I will only touch on the focus of the book which is Warren Buffett’s investment philosophies.
There are 12 tenets grouped in 4 categories namely, business tenets, management tenets, financial tenets and value tenets.
Simple and Understandable Business
Invest in your “circle of competence”, that is, business that you understand. In this way, you can accurately interpret developments and prospects of the business, and make a correct investment judgment thereafter. In his own words:
“It’s not how big the circle is that counts, it’s how well you define the parameters.”
[Free Ebook] How should you invest your first $20,000?
We asked 14 Singapore finance bloggers to share what they would do if they could go back in time and invest their first $20,000. They can no longer rewind time, but you can learn from their experience and hopefully start with a better footing.
“An investor needs to do very few things right as long as he or she avoids big mistakes.”
A steady track record of a business is a relatively reliable indicator that the business would be successful and profitable in the long run. Secondly, businesses that are undergoing major changes (e.g., organization restructuring) are to be avoided as the likelihood of committing major business errors is increased. He says, “[my approach is] very much profiting from lack of change. That’s the kind of business I like.” Thirdly, businesses that are in the midst of solving difficult problems should be avoided too as turnarounds rarely come true.
Favorable Long-term Prospects
Warren Buffett defines a franchise as a company whose product/service is very much needed, with no close subsitutes, and is not regulated. These features create a moat that give the company an edge over its rivals. The moat should be big and sustainable – In his words: “The key to investing is determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”
Buffett views allocation of capital as an exercise of logic and rationality and is the foremost important skill a management must have. This is especially true in a matured business where growth rate has slowed and it has more cash on hand than it needs for development or operating costs. The management must decide rationally to reinvest in business or return money to shareholders.
Buffett prefers managers to report companies’ performance beyond Generally Accepted Accounting Principles (GAAP). This is because GAAP requirements can be easily met and by lumping all businesses of the company into one industry, it does not provide a clear picture to the shareholders. A good report must answer 3 questions:
1) How much does the company worth approximately?
2) What is the likelihood that it can meet its future obligations?
3) How well are the managers carrying out their jobs, given the situations?
In addition, managers should admit their mistakes openly to shareholders as Buffett believes they would be more likely to correct them. Too much excuses and covering will only serve their short term personal interests and compromise long term interests of every stakeholder.
The Institutional Imperative
Institutional imperative is the tendency for the management to follow the behaviour of other companies, regardless of the degree of irrationality. It is human nature that caused institutional imperative. Managers find it very difficult to answer to shareholders with a loss while other companies are reporting gains, even though they know that these companies are not going the right direction and that the gains area actually short-lived.
Return on Equity
Earnings Per Share (EPS) is not a a good indicator of a company’s annual performance as it can retain a part of the growth in earnings to increase their equity base. A more reliable indicator will be Return on Equity (ROE) = ratio of earnings from operation to shareholders’ equity.
A few important points to take note with the use of ROE. Firstly, all values of equity must be taken at cost and not market value. This is because market value fluctuates and can either play down a good operating performance (when stock market rise, equity rise and being the denomiator, it will bring down ROE) or make a mediocre operating performance look good.
Secondly, factors affecting the numerator of ROE ratio have to be eliminated. Factors like capital gain from one time exceptional sale of an asset must be excluded. Buffett only wants to look at how much returns can the management bring through the operation of the business, given the allocated capital.
Lastly, it is important to take note of the debt level of a company despite of its high ROE. Too high a debt level, the company will meet difficulties during economic slowdown. Buffett likes companies perform with little leverage employed.
Cash flow analysis is not a credible indicator of the value of a company as it leaves out an important consideration – capital expenditure. Cash flow is defined by net income after taxes, depreciation, depletion, amortization, and other noncash charges. Clearly, capital expenditure is not anywhere in the equation, and Buffett said about 95% of US companies incur such expenditure equal to their depreciation rates. This should be view as an expense as much as labor and utility cost. Buffett came out with his own indicator called “Owner Earnings” which actually has the same formula as cash flow analysis, only to include the subtraction of the estimated capital expenditure value.
Minimizing cost is an important aspect of every businesses. Businesses with high-cost operations have a tendency to increase its overhead and fail to convert sales into profits. A good management will always strive to keep cost low like how Buffett puts it across,”the really good manager does not wake up in the morning and say, ‘This is the day I’m going to cut cost,’ any more than he wakes up and decides to practice breathing.”
One Dollar Premise
Retained earnings should be and invested in the company to produce above-average return. The proof that a company is achieving this is a greater rise in the company’s market value in time to come. Buffett’s criteria is to select companies that can at least match a dollar of retained earnings with a dollar of market value. Of course, the higher the market value against the dollar of retained earnings the better.
Calculate What the Business is Worth
Buffett uses John Burr Williams’s dividend discount model to value a business. The formula is to take total net cash flow (or owner earnings, as discussed above) expected to occur over the life of the business, discounted by an interest rate to today’s value. This method can use to value different kind of securities by brinigng them to a common base for comparison.
As this method requires one to make an estimation of a business’s future earnings, he/she has to know the business well enough, that is within his/her circle of competence (1st tenet).
Buffett uses the risk-free rate as the discount rate. Risk-free rate is said to be the current rate of the long-term government bond as the certainty of government paying the coupons is very high. When interest rates are low, Buffet would up his discount rate. Typically, with bond yields less than 7%, he would use a discount rate of 10%.
Buy at Attractive Prices
If you are able to follow the first 11 tenets, it is not enough to guarantee your investment would be successful. There are 2 conditions – buy at sensible price and the business realises the estimated expectation. The former condition is what one can control. Buffett adopts Benjamin Graham’s value investing method, that is to purchase stocks with a margin of safety.
This margin of safety is advantageous in 2 ways. Firstly, it gives an allowance for the stock price to drop and yet still able to have a positive return. Secondly, it will give him an extraordinary return when the stock price reflect the true intrinsic value of the company.