Buffett's Lessons: More Appropriate than Ever

I first read The Warren Buffett Way at the heights of the dotcom boom. I remember applying the notion of intrinsic value to companies like Ariba (ARBA) and CMGI (CMGI) and getting values of less than one-tenth of their market capitalizations. I was certain I was doing something wrong.

A decade later I’m trying to position my portfolios for the next ten years. It is a good time to revisit the principles distilled in The Warren Buffett Way. I’ve re-read the book recently, and it seems to make much more sense now after gaining more experience investing and going through the depths of the financial market collapse.

Robert Hagstrom does a very good job simplifying the process of evaluating an investment. He examines twelve investment tenets with a focus on the business, management, financials, and valuation.

Business Tenets
1. Is the business simple and understandable?
2. Does the business have a consistent operating history?
3. Does the business have favorable long-term prospects?

In my own investing, I always tend to focus on #3. I’m always drawn to the next big thing. This interest is often to the detriment of #1 and #2. Too many times I’ve been drawn to investments that show tremendous promise, but fail to demonstrate consistent, long-term profitability. The requirement that a business be simple and understandable has also been a weakness.

I would say that the recent financial crisis has demonstrated that many investors did not understand the risks inherent with many companies in the financial sector. My own investment in First Marblehead was very costly early on in the meltdown. My recent look at CapitalSource is an example of a company with a good deal of complexity. Even after close examination and a careful read of their annual report and conference call transcript, I’m not sure I fully understand the risks. The value appears compelling, but the business is certainly not simple and understandable.

Simple and understandable also requires that an investor stay within their circle of competence. Having worked in commercial real estate for over 11 years, understanding the risks and business of REITs may come more easily to me than comprehending a mining company or a company in the energy sector.

Management Tenets
4. Is management rational?
5. Is management candid with its shareholders?
6. Does management resist the institutional imperative?

One of the most difficult aspects of investing is evaluating management. There are, of course, extreme examples of management behaving badly, but it is not always so easy to see. Quarterly calls and annual reports are a great place for management to communicate their strategy and decisions to shareholders. As an investor, I want to see that the decisions of management make sense.

There is nothing more frustrating than a management team trying to gloss over bad decisions and poor performance. In quarterly reports, investors will often see a headline touting one or two metrics where performance was acceptable during a horrid quarter. During the recent financial meltdown, how many financial institutions have admitted that the sought too much leverage and invested in poor assets. Candor can certainly be difficult to come by.

The institutional imperative is the degree to which a management team follows the crowd. Buffett himself is a great example of this. During the years before the financial crisis, he went to great efforts to reduce exposure to derivatives, while companies like AIG were absorbing ever more exposure to these instruments.

Financial Tenets
7. What is the return on equity?
8. What are the company’s owner earnings?
9. What are the profit margins?
10. Has the company created at least $1 of market value for every dollar retained?

I think investors often make investing more complicated than it needs to be. Companies with light business models and high profit margins will produce better returns. If retained earnings can be invested in more growth, the company will likely produce strong returns over a long period of time.

Value Tenets
11. What is the value of the company?
12. Can it be purchased at a significant discount to its value?

Hagstrom effectively explains how to value a company in The Warren Buffett Way. The book provides many good examples of how Buffett views value. For new investors, this is a great place to start. For more experienced investors, this book will serve as a reminder of how simple investing should be.

Comments

[Village Idiot:]

A good reminder to re-read a book that should be on every investor's shelf.

Jul 29 03:43 AM

[John Galt:]

There are a million great ideas that never pan out. These types of investments are a dime a dozen, but in reality even have a lower probability of success than that.

One thing I always like to think about is how you could go up to a guy on the street to pick stocks vs. say a Wall Street broker and the common guy picking names he knows... Apple, Coca-Cola, J&J, Exxon Mobile will beat the broker picking some of these riskier stocks you've never heard of. That's exactly it... Are you picking "stocks", or good quality companies?

You might not double your money buying Coca-Cola, but you aren't going to lose all your money either. But If it compounds over time...

Jul 29 08:57 AM

[Mad Hedge F...:]

Nothing sadder than an aging hero. A lot of people like to follow Warren Buffet’s Berkshire Hathaway (BRK/A) as a leading indicator for the market. What better guide than a portfolio of the best of the best, run by the world’s great investor? Recently the news has not been good. If you wonder what a stock looks like when it is rolling over on diminishing volume, this is it. The only question is how big, how fast. As much as I worship the avuncular, chocolate milkshake loving, Sees Candy eating Oracle of Omaha, memorizing his annual letter to investors and hanging on his every spoken word, he hasn’t been doing that well lately. Since March, his main investing vehicle has only managed a 35% gain, compared to a 40% pop for the S&P 500; despite heavy weightings in such best of breed financials like Goldman Sachs (GS). Better keep his ticker on your desk top, because what BRK/A does, the world will follow

Jul 29 12:39 PM

[Larry House:]

I too have gone back to the bookshelf and pulled down the Graham & Dodd Security Analysis. A key point, seemingly overlooked today, is the importance of the macro environment in analyzing the market, a sector, or a company. A good company can be held in check by the surrounding climate. Buffett's principles are sound, but his portfolio was not spared in the downturn. Macro conditions trump company fundamentals.

Jul 29 02:11 PM

[Ricard:]

I would counter that this is true in the 'short term' when everyone votes with their pocketbooks. Right now, things are awful, so people are voting accordingly...however, that is usually the best time to buy for the long term. In that sense, macro events trump technical investing handily, but not necessarily fundamental value investing.

Anyone who bought in the dips the past year has probably still kept multiples of their original investment. That is telling. Myself, I was terrified while doing so, but seems I had good company - Grantham wrote this piece shortly after (included the SA link in case you can't access the GMO website):

seekingalpha.com/artic...


To evaluate Buffett's style requires scoring it on his timetable. If he fails on the long term, and touts himself as a long term investor, then something is wrong. For this crisis it is too early to tell. For the last one, one could make a serious argument that he should have sold his stocks pre-2000 and re-evaluated his portfolio. Still, relative to tech funds, and now relative to value funds weighted in financials, and even compared to the S&P 500 for the past 10 years, he has done very well. I think Buffett has passed his own trial by fire, and walks the walk.


On Jul 29 02:11 PM Larry House wrote:

> I too have gone back to the bookshelf and pulled down the Graham
> & Dodd Security Analysis. A key point, seemingly overlooked
> today, is the importance of the macro environment in analyzing the
> market, a sector, or a company. A good company can be held in check
> by the surrounding climate. Buffett's principles are sound, but
> his portfolio was not spared in the downturn. Macro conditions trump
> company fundamentals.

Jul 30 01:16 AM

[roy piper:]

It's a great book that heavily influenced me.

Aug 22 10:30 AM

[Patrick Prothe:]

These practices never go out of style. Particularly #1: is the business simple and understandable. If the business owner has difficulty explaining how they make money and what their business is about in 30 words or less, it's probably not simple enough. I think many look for shiny new concepts to avoid doing the hard work it takes to build a sustainable, profitable business. Howard Mann has one of the best books on this: brickyardpartners.com/.../

Aug 22 12:01 PM

[kool:]

very solid way of thinking process and it's totally a must in choosing a company to invest.

i recently picked a company, although it's in a turn-around stage but it's solid and has a huge space to grow in regenerative medicine. it has a new CEO who is proven to be a turn-around expert with very low key, doing more than he said, the company is Thermogenesis (KOOL). Check it out, they can either break-even or make a profit as soon as this current quarter.

Aug 23 11:11 AM

[CaptainJJack:]

While I've read a lot on Warren Buffet, my all time favorite book on the subject of investing is The Intelligent Investor by Benjamin Graham who, as most people know, was Buffet's teacher, and endorsed this book as "By far the best book on investing ever written".

I cannot tell you how important that book was to me during the crisis of last fall and this spring.

Graham developed the concept of intrinsic value, and he was also the first to point out how difficult it was to obtain. He said that its only real usefulness occurs when there is such a separtion between the market value and the intrinsic value that even allowing for enormous error in your estimate of intrinsic value, you still conclude that the market price is wrong.

He called this the margin of safety.

While I also like and use concepts like ROE and ROIC, I recognize that the market capitalization may be so much higher than the book value, they may have no meaning -- which is just another way of saying that even good companies, with good managements may be poor investments if the price is too high.

Aug 23 06:37 PM