Warren Buffett's 'Secret' Investment Formula 13 comments
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As one of the most successful investors ever, Warren Buffett's methods are widely studied and many attempt to replicate them. Mr. Buffett has frequently discussed his investing criteria and the influence Ben Graham had on him in the early days. And he has repeatedly said over the decades that value investing is simple, but not easy.
So just how simple is Buffett's investing methodology? There are many stories out there that Buffett does not use a computer (other than to play bridge online), hence he does not use the ubiquitous Wall Street crutch, the spreadsheet financial model. Buffett also doesn't use a calculator. Maybe it's that Buffett is just so darn sharp that his brain is the only calculator he needs.
There is no doubt Buffett is super sharp, and able to see what matters and quickly and efficiently evaluate it. But, I think that is just a bonus for Buffett - not a requirement to practice his investing style. He would agree, I think, since he has frequently stated that investing success only requires an average IQ. Certainly we are now very familiar with the damage done by those who supposedly have superior IQ's.
Alice Schroeder recently released "The Snowball", the most complete account of The Man to date (and next on my reading list - if I only had any time to read books). Ms. Schroeder had unprecedented access, spending years in Buffett's office going through his old files. How did she gain Buffett's approval? Through her work as an insurance analyst a decade ago for Paine Webber and Morgan Stanley. Her reports from that era on Berkshire (BRK.A) are the only coherent analyst reports on Buffett's empire that I have ever read. And her valuation model for Berkshire was the best I've seen. I still use my own version of it. I think she won the Buffett lottery because she was the only one who "got" Berkshire on Wall Street.
Schroeder recently gave a keynote at the Darden Value Investing Conference. In it she clearly laid out Buffett's "secret" investment methodology. But first she also made it clear that Buffett is a unique animal. At age 7 he asked for a book titled "Bond Salesmanship" for Xmas and read it cover to cover. She describes him as someone who is always thinking "what more can I do", especially to get an edge on the other guy. And, he is a learning machine with a cumulative mental file cabinet. And he always thinks like a horse handicapper, he's always thinking about probabilities.
So what is Buffett's secret method? Here it is step by step:
- Look at the risk of loss. What is the probabilty that I will permanently lose money here, and what could happen that would result in total loss? If there is ANYTHING that could reasonably result in a total loss, stop right there. Buffett never tries to talk himself into any investment. He says that much of his success is from immediately passing on things due to realistic appraisal of catastrophic risk.
- Look at historical financial data. Look at the historical quarterly sales, expenses and profits (and cash flow of course) for each line of business or operating unit. DO NOT build a model or try to predict the future. Schroeder says there was not one model of any kind in Buffett's files - just simple hand-written tables with historical financial data.
- Once he's happy with the first two critieria, he sets his price. He "only" requires that he receive a day one return of 15%, with a good likelihood that his return will compound from there. Although Schroeder is not clear on this, I assume he looks at cash earnings or the so-called "owner's earnings" for his 15% return. Essentially this is cash from operation, less one-time and options benefits, minus maintenance or essential capital expenditures. So you could say he is looking to buy in at 6.67 (or less) x today's cash flow - something that's been nearly impossible up until September.
There you have it, Buffett's secret. Extreme simplicity that requires extreme discipline to execute. Buffett has the advantage of not having to answer to anyone. He says he gets up and looks in the mirror, then everyone has had their say for the day. Furthermore, he believes that 90% of being successful in business is guts: you must only answer to yourself. He can wait indefinitely for a good opportunity. This is in direct contrast to the typical money manager, who has to answer to clients, employers, media, and on and on. Hence Buffett's is largely an IMPOSSIBLE strategy to execute on Wall Street. However, as an individual investor you only have to wrestle with your own psyche, and that will be the hardest part of investing like Buffett.
What about future predictions?? Everyone knows the stock market is always looking 6 months ahead, always anticipating the future. Buffett says that the whole purpose of investing with Graham's infamous "margin of safety" is to render forecasting unnecessary. And margin of safety is ALWAYS a function of price paid - hence Buffet's 15% day one return requirement. Imagine if everyone invested this way. Even more Wall Streeters would be out of jobs: analysts, strategists, economists - worthless (not that they have any value now - they're just paid as if they do).
I plan on presenting a series of stock ideas over time in the premium blog that I think fit Buffett's "secret" method. There has been no better time in my 12 year investing career to look for such bargains. Sure it's tough out there, and anything you buy today will likely go down tomorrow. Buffett was recently interviewed by Tom Brokaw, and had this to say about how to deal with today's market, and how investors can steel themselves against the rampant fear and panic:
If you own a farm nobody tells you when it's gone down 50 percent 'cause you don't get a quote every day. But you really look to the farm and what it produces to determine whether you made a good investment. Now if people look to the newspaper every day at the price of a stock to determine whether they made a good investment they're making a mistake.
They have to look to the business, the asset itself. If you own an apartment house you wouldn't get a quote on it every day. You'd just look at-- what the rent rolls were, and your taxes were and expenses were. And if they all came in with--in line with what you expected when you bought it, you'd feel you'd made a satisfactory investment, and you'd never get a quote on it. So I don't look at quotes. I can't tell you what Berkshire Hathaway is selling for today."
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The article reiterates these simple principles.
The article reiterates these simple principles.
What is smart about it, to lose and win with Dow Jones?
I same can call and investor or manager of any company who's stock is down 40% with the market.
It is not hard to perform like SP 500 or DJIA in a bull market, crash is only time when one can see who is a real winner and on this scale Buffett is not.
If you would call him most rich person on earth, then it is impossible to argue, but most successful he is not.
I want to show you here investor who beated Buffett with wide margin in 2008, the most challenging year since 1929.
www.marketguru.com/ROL...
I believe this must be one of his rules:no debt,always paying cash and knowing that berkshire hathaway has US$ 106.6 billions in reserves funds,following this rule might not be that hard.
As far as "showing us" an investor who "beated" Buffet in 2008, I would like you to show us an investor who has come anywhere near Buffet for the last 50 years.
You remind me a lot of the guys in 1997-2000 who were saying that "Buffet had lost his touch" and was an "investment has-been". Those guys are now (as the song goes) "parking cars and pumping gas" having lost their collective shirts in 2000-2002.
On Jan 25 06:36 AM ROLEX18K wrote:
> it is stupid, sorry, to call W.Buffett the most successful or best
> investor when BRK.A and BRK.B have same correlation as Dow Jones
> and on the comparisan chart look just the same, all 3 down 40%.
>
> What is smart about it, to lose and win with Dow Jones?
> I same can call and investor or manager of any company who's stock
> is down 40% with the market.
> It is not hard to perform like SP 500 or DJIA in a bull market, crash
> is only time when one can see who is a real winner and on this scale
> Buffett is not.
> If you would call him most rich person on earth, then it is impossible
> to argue, but most successful he is not.
> I want to show you here investor who beated Buffett with wide margin
> in 2008, the most challenging year since 1929.
>
> www.marketguru.com/ROL...
>
A good point 4 would be to look at the quality of management. Unfortunately, Buffett's stake is GE makes it appear that Buffett was one of many investors taken in by shoe salesman Jeffrey Immelt.
Since Immelt assumed the throne in September 2001, he has done nothing but drive all aspects of that business into the ground, from the liberal NBC property that propels drivel into mainstream America to the failed Honeywell merger in 2002.
The worst part about Immelt's merger mania might be funding the whole process in great part with commercial paper.
Now, GE is another quasi-government entity with its GE Capital and GE Money businesses. Expect GE infrastructure companies to benefit from their "close cooperation" with the U.S. Treasury department. Electric, water, military and other divisions should do well under the Messiah as a reward for NBC's complicity in his ascension.
As further proof that they might even be in on the plans of our new Fabian Socialist administration, GE plans to spin off consumer appliance and lighting businesses. Taking money away from upper middle class buyers will certainly crater the GE Profile appliance division.
Time Warner still, apparently, hopes to acquire NBC Universal. Hopefully, GE can jettison that dog.
But now that Buffett has a say in GE and a new love for socialist economic policy, perhaps GE will decide to keep NBC... who knows.
Perhaps the worst GE blunder was to decide to hold 100 percent of its own mortgage loans and then buy a big stake in AIG, the company that took the losing side of credit default swaps.
Perhaps Buffett decided to take his initial $3B GE preferred stock stake in order to fix the company. In that case, I wish him all the best. You've got to ask how much he'll be competing with the government for payment on that preferred interest.
As an owner of BRK shares, my biggest concern had been that BRK's ROE has not been close to 15% over the past few years.
The biggest problem has been that BRK both generates so much cash flow and that Buffet sits on the cash if he doesn't see anything that meets his 15% ROE standard. He refuses to consider a dividend, and he has said he believes that ultimately he will find appropriate investments.
Recently, he has opened up his pocketbook and has been putting A LOT of cash to work. He's buying BNI and COP, and both are trading at exceptional values.
So, I can almost guarantee that BRK will under perform when markets have been high for a while, but I expect his buying great companies at good prices will payoff -- in fact, I am counting on it.
Finally, I expect that like Jeremy Grantham, the markets will go a lot lower before they get better, on the logic that markets tend to over correct, and with the S&P earnings projected to be in the $55/share range in 2009, the current S&P P/E multiple indicates the overall market is no screaming buy.
Buffet will buy companies with great management and leave them alone and this is one of the reasons for his success.
However I do want to make a point about your concern w.r.t. Berkshires ROE which is not as high as companies that Buffett looks for. You need to consider that Berkshire has a large portfolio of stocks which if he likes a stock does not typically sell (e.g. KO, PG, AXP, JNJ, WPO, WFC etc). This stock portfolio has over the years grown with the market and has the effect of increasing Berkshire's equity (balance sheet) but apart from dividends from these stocks, any unrealized gains are not get reflected in net income (income statement). This makes the calculation of ROE skewed in the case of Berkshire since any unrealized growth in the stock portfolio actually has a negative impact on ROE. The fact that the ROE is as high as it is for Berkshire should actually be a comfort that the rest of the wholly owned subsidiaries are contributing as much to the income part of the equation that they are offsetting the unrealized gains in the stock portfolio.
On Jan 25 11:24 AM CaptainJJack wrote:
> I think Buffet's strategy is even simpler than you indicate: he buys
> companies with consistently high ROEs. If a company shows a solid
> history of high ROEs, it almost has to have a strong competitive
> advantage. The only other issue then is "how much to pay?".
>
> As an owner of BRK shares, my biggest concern had been that BRK's
> ROE has not been close to 15% over the past few years.
>
> The biggest problem has been that BRK both generates so much cash
> flow and that Buffet sits on the cash if he doesn't see anything
> that meets his 15% ROE standard. He refuses to consider a dividend,
> and he has said he believes that ultimately he will find appropriate
> investments.
>
> Recently, he has opened up his pocketbook and has been putting A
> LOT of cash to work. He's buying BNI and COP, and both are trading
> at exceptional values.
>
> So, I can almost guarantee that BRK will under perform when markets
> have been high for a while, but I expect his buying great companies
> at good prices will payoff -- in fact, I am counting on it.
>
> Finally, I expect that like Jeremy Grantham, the markets will go
> a lot lower before they get better, on the logic that markets tend
> to over correct, and with the S&P earnings projected to be in
> the $55/share range in 2009, the current S&P P/E multiple indicates
> the overall market is no screaming buy.
>