favourite steakhouse, were largely undamaged (see page 11). But by the end of the 1960s, the markets were flying upwards to ever greater heights and Buffett was finding it increasingly hard to find suitable investment opportunities. In the end, he decided to liquidate the partnership in 1970 2
and focus instead on a small Massachusetts textile company named Berkshire Hathaway. Buffett had first invested in Berkshire in 1962 when its stock price was just US$8, compared with net working capital per share of US$16.50. As further stock came on the market, he just kept buying more, and soon the Buffett Partnership was the company’s largest shareholder. Berkshire Hathaway was, however, in an absolute mess, with huge mills that cost more to maintain than they generated in cash. Buffett either needed to get out for a small profit, or to engineer a change in management. In the end, he chose the latter, and, in 1965, with the stock price at US$18, Buffett took control of the company. Buffett’s first step was to put a new man, Ken Chace, in charge of the textile operations. He explained that he needn’t bend over backwards to chase unprofitable sales, but that he would be judged according to cash return on invested capital. Buffett was about 30 years ahead of his time in using this measure, which achieved buzzword status in the 1990s, but it set the scene for his long tenure at the company—the Berkshire subsidiaries should only invest cash at attractive rates of return, otherwise Buffett himself would take it and find other opportunities. And there were plenty of other opportunities. The Washington Post, Gillette and Coca-Cola (see page 12) are among the more famous listed companies in which Berkshire has made huge profits. But equally successful have been the company’s purchases of entire businesses, such as GEICO (see page 11), See’s Candies, the Buffalo News, Nebraska Furniture Mart (see page 10) and Borsheim’s Jewelry. Whether purchased in full or in part, all of these businesses benefited from having a strong, defensible business franchise, enabling them to churn out everincreasing quantities of cash for investment in new opportunities. There’s more about Buffett’s approach to investing on page 5, and on his favourite ‘franchise’ type of investment on page 9. The Berkshire Hathaway share price is now edging up towards US$90,000, giving an average annual return, since Buffett first took control, of about 26% per year. The market value of the company is now well over US$100bn and the only thing standing in its way is the difficulty of finding big enough and good enough opportunities to make a difference to such a huge company—a fact that Buffett frequently moans about in his annual letters to shareholders. Having too much money, though, is a problem that few people get to complain about.
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Warren Buffett began his journey towards his estimated wealth today of US$40bn by cobbling together a few thousand dollars during his childhood by collecting golf balls, operating a pinball-machine business, running paper rounds and doing any other odd jobs that came his way. By the time he took Ben Graham’s investing course at the age of 20, Buffett had accumulated US$9,800 (see Note 1).
charts the progress of one of Buffett’s 1950 investment dollars up until 2004, compared to how one dollar might have fared being invested in the overall US stockmarket (see Note 2). We’ve done the chart on a logarithmic basis. It sounds a bit scary, but it’s the best way to do charts of things that compound over time, because it gives equal weight to the same proportional increases. But there’s another very good reason for doing it this way, and that is that if we didn’t, then the US stockmarket would not even register on the Working with Graham in New York, Buffett then achieved the best returns of his career, compounding his same chart as Buffett—quite literally, because the dollar money at 56% a year to reach a total of US$140,000 when invested with the US stockmarket ends up at just less than a thousandth as much as the dollar invested with Warren he returned to Omaha in 1956. Buffett then placed this money into his investing partnership. Between 1957 and Buffett. Don’t believe us? Well here’s the normal chart 1970, he compounded his investments at an average rate then. (See—we told you.) of 28% a year. Through this period, however, his own Buffett’s investments (linear scale) personal wealth benefited from a kicker effect thanks to performance bonuses from the partnership. $600,000 When he liquidated the Buffett Partnership in 1970, he $500,000 was able to convert his share into a stake of $400,000 approximately one third in Berkshire Hathaway. Since then, Berkshire Hathaway’s net assets have compounded $300,000 at an average rate of 23% per year (though the intrinsic $200,000 value of Berkshire Hathaway, and its shares, have $100,000 compounded at a somewhat higher rate). $0 I Over the full 54 years, therefore, Buffett’s investments I I I I I 1950 1960 1970 1980 1990 2000 have grown at an average rate of 27.6%. The graph below Note 1. Buffett’s returns: The returns for Warren Buffett comprise three main sections. Firstly, there are Buffett’s own personal returns between 1950 and 1956, when he turned US$9,800 into US$140,000 (data taken from Davis, ‘Buffett Takes Stock’, in Lowenstein, Buffett —The Making of An American Capitalist). Secondly, there are the returns of the Buffett Partnership between 1957 and 1969. Finally, there are the returns of Berkshire Hathaway since 1970.
Buffett’s investments (logarithmic scale) $1,000,000 $100,000 $10,000 $1,000 $100 $10 $1 I 1950
I 1960
I 1970
I 1980
I 1990
I 2000
Note 2. US stockmarket returns: From 1965 to 2004, the returns of the US stockmarket are taken as the return of the S&P 500 Index, with dividends reinvested. From 1950 to 1964, they are taken as the return of the Dow Jones Industrial Average, with 5% added each year as an approximate adjustment for dividends.
Key influences—Graham and Munger Ben Graham Ben Graham was a successful investor in his own right, but he is remembered most for his teachings on investment theory and analysis—and particularly for the education he provided to Warren Buffett. Graham’s books, Security Analysis, co-written with his former student David Dodd in 1934, and The Intelligent Investor (1949), almost define the value investing approach. It was after reading The Intelligent Investor, which Buffett has since described as ‘by far the best book on investing ever written’, that Buffett decided to enrol in Graham’s class at the University of Columbia. Graham was born in London in 1894, but moved with
his family to New York the following year. After graduating second in his class from the University of Columbia, he was offered teaching positions in three departments— English, Mathematics and Philosophy—but chose instead to take a job as a stock exchange runner. After a brief interruption for the First World War, Graham became a full partner in the firm of Newburger, Henderson and Loeb at the age of 26, before forming the Graham Newman partnership with his friend Jerome Newman in 1929. When the crash came, Graham was relatively insulated by his value investing approach, with his main fund—the [ CONTINUED ON PAGE 4 ]
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Graham on Buffett: ‘Warren has done very well.’ Buffett on Graham: ‘It is difficult to think of possible candidates for even the runner-up position in the field of security analysis.’
‘Joint Account’—losing a tolerable 20%. But he jumped back in with borrowed money when the market started dishing up incredible bargains in 1930. Unfortunately, however, as John Kenneth Galbraith observed in his 1954 book, The Great Crash: ‘The singular feature of the great crash was that the worst continued to worsen.’ By 1932 the Joint Account had fallen 70%. Of course Graham’s strategy was perfectly sound, except that by borrowing money he had restricted his ability to wait for the market to return to rational valuations. No doubt this episode had a lot to do with the ultra-cautious approach Graham adopted for the rest of his days. Alongside his investing activities, Graham taught a course on investment at the University of Columbia from 1928 until the 1950s. It was through this that he met Warren Buffett and a number of mutual friends and associates, such as Walter Schloss (see the cover story to issue 178), Tom Knapp, Ed Anderson and Bill Ruane—a group that later became known as the Superinvestors of Graham and Doddsville after a speech given by Buffett at the University of Columbia in 1984 to celebrate the 50th anniversary of the publication of Security Analysis. Ben Graham lies at the foundation of almost all of Buffett’s investment thinking. Indeed it was Graham who confirmed and developed in Buffett the very idea of value investing: that a stock had an intrinsic value that was independent of its market price. Through Graham, Buffett learnt to take advantage of fickle human nature rather than to be hostage to it: to allow sentiment to set up opportunities, rather than to hope for it to carry an investment forwards—if a value share was correctly chosen, the simple passage of time was a far more reliable way of making profits. The other key idea that Buffett took from Graham was the ‘margin of safety’ principle, which Buffett has since described as the ‘cornerstone of investment success’. Given their central position in Buffett’s investment philosophy, these concepts are fleshed out in more detail on page 5. Charlie Munger Charlie Munger is the vice-chairman of Berkshire Hathaway and Buffett’s long-time friend and confidant. Buffett is quick to stress Munger’s importance to his own and Berkshire Hathaway’s success and typically describes him as his ‘partner’—although he has also dubbed him the ‘abominable no man’ on account of his ability to see the downsides in anything. Others talk about Munger as 4
Buffett’s alter ego. Buffett himself once said that they thought so much alike that it was ‘spooky’. Munger was also originally from Omaha, being born there in 1924 and even working in the Buffett family store in his teens, but after a year studying maths at the University of Michigan, he joined the army in 1942 and was sent off to study meteorology in Pasadena, California. After the war, he went to Harvard Law School, before returning to Pasadena to practise as a lawyer. In 1962, he started his own law firm, Munger Tolles & Olson, but he made more money from property development and, soon after his first meeting with Buffett, arranged by mutual friend Ed Davis in 1959, Buffett is said to have explained to Munger repeatedly that he felt law was a waste of his talents. This led to Munger forming his own investment partnership with some friends in Pasadena. Munger’s results were more volatile than Buffett’s, but they were nevertheless extremely good. Munger’s investment style was, not surprisingly, given their legendary rapport, very close to Buffett’s, being based on intrinsic value, patience and grabbing opportunities firmly when they arrived. And of course the two frequently discussed their ideas. There was, however, one crucial difference between them in the early days. Buffett was still heavily influenced by the ‘deep value’ approach of his mentor Ben Graham, and he sought out companies that had plenty of cold hard assets to back up their values. Munger, however, was far more inclined to accept the intangible value of a strong brand. In fact, for the same amount of profit, he preferred businesses to have a minimum of tangible assets, because the maintenance of the hard assets would be a drain on cash earnings. Munger had respect for Graham, but he didn’t share Buffett’s devotion. As he said at the 1991 annual meeting of Wesco Financial (a Berkshire affiliate of which he is chairman), ‘Ben Graham had blind spots. He had too low an appreciation of the fact that some businesses were worth paying a premium for.’ This new influence came at a lucky time for Buffett, for just as the popularity of Graham’s deep-value asset plays were causing them to dry up, so the age of the consumer mega-brand was dawning, and with Munger at his righthand side, Buffett was ready to take advantage.
Munger on Buffett: ‘People couldn’t believe that I suddenly made myself a subordinate partner to Warren. But there are some people that it’s OK to be a subordinate partner to.’ Buffett on Munger: ‘Charlie can analyse and evaluate any kind of deal faster and more accurately than any man alive. He sees any valid weakness in 60 seconds. He’s a perfect partner.’
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Through his annual letters to the shareholders of Berkshire Hathaway, Warren Buffett has described his approach to investment many times over, in intimate detail. The trouble is that, like the finest of oracles, the information is provided piecemeal and the various strands need pulling together to make a whole.
the coat-tails of a rising stock price, was described by Graham and Dodd in Security Analysis as being ‘largely a matter of A trying to decide what B, C and D are likely to think—with B, C and D trying to do the same.’ Such speculators fail to recognise the fundamental paradox of the market trying to chase its own tail in this fashion. This type of behaviour, however, does frequently cause The basic philosophy is one of simple common sense, a stock’s market price to depart dramatically from its intrinsic value—so much so that an investor can buy the of seeing the wood for the trees and of being realistic stock confident that he or she is getting a bargain. Graham about your abilities. It can be thought of as standing on five main planks: stick to your circle of competence; focus emphasised that ‘intelligent investing’ was all about on the intrinsic value of stocks rather than on how others following value rather than prices, and Buffett took the might price them in the market; value stocks as the part- point to heart. ownership of a business; only buy when the price permits you a substantial margin of safety; and make sure that you Valuing stocks as part-ownership of a business Once you’ve decided that a particular stock is within have the psychological fortitude to take advantage of the your circle of competence, and you’ve recognised that you herd rather than be trampled by it. Let’s take a look at need to buy it for less than its intrinsic value, your next these elements in turn. job is to assess that value. Defining your circle of competence This is where many investors get into difficulty, because The first Buffett rule is to consider carefully your circle there are a whole host of valuation methods that people bandy about, but the trick is to recognise that all of them of competence. If you decide that you will be unable to beat the market at its own game then your journey stops are merely shortcuts designed to get you closer to the here, and there’s nothing wrong with that. As Buffett wrote ultimate truth of the discounted cash flow (DCF) in his 1993 shareholder letter: ‘Another situation requiring calculation. As Buffett wrote in his 2000 letter to shareholders: ‘Common yardsticks such as dividend yield, wide diversification occurs when an investor who does the ratio of price to earnings or to book value, and even not understand the economics of specific businesses nevertheless believes it is in his interest to be a long-term growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of owner of … industry. That investor should both own a cash flows into and from the business.’ large number of equities and space out his purchases. The true definition of value is the DCF calculation, and By periodically investing in an index fund, for example, the know-nothing investor can actually outperform most —in theory—it works like this. You tot up all the cash that you expect to come into a company, discounted by an investment professionals. Paradoxically, when “dumb” money acknowledges its limitations, it ceases to be dumb.’ appropriate interest rate to reflect how long you have to wait for its arrival, and then you take away all the cash to Buffett expects that most investors ‘both institutional and individual’ will find that this is the best way to invest. go out of the company, similarly discounted, and what For those that decide to aim higher than this, however, the you’re left with is your intrinsic value. Or as Buffett put it ‘circle of competence’ remains a key consideration. As he in his 1992 shareholder letter: ‘The value of any stock, bond or business today is determined by the cash inflows wrote in his 1996 shareholder letter: ‘What an investor and outflows—discounted at an appropriate interest rate needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be —that can be expected to occur during the remaining life an expert on every company, or even many. You only have of the asset.’ Well that’s the theory anyway. In practice, the DCF to be able to evaluate companies within your circle of competence. The size of that circle is not very important; calculation is typically abused to the point of being virtually unrecognisable—of which more in a moment— knowing its boundaries, however, is vital.’ and this has led to its being much discredited. Charlie Focusing on intrinsic value Munger, in fact, was once moved to point out in a After establishing your circle of competence, the next Berkshire Hathaway shareholder meeting that he had never actually seen Buffett doing a DCF calculation—to step is to recognise the fundamental truism of value which Buffett retorted that there are some things that a investing—that every stock has an underlying, intrinsic value that is independent of its market price, and that the gentleman only does in private. The apparent conflict can be resolved by returning to best way to profit from stocks is to buy them when they are priced below their intrinsic value and then be patient Buffett’s 1992 shareholder letter, where he explains that while that value is realised—as it must ultimately be, if the ‘Though the mathematical calculations to evaluate equities are not difficult, an analyst—even one who is experienced stock is correctly identified as undervalued, even if that means holding on to it forever. To put it another way, some and intelligent—can easily go wrong in estimating future stocks are cheap and some are expensive, and you’re best [cash flows]. At Berkshire, we attempt to deal with this off buying the cheap ones. [ CONTINUED ON PAGE 6 ] The alternative approach, which is to try to grab on to The Intelligent Investor PO Box 1158, Bondi Junction NSW 1355 Phone: (02) 9388 0042 Fax: (02) 9387 8674 info@intelligentinvestor.com.au www.intelligentinvestor.com.au
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problem in two ways. First, we try to stick to businesses rather than chopping them off at some arbitrary point. He we believe we understand. That means they must be also uses the yield on long-dated government bonds as the relatively simple and stable in character. If a business is discount rate for all investments, although he’s said that complex or subject to constant change, we’re not smart he doesn’t like to take the discount rate much below 7% enough to predict future cash flows … Second, and even if the bond yield falls to lower levels (as it has in equally important, we insist on a margin of safety in our recent years). The precise number used probably isn’t that purchase price. If we calculate the value of a common important, so long as it relates to what’s available on stock to be only slightly higher than its price, we’re not conservative investments in the current climate (your sointerested in buying.’ called ‘opportunity cost’). What matters is that the same Ben Graham also noted in Security Analysis that number is used for all opportunities and that risk is intrinsic value was virtually impossible to calculate with considered separately from the value equation. any precision: ‘[The investor is] concerned with the Of course the other key point in Buffett’s way of intrinsic value of the security and more particularly with thinking is that if you have to go so far as to write your the discovery of discrepancies between intrinsic value and sums down on a piece of paper, or worse if you have to the market price. We must recognise, however, that build a complicated spreadsheet, then you’re unlikely to intrinsic value is an elusive concept.’ But Graham went on have a sufficient margin of safety in the investment, so you to explain that ‘it is quite possible to decide by inspection might as well forget it. As Buffett explained to Fortune that a woman is old enough to vote without knowing her magazine in 1995: ‘I’m like a basketball coach. I go out on age, or that a man is heavier than he should be without the street and look for seven footers. If someone comes up to me and says, “I’m five foot six, but you should see me knowing his exact weight’. So the DCF calculation is important not because of any handle the ball,” I’m not interested.’ If we return briefly to Buffett’s assertion that he copes numbers that it might churn out; it’s important because it can point you towards the factors that actually matter to with the problems presented by the DCF by only looking at businesses that are ‘simple and stable in character’ and a stock’s underlying value. You can then make a broad assessment of the situation and decide whether the stock by then applying a large margin of safety, it’s not a long is undervalued by a sufficient margin to provide a degree stretch to imagine that, for a high-quality stock with dependable cash flows, he might think of a stock’s current of safety. annual cash flow (or perhaps the average cash flow over the When professional investment analysts do their DCF calculations on extreme multi-page spreadsheets, they are last few years for a cyclical stock) as continuing on forever, either missing the point, or they are trying to pull the wool with no growth at all. He might then think of any growth that might come his way as giving him his margin of safety. over our eyes. In their eagerness to produce a precise valuation that they can bandy about, they forget what it is (We’ll say more about this in the next section.) they are trying to achieve. So they distort the calculation to suit their BUYING WHOLE BUSINESSES purpose, which is generally to sound In addition to making listed investments through Berkshire Hathaway, Buffett has like they’re saying something very made a habit of buying whole businesses. In fact, if he likes a business, this is clever about the near future, so as to his preferred approach—after all, if it’s worth buying one share, why not buy the encourage us to believe that riches whole lot? might be just around the corner if we Of course the trouble with this is that some of his targets are extremely large, listen to them (and trade shares on and Buffett is not prepared to engage in hostile takeovers, nor pay the premiums their advice). A typical manifestation that are typically required for takeovers of listed companies. After all, when of this is where analysts expend investors know that Buffett is buying, they might suddenly find a certain reluctance considerable energy pinning down the to sell. So his purchases of entire businesses are typically limited to private cash flows for the next few years to a companies, and he frequently sets out his list of wants, in annual reports or even fine degree of accuracy, before newspaper advertisements. The following is a typical appeal: slapping on an arbitrary ‘terminal If you have a business that fits the following criteria, call me or, preferably, write. value’ to represent the cash flows for Here’s what we’re looking for: the remainder of the company’s life. 1. Large purchases (at least US$10 million of after-tax earnings); Quite often this terminal value makes 2. demonstrated consistent earning power (future projections are of little interest up the bulk of the valuation, which to us, nor are ‘turnaround’ situations); rather makes a mockery of the 3. businesses earning good returns on equity while employing little or no debt; pretence of precision in the 4. management in place (we can’t supply it); calculation of next year’s cash flow. 5. simple businesses (if there’s lots of technology, we won’t understand it); Buffett does indeed use the DCF 6. an offering price (we don’t want to waste our time or that of the seller by talking, calculation to define value, but he’s even preliminarily, about a transaction when price is unknown). very careful about how he handles it. We will not engage in unfriendly takeovers. We can promise complete Most particularly, he recognises its confidentiality and a very fast answer—customarily within five minutes—as to lack of precision and he takes into whether we’re interested. account the cash flows as they’ll continue for the asset’s entire life, 6
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Allowing a margin of safety Buffett wrote in his 1990 letter to shareholders: ‘In the final chapter of The Intelligent Investor, Ben Graham [wrote]: “Confronted with a challenge to distil the secret of sound investment into three words, we venture the motto, Margin of Safety.” Forty-two years after reading that, I still think those are the right three words.’ Graham’s basic idea with ‘margin of safety’ was to start by isolating the basic rock solid cash flow that a company was able to produce year in, year out—the cash flow that a banker might consider reliable enough to support the interest on a loan. Then if you could buy into that company at a price at which that ‘bankable’ cash flow produced a yield equivalent to the return that you were targeting (the discount rate in the DCF calculation from the previous section), then you’d basically have your cake and eat it too. You’d get your targeted return as a minimum, and any growth you might expect on top of that would be your margin of safety. In theory, the growth that companies produce is generated by the company reinvesting some of its earnings. So on its strictest interpretation, Graham’s ‘margin of safety’ principle means you use the company’s bankable cash flow—that which remains after some of the earnings are reinvested in the business, and which can be relied upon, year in year out—to price the investment, while the reinvested earnings and the growth that they
produce gives you an unknown quantity of cream on the top. As Graham wrote in The Intelligent Investor: ‘If the picture is viewed as a whole, there is a reasonably close connection between the growth of corporate surpluses through reinvested earnings and the growth of corporate values. Over a ten-year period the typical excess of stock earning power over [bankable cash flow] may aggregate 50% of the price paid. This figure is sufficient to provide a very real margin of safety.’ Despite this ‘very real’ margin of safety, Graham advised against allowing much of it to creep into one’s assessment of value. ‘In many cases,’ he wrote, ‘such reinvested earnings fail to add commensurately to the earning power and value of [the stock].’ And with particular reference to cyclical stocks, he added: ‘Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favourable business conditions. The purchasers view the current good earnings as equivalent to “earning power” and assume that prosperity is synonymous with safety.’ Buffett undoubtedly took all this to heart but, helped considerably by Charlie Munger, he developed his thinking so that he was prepared to go somewhat further than Graham in allowing reinvested earnings into his value calculations. As Buffett explained to Forbes magazine in 1996: ‘Charlie shoved me in the direction of not just buying bargains, as Ben Graham had taught me. This was the real impact he had on me. It took a powerful force to move me on from Graham’s limiting view. It was the power of Charlie’s mind. He expanded my horizons.’ Of course the effect of accepting all of a company’s earnings at face value and using them in your value calculations would be to move from using cash flow yields and cash flow multiples to the ubiquitous earnings yields and PERs. Let’s say, for example, that you’re using a discount rate of 7% (that is, a multiple of 14.3—which is 1 divided by 7%) and are looking at a company that has earnings of $10m a year, of which $4m is reinvested in the business each year, $1m is considered to be excess earnings thanks to boom conditions, and $5m remains as bankable cash flow. In this case, the strict Graham approach would mean you’d price the company at 14.3 times its $5m bankable cash flow, which would give $72m, corresponding to a PER of 7.2. But if you went to the other extreme, of also giving the company the benefit of the doubt on its sustainable reinvested earnings, thereby allowing no margin of safety, you’d price the company at 14.3 times its $9m sustainable earnings, or $129m, which would correspond to a PER of 12.9. So you might imagine that, for the very finest franchises, where Buffett considers that the reinvested earnings are almost certain to produce a commensurate increase in future earning power (and are therefore almost as bankable as the free cash that is left over), he might go as far as allowing all of a company’s earnings in his value calculations, thereby reverting to normal PERtype calculations. But as business quality falls away, then these relaxed standards would tighten up very quickly, and for average businesses, you’d be right back at the strict [ CONTINUED ON PAGE 8 ]
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And when you use the same number for your cash flow year after year, the DCF calculation simplifies down to a simple division of that single cash flow number by your discount rate. Imagine you have an investment that spits out $1m a year, regular as clockwork, and you decide that you should be getting 7% from your investments, then the investment would be worth $14.3m to you ($1m divided by 7%), because this is the amount for which $1m a year represents a return of 7%. So it’s all a bit circular. You make a realistic assessment of how much you want to be making from your investments (which is your ‘opportunity cost’ and therefore your ‘discount rate’) and then work out what you’d have to pay for an investment to make that amount—and that, not surprisingly, is the investment’s value to you. Of course, all this can be turned on its head as well, because by using a discount rate of 7%, you’re effectively saying that you’re prepared to pay a multiple of 14.3 (1 divided by 7%) times cash flow for your investment. And if you were in fact able to get the investment for a multiple of 12 times the cash flow, then you’d be getting a ‘cash flow yield’ of 8.3% (1 divided by 12), which is more than you were aiming for and deserving of a nice pat on the back. If this is all beginning to sound rather familiar, then that’s because it is: at this basic level, with the same cash flow repeating year after year, the DCF calculation simplifies down to a cash flow equivalent of the price-toearnings ratio (PER). You just have to pick your cash flow carefully and decide how much of a return you want to make, and that will tell you the most you can pay for the investment. Of course it’s probably quite conservative to think about the cash flow staying the same year after year —most companies will be reinvesting some of their profits in the hope of generating growth—but it would at least provide you with a margin of safety.
M3/WARREN BUFFETT
Buffett’s Investment philosophy
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Graham approach of only allowing for the bankable cash flow. As Buffett explained to Forbes in 1993: ‘Charlie made me focus on the merits of a great business with tremendously growing earning power, but only where you can be sure of it—not like Texas Instruments or Polaroid, where the earning power was hypothetical.’ For worse than average businesses, of course, there’s often little in the way of bankable cash flow, so it would be hard to have any valuation that allowed a Graham-type margin of safety. Having said all this, so as not to lose sight of what it is that we’re trying to achieve, we’ll repeat the point that Buffett made in his 2000 shareholder letter: ‘Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business.’ In the real world, cash flows aren’t these steady stable things that roll into and out of formulas, and you have to take account of how they might develop in future, quite apart from all the academic stuff about reinvested earnings. Sometimes a company will invest a dollar and get nothing back, whereas on other occasions a company might invest a dollar and get a dollar back every year. When Buffett started buying Coca-Cola shares in the (northern) autumn of 1988, long-term US treasury bond rates stood at about 9%, which would suggest a top whack PER of about 11 if he was prepared to allow for all the reinvested earnings. But he was sufficiently confident of the future for Coca-Cola’s cash flows that he was prepared to go further—to a PER of 13 in fact, implying an earnings yield of only 7.7%—for what he has since described (to Fortune magazine in 1993) as ‘the best large business in the world’. Despite the relatively high price, he later explained to students at the University of Columbia in 1993: ‘I was as sure of the margin of safety with Coke as when I bought Union Street Railway at 40% of net cash. In both cases, you’re getting more than you pay for. It’s just that one was easier to spot.’ (See page 12 for more on Buffett’s investment in Coca-Cola.) Having the right psychology Most of the foregoing makes intuitive sense, and as Buffett noted, ‘the mathematical calculations to evaluate equities are not difficult’. So why is it that most people make such awful investors? The answer is that while the approach is easy enough to describe, it’s very hard to follow in practice. What sets Buffett and other ‘intelligent investors’ apart is their psychological ability to actually follow these rules. Overconfidence, greed, fear and the herd instinct all play their part in ruining the best-laid plans of investors. As Buffett wrote in his 2004 shareholder letter: ‘Over the [past] 35 years … business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback [industry] in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead, many investors have had experiences 8
ranging from mediocre to disastrous. ‘There have been three primary causes: first, high costs, usually because investors traded excessively or spent far too much on investment management; second, portfolio decisions based on tips and fads rather than on thoughtful, quantified evaluation of businesses; and third, a start-and-stop approach to the market marked by untimely entries (after an advance has been long underway) and exits (after periods of stagnation or decline). Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.’ INVESTING OTHER PEOPLE'S MONEY If there's one type of business that Buffett prefers to the giant consumer franchise, it's a business that brings with it extra capital for him to invest-especially if that capital comes at a low cost. It enables Berkshire to invest the capital, pay the cost and pocket the difference. Because Buffett is confident of his ability to invest the capital well, having more of it at a reasonable cost has enabled Berkshire to 'leverage' its investment returns. This has been a constant theme for the company over the years, and there are two principal ways that it's been achieved. Insurance In insurance, the customer pays premiums upfront, with the insurance company paying out claims later on, as and when they arise. In the meantime, the insurance company sits on the premiums and is able to invest them for its own benefit. Through subsidiaries like GEICO and General Re, Berkshire Hathaway had an insurance float totaling US$46bn at the end of 2004. Float, however, can come at a cost. If claim payments are greater than the premiums collected, then an underwriting loss is made and this is the cost of having the capital to invest. Through exceptional underwriting discipline, Berkshire Hathaway has been able to keep the cost of its float close to zero over the years. Indeed in about half its 38 years in the industry, it has managed an underwriting profit-meaning that it has effectively been paid to hold other people's money. Trading stamps Trading stamps operate (or operated, because they're very uncommon nowadays) as a sort of loyalty scheme. Supermarkets would issue the stamps to shoppers as an incentive to shop at their stores and pay a fee to the trading stamps company for the pleasure. The trading stamps company would then redeem the stamps—at a later date— for toasters, hair dryers and various other accoutrements. So the trading stamps company collected money early and only paid it out later on, thereby always sitting on a surplus of capital. To a men like Buffett and Munger, that's more tempting than a steak to a starving dog. So it's perhaps not surprising that both men found themselves independently buying shares in Blue Chip Stamps, one of the biggest trading stamps companies, in the 1960s. Berkshire Hathaway was a long-time majority shareholder in Blue Chip Stamps, finally executed a full merger with the company in 1983.
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There is probably no safer ‘earning power’ in the world than the big consumer franchises, and over time these have come to form the bullseye of Buffett’s ‘circle of competence’. Indeed, Berkshire Hathaway’s three biggest publicly listed stockholdings at the end of 2004—American Express, Coca-Cola and Gillette, which together accounted for more than half of Berkshire’s listed holdings—all fit into this category. It was a similar story in 1994, except that the media company Capital Cities/ABC was in the top three in place of Gillette (which was then the seventh largest holding). Explaining his purchase of a stake in Guinness PLC in 1991, Buffett described his penchant for this type of business: ‘We continually search for large businesses with understandable, enduring and mouth-watering economics that are run by able and shareholder-oriented managements. This focus doesn’t guarantee results: We both have to buy at a sensible price and get business performance from our companies that validates our assessment. But this investment approach—searching for the superstars—offers us our only chance for real success. Charlie and I are simply not smart enough, considering the large sums we work with, to get great results by adroitly buying and selling portions of far-from-great businesses. Nor do we think many others can achieve long-term investment success by flitting from flower to flower. Indeed, we believe that according the name “investors” to institutions that trade actively is like calling someone who repeatedly engages in one-night stands a romantic.’ Buffett’s words here are more carefully chosen than their floating style would suggest, and by picking through them carefully, we can get a window on Buffett’s idea of the perfect stock.
qualities, whose products it’s almost impossible to imagine being superseded any time soon. ‘Take chewing gum for example,’ said Buffett at the 1996 Berkshire AGM, ‘Folks chew the same way today that they did 20 years ago. Nobody’s come up with a new technique for doing that.’
Mouth-watering economics Several of Buffett’s investments fall easily into the mouth-watering variety—Coca-Cola, See’s Candies, Guinness to name a few—but his point here, of course, is that their underlying economics must be enough to get you salivating. The place to start with this is the discounted cash flow calculation which, as we saw on page 5, tells us that we want to see more and more cash coming into a business over the years, and as little as possible going out. Buffett summed this up in his 1992 shareholder letter: ‘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 evergreater amounts of capital at very low rates of return.’ Naturally, given that these are the best economics for a business, plenty of people will be rushing to the areas where this can be achieved—ultimately pushing down the returns available for all. So the best businesses to own are those that have such powerful competitive advantages that their would-be competitors are unable to gain a toehold. Buffett made this point with reference to Coca-Cola and Gillette in his 1993 shareholder letter: ‘The might of their brand names, the attributes of their products, and the strength of their distribution systems give them an enormous competitive advantage, setting up a protective moat around their economic castles. The average company, in contrast, does battle daily without any such Understandable economics means of protection. As Peter Lynch says, stocks of companies selling commodity-like products should come The first point echoes the comments made about ‘circles of competence’ on page 5. If you don’t understand with a warning label: “Competition may prove hazardous how a company earns its crust, then you shouldn’t invest to human wealth.”’ in it. Investors in Enron will have wished they had learnt Run by able and shareholder-oriented management this lesson. As Buffett noted at the 1996 Berkshire A great business is essential, but Buffett invariably Hathaway annual meeting: ‘It’s not impossible to write [an accounting] footnote explaining deferred acquisition costs insists that it’s run by great managers that treat it as an owner would. As the Omaha World Herald quoted him as in life insurance or whatever you want to do. You can write it so you can understand it. If it’s written so you can’t saying in 1994: ‘I always picture myself as owning the understand it, I’m very suspicious. I won’t invest in a whole place. And if management is following the same company if I can’t understand the footnote, because I policy that I would follow if I owned the whole place, that’s know they don’t want me to understand it.’ a management I like.’ With companies like Coca-Cola and Gillette, it’s easy to Buy at a sensible price see how they make money—they make a product, they Of course, it’s perfectly possible to make a lousy offer it for sale, and it’s easy to see why people buy it—and investment in a great business with fabulous management there’s nothing in the accounts that suggests that the if it’s bought at too high a price. And even though Buffett company is trying to hide anything from its owners. has been prepared to go a little further than Ben Graham, Enduring economics in terms of price, for a really great company, he still sticks The value of a company is defined by the net cash that adamantly to the margin of safety principle. As we saw on page 5, Buffett was prepared to stretch to a PER of 13 for flows into it over its entire lifetime, so it can play havoc with a valuation if that lifetime is suddenly cut short. [ CONTINUED ON PAGE 10 ] Buffett therefore prefers businesses that have enduring The Intelligent Investor PO Box 1158, Bondi Junction NSW 1355 Phone: (02) 9388 0042 Fax: (02) 9387 8674 info@intelligentinvestor.com.au www.intelligentinvestor.com.au
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Buffett’s bullseye—the consumer franchise
M3/WARREN BUFFETT
Buffett’s bullseye—the consumer franchise
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his original purchase of Coca-Cola, which might be equivalent to a PER in the low 20s in the current environment of lower long-term interest rates, but that’s what he’s prepared to pay for the ‘best large business in the world’ and for lesser-quality businesses, the price will quickly come down. And if the price isn’t right, Buffett is quite happy to
stand by and watch. Both he and Munger have always talked in glowing terms about the business quality of Wrigley’s chewing gum, but they haven’t found it available at the right price. As Munger explained at the 2001 Wesco Financial annual general meeting: ‘Wrigley is a great business, but that doesn’t solve the problem. Buying great businesses at advantageous prices is very tough.’
Top-quality management Lou Simpson Born in Chicago in 1936, Lou Simpson majored in accounting and economics at Ohio Wesleyan University, before obtaining a master’s degree in economics from Princeton in 1960. After a brief career as an academic, he joined the Chicago investment firm of Stein, Roe and Farnham in 1962, where he stayed until 1969. He then moved through several more investment positions, before joining GEICO (see page 11) in 1979. The story goes that GEICO was looking for a new investment manager and the chairman, Jack Byrne, was to send four final candidates to see Buffett (Berkshire Hathaway at the time owned 30% of GEICO). But immediately after meeting Simpson, Buffett phoned Byrne and said: ‘Stop the search. That’s the guy.’ ‘We talked about Rose Blumkin the Chicago Cubs,’ Simpson later quipped about the Rose Gorelick was born in 1893 in a small village near interview. Minsk in Russia. She never had any formal education, but As head of investments for GEICO, Lou Simpson has remembered helping her mother run the family grocery the unenviable task of investing for Warren Buffett— store from as young as six years old. Legend has it that which must feel something like putting for Tiger Woods. Rose left home at the age of 13, walking 18 miles barefoot Yet Simpson does a fine job and Buffett is unstinting in to the nearest train station with her shoes over her his praise. shoulder to preserve their soles. She found work in a In the 17 years from the time he joined GEICO to the dry-goods store and, within three years, she was managing time it was fully taken over by Berkshire in 1996, he the store together with its six male employees. compounded its equity portfolio at a rate of 24.7% a year, Rose married Isadore Blumkin in 1913, and left compared to 17.8% for the S&P 500 Index. revolution-torn Russia for the US in 1917. The two of them operated a successful clothing store, and had four children, before Rose opened the Nebraska Furniture Mart in 1937. She went to Chicago to buy stock and told the manufacturers: ‘I’m from Omaha. I’m starting up a business. I don’t have any money. But you can trust me. I’ll Simpson’s five rules for investment: pay you.’ As she recalled later, they replied: ‘Talking with 1. Think independently. you we’ll trust you anything.’ ‘Mrs B’ operated the Nebraska Furniture Mart according 2. Invest in high-return businesses to her abiding principle: ‘Sell cheap and tell the truth.’ It that are run for the shareholders. was an immediate success and by the time it was bought by 3. Pay only a reasonable price, Berkshire Hathaway in 1983, it was generating annual sales of US$87m (these have since grown to nearly US$400m). even for an excellent business. The story has a twist because, in 1989, Mrs B’s 4. Invest for the long term. grandsons sidelined their 95-year-old grandma from the running of the business and she walked out. Six months 5. Do not diversify excessively. later, she opened the competing ‘Mrs B’s Warehouse’ right across the street and, by 1991 when Buffett effected a truce with flowers and a box of See’s chocolates, it had become Omaha’s third-largest carpet outlet. Mrs B died in 1998 at the age of 104.
Buffett has always made a great deal of the importance of working with managers of the utmost competence and integrity as this quote from the Omaha World Herald in 1994 makes clear: ‘Somebody once said that in looking for people to hire, you look for three qualities: integrity, intelligence, and energy. And if they don’t have the first, the other two will kill you. You think about it; it’s true. If you hire somebody without the first, you really want them to be dumb and lazy.’ This report lacks the space to describe the qualities of all of Berkshire’s excellent managers—for that you’ll need The Warren Buffett CEO: Secrets of the Berkshire Hathaway Managers by Robert Miles—but hopefully these two snapshots give a flavour of the strengths he admires.
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In his 1997 shareholder letter, Buffett explained how he liked to adopt a patient approach: ‘We try to exert a Ted Williams kind of discipline. In his book The Science of Hitting, Ted explains that he carved the strike zone into 77 cells, each the size of a baseball. Swinging only at balls in his “best” cell, he knew, would allow him to bat .400; reaching for balls in his ‘worst’ spot, the low outside corner of the strike zone, would reduce him to .230. In other words, waiting for the fat pitch would mean a trip to the Hall of Fame; swinging indiscriminately would mean a ticket to the minors.’ When the ‘fat pitch’ comes along, Buffett is prepared to back his judgment. Here are three that Buffett has slugged into the bleachers. GEICO When taking Ben Graham’s investing class at the University of Columbia, Buffett was intrigued to learn that his hero was chairman of an insurance company in Washington DC, called the Government Employees Insurance Company, or GEICO, so he decided to take a trip down to see his father (who had been re-elected to Congress) and pop in to the company for a visit. He arrived at GEICO on a Saturday and, despite the office being closed, he talked his way in and ended up talking to a young executive, Lorimer Davidson (who eventually rose to be chief executive of the company). Davidson later said of the meeting: ‘After we talked for fifteen minutes I knew I was talking to an extraordinary man. He asked searching and highly intelligent questions.’ Davidson answered those questions for four hours, and Buffett was hooked on both GEICO and the insurance industry. The low-down on GEICO was that it offered insurance by direct mail (thereby cutting out costs) and it offered it only to government employees, who tended to have lower claims rates. These two factors gave the company considerable advantages over its rivals. Buffett made money for himself by buying and selling the stock a few times in the 1950s, but he largely left it alone—until 1976. By this time, Davidson had been and gone as chief executive and the company had grown massively. Unfortunately, the growth in later years had been too quick. The company had relaxed its policy of insuring only the lowest-risk drivers, but had kept its premiums at the same low level. On top of this, the cost of claims was increasing because of high inflation. The company announced a huge loss of US$126m for 1975 and its survival was in jeopardy. Its stock price, which had been as high as $42 in 1974, slumped to below $5. The chief executive was sacked and Jack Byrne was moved in to replace him. Buffett organised a meeting with the new man and diagnosed that GEICO’s major competitive advantage—its status as lowest-cost operator —was intact, but that the underwriting discipline had gone AWOL. Buffett also immediately took a shine to Byrne and figured that he would be able to lead the company out of its crisis. The next morning he started building a stake in GEICO at prices beginning at $2.125.
Thanks in no small part to Buffett’s support, GEICO was able to raise fresh capital and reinsurance to get back on its feet, and within six months the stock had risen to more than $8, but Buffett’s response was to keep buying more shares. The company also started using the excess cash that it was again generating to repurchase stock, thereby further increasing Berkshire’s stake. By the early 1980s, Berkshire owned 33% of GEICO and, by 1994, further buybacks had taken its ownership beyond 50%. When Berkshire eventually bought the final 49% in 1996, the offer valued the 51% it already owned at US$2.3bn, 50 times the $46m cost of its original stake. American Express American Express was one of the most significant investments for the Buffett Partnership and was the classic case of a great company fallen on hard times. In 1963, as Roger Lowenstein puts it in his biography: ‘Air Travel having become affordable, the middle class was embarking on the Grand Tour, and the traveller’s cheque had become its passport … Half a billion dollars of the company’s scrip was in circulation … [and] … 1 million people carried American Express cards.’ But the entire operation depended on the public’s faith in American Express’s currency, and this came under threat from a scandal that broke in New Jersey. It turns out that an American Express subsidiary received salad oil from a company called Allied, for which the Amex subsidiary provided receipts. Allied raised loans using the receipts as collateral, but it went bust and its creditors came looking for the salad oil held by the Amex subsidiary. Unfortunately it turned out that the salad oil was in fact seawater and Allied’s creditors were none too happy. American Express stock slid from 60 cents to 48 cents as rumours abounded that the company might have to foot a bill of as much as US$150m. This was particularly so after the chief executive of the company, realising that the public’s trust was everything in Amex’s business, took the unusual step of saying that the company felt ‘morally bound’ to honour the debt even though, legally, it could perhaps have cut loose its now-bankrupt subsidiary (Buffett later supported this moral stance in court when it was challenged by disenchanted shareholders). To assess the situation, Buffett famously took a trip to Ross’s Steak House in Omaha, where he sat behind the cashier and observed that here, in the heart of middle America, customers were continuing to pay for their dinner using Amex cards and that they were being accepted for payment. From this Buffett deduced that not only would Amex survive the scandal, but that it had a truly bullet-proof franchise. In early 1964, American Express hit a low of around 35 cents and Buffett invested about a quarter of the partnership’s money in the stock. By 1965, the stock had rebounded to over 70 cents, but Buffett held on. By 1967 it was up to $1.80.
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Hitting the fat pitch
M3/WARREN BUFFETT
Hitting the fat pitch
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Coca-Cola Buffett started his research into The Coca-Cola Company at the age of five, when he would buy a six-pack from the family grocery store for 25 cents and sell the individual bottles around the neighbourhood for five cents each. ‘In this excursion into high margin retailing,’ he later said in his 1989 shareholder letter, ‘I duly observed the extraordinary consumer attractiveness and commercial possibilities of the product. I continued to note these qualities for the next 52 years as Coke blanketed the world. During this period, however, I carefully avoided buying even a single share, instead allocating major portions of my net worth to street railway companies, windmill manufacturers, anthracite producers, textile businesses, trading stamp issuers and the like.’ He made up for the oversight in some style in late 1988 and early 1989, when he accumulated 7% of the company. Within three years, the value of the stake had increased by
nearly four times, and, at US$3.75bn, it was worth more than the US$3.4bn that the whole of Berkshire Hathaway had been worth when Buffett had started buying. At the time, Buffett described the purchase as ‘the ultimate case of putting your money where your mouth is’. But he was cagey about his reasoning, saying: ‘It’s like when you marry a girl. Is it her eyes? Her personality? It’s a whole bunch of things you can’t separate.’ Subsequently, Buffett has explained that he was particularly swayed by the enduring strength of the brand. This, he says, was brought home to him by a story in Fortune magazine, which noted: ‘Several times every year a weighty and serious investor looks long and with profound respect at Coca-Cola’s record, but comes regretfully to the conclusion that he is looking too late’. What really got to Buffett about this magazine story, though, was that it had been penned 50 years previously, in 1938. With the shares at an attractive valuation following the ‘New Coke’ fiasco, he decided it was time to start buying.
AUSTRALIAN BUFFETT STOCKS So which companies on the Australian Stock Exchange might tempt Warren Buffett? Well there’s a clue to one of them in the question. If you want to buy shares in Australia, you’ve pretty much got to do it on the Australian Stock Exchange. It’s the best type of ‘toll-road’ business because instead of relying on a brand to attract business, there just isn’t any other way around. This enables ASX to make excellent profits, and it does it from a tiny base of capital—achieving returns on capital employed of over 100%—so that most of its profits are free for distribution to shareholders. One trouble with ASX, though, is that its earnings are very cyclical, so it’s hard to figure out what numbers to use for valuation purposes. The other trouble is that it’s typically priced very highly. Another local stock that might pique Buffett’s interest is Westfield. Here’s a company that literally shouts its name from the roof-tops. By adding its brand and expertise to a shopping centre, Westfield can turn a bunch of shops into a cash machine. It’s hard to imagine a business in Australia that has more ‘understandable, enduring and mouth-watering economics’. Other possibilities for Buffett in this country might be Harvey Norman, which has an excellent franchise and superb entrepreneurial management in Gerry Harvey; Woolworths, which continually oustmarts its rival Coles Myer in Australia’s cosy supermarkets duopoly; and the big four banks, which continue to rake in the cash despite any number of hiccups— although perhaps management might be considered inadequate in some cases.
Further reading The best way to benefit from Warren Buffett’s wisdom is to read his famous annual letters to the shareholders of Berkshire Hathaway, which are available from www.berkshirehathaway.com The Essays of Warren Buffett: Lessons for Corporate America by Lawrence Cunningham offer a selection of some of the best bits. Undoubtedly the best Buffett biography is Buffett: The Making of an American Capitalist by Roger Lowenstein. Of Permanent Value: The Story of Warren Buffett by Andrew
Kilpatrick, while not what you would call a biography, is a fabulous 1,000-page collection of snippets about Buffett’s life. The Warren Buffett CEO: Secrets of the Berkshire Hathaway Managers by Robert Miles is a fascinating run down on the superb business managers that run Berkshire Hathaway’s many subsidiaries. Warren Buffett Speaks by Janet Lowe is an excellent collection of Buffett’s famous sound bites.
Important information about The Intelligent Investor. WARNING This publication is general information only, which means it does not take into account your investment objectives, financial situation or needs. You should therefore consider whether a particular recommendation is appropriate for your needs before acting on it, seeking advice from a financial adviser or stockbroker if necessary. The Intelligent Investor and associated websites are published by The Intelligent Investor Publishing Pty Ltd (Australian Financial Services Licence number 282288). DISCLAIMER This publication has been prepared from a wide variety of sources, which The Intelligent Investor Publishing Pty Ltd, to the best of its knowledge and belief, considers accurate. You should make your own enquiries about the investments and we strongly suggest you seek advice before acting upon any recommendation. COPYRIGHT The Intelligent Investor Publishing Pty Ltd 2005. No part of this publication, or its content, may be reproduced in any form without our prior written consent. This publication is for subscribers only. DISCLOSURE In-house staff currently hold shares in HVN and Berkshire Hathaway. This is not a recommendation. 12
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