Warren Buffett Investing Series II
Discover the finer details of Buffett’s investing philosophy.
Warren Buffett Investing II
For those who may prefer, this presentation covers the same principles explained in the text below:
Contents:
Key Questions in Analysing Financial Statements
Buffett’s Owner Earnings
Business Risk
Price Risk
Personal Risk
Berkshire Hathaway’s Cost of Capital
Selling a Business or Investment
Thank you
“What Should I Do Next?”
Buffett’s Three Steps to Investing
Buffett Quote: “It’s far better to buy a wonderful company at a fair price, than a fair company at a wonderful price.”
Can you see out 5, 10, 15 years and have a reasonable probability of gauging the future correctly? (Is the business within your circle of competence?) You don’t have to invest in anything you don’t like or deem too difficult. Wait for a “fat-pitch”. Assuming you like the projections of what you think the business will earn into the future, move on to step 2.
How do you feel about the management? You must like the management because you’re almost never going to change the management of any business you buy.
You must like the price.
Reading Annual Reports
Buffett Quote: “When I take a look at a company’s annual report, if I don’t understand it, they don’t want me to understand it.”
Buffett reads hundreds of reports per year. He tries to read the reports of companies he thinks he can understand.
Buffett: “Is the management telling us, through the report, what we’d want to know about if we owned 100% of the company? If yes, and if the management has spoken in a way that we can understand, then it definitely improves our feeling about investing in such a business; and the reverse turns us off to some extent.
We don’t want to read a bunch of public relations fluff, and we don’t want to see many pictures with few facts.
We want to understand the business better once we’ve gone through the annual report than when we picked it up. This is not difficult for a management to do if they want to do it.
I read annual reports of the company I’m looking at and I read the annual reports of the competitors – that is the main source of material.”
Financial Statements
Buffett Quote: “Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.”
Key Questions in Analysing Financial Statements:
Financial statements must enable a user to answer three basic questions about a business:
Approximately how much is the company worth?
How likely is it to meet its future obligations?
How good a job are the managers doing in operating the business?
Buffett’s Owner Earnings:
Cash Flow = A + B – C = “Owner Earnings”
A = Operating earnings (reported earnings)
B = Depreciation, depletion, amortisation + certain other non-cash charges
C = Required reinvestment in the business
The average amount of capitalised expenditures for plant and equipment, etc., that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in C.)
Owner Earnings are the relevant item for valuation purposes. Debt-servicing ability evaluation must not ignore C.
Risk
Buffett Quote: “Rule number one is never lose money. Rule number two is never forget rule number one.”
Warren Buffett believes it is madness to risk what you have and need for what you don’t have and don’t need.
Risk relates to several possibilities. One relates to permanent capital loss. Another relates to an inadequate return on the capital invested.
Business Risk:
Business risk can arise from having too much debt in the capital structure.
The nature of the business can be risky. For example, airlines require a huge amount of capital investment upfront.
Other business risks include long lead times, and the risk of low-cost competition in a commodity business.
Price Risk:
Paying too much for the business is a big risk. – This is usually a risk of time rather than a risk of principle. It may take time for the intrinsic value of the business to catch up with the stock price.
Personal Risk:
You must be able to maintain your focus and belief in the fundamentals of the business and not get too concerned with the stock market. The stock market is there to serve you, not to instruct you.
It is a huge risk when you simply do not understand the business or the industry: when you don’t know what you’re doing.
The Importance of Cash
Buffett Quote: “Only when the tide goes out do you discover who’s been swimming naked.”
Financial staying power requires a company to maintain three strengths under all circumstances: (1) a large and reliable stream of earnings; (2) massive liquid assets; and (3) no significant near-term cash requirements.
At a healthy business, cash is sometimes thought of as something to be minimised – as an unproductive asset that acts as a drag on such markers as return on equity. Cash, though, is to business as oxygen is to an individual: never thought about when it is present, the only thing in mind when it is absent.
Cost of Capital
Buffett Quote: “Don’t pass up something that’s attractive today because you think you will find something better tomorrow.”
Berkshire Hathaway’s Cost of Capital:
Warren Buffett and Charlie Munger do not believe in using a mathematical formula in order to calculate a “cost of capital” figure.
Buffett and Munger: The cost of a deal: The opportunity cost involved in buying something else or in buying more of something already owned.
Furthermore, …
Does it make more sense to retain earnings or pay earnings out to shareholders?
If the business can create more than one dollar of present valued earnings for every one dollar retained, the earnings can be retained. The capital should then be employed into something that promises the greatest return, taking into account the risks (certainty) involved. How can the capital be most intelligently put to use?
If the earnings are to be paid out to shareholders, will it make more sense to repurchase current shares outstanding or pay dividends?
If the dollars retained in the company prove more valuable in the hands of the company than in the hands of the shareholders, the cost of capital has been exceeded.
Two Categories of Outstanding Acquisitions
Buffett Quote: “Beware the investment activity that produces applause; the great moves are usually greeted by yawns.”
The first involves businesses that are particularly well adapted to an inflationary environment. Such favoured businesses must have two characteristics:
An ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilised) without fear of significant loss of either market share or unit volume.
An ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital.
The second category involves the managerial superstars – those who can recognise, unlock and realise the full potential of a business.
When Does Buffett Sell?
Buffett Quote: “If you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes.”
Selling a Business or Investment:
Buffett: “If we lose confidence in the management, if we lose confidence in the durable competitive advantage, if we recognise we made a mistake when we went in, we will probably sell.
When we buy a business, it’s with the intention to keep it forever. We make two exceptions to this: When they promise to start losing money indefinitely or if we have major labour problems. We typically won’t sell a business even if we’re offered more money than its worth.
We think it helps us in running our businesses over time. With stocks and bonds, we sell them; but we’re more reluctant to sell them than most people.
We always like to have a certain level of cash on hand. I may sell some stocks to maintain our required minimum level of cash that I feel comfortable keeping.
(If, for example, there was a time when we committed a lot of capital over a short time period, I may sell stocks to boost our cash levels.)
I sold J&J to take advantage of certain opportunities which would not be around forever. I could always buy J&J back again at a later time.”
Conclusion
Buffett Quote: “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”
Thank you for visiting School of Value Investing.
“What should I do next?”
Learn to speak the language of business and investment like the legends:
Understand how to read and analyse Financial Statements.
Become a more intelligent investor by understanding the Commodities Investment Industry.