Now let us switch the gears and talk about the master investor, Warren Buffet. A man of simple tastes, Buffet relies very heavily on fundamental analysis. I cannot recall who told me this about Buffet, either a friend or a relative, that Buffet is confident about all the companies in his portfolio, so much so to the extent that he would not flinch if a stock lost 1/3 of its value overnight because its financials and fundamentals dictate it to be in fact a solid company. I cannot say that the following information is absolutely verified by Buffet as I have not had a sit-down with him yet, but after reading a biography of his, I do believe it captures his investing philosophy.
Buffet believes that when investing in a company, the ultimate goal of that investment is to completely own that company. So under ideal conditions, you would have enough money to own 100% of that company and your money would be safe in this.
Following are some general guidelines and prudent factors to keep in mind, which Buffet follows with his investments:
1.) The company in mind must be able to reasonably predict its earnings
2.) A company with predictable earnings has good economics, which leads to lots of free cash flow, which can be used to by businesses or buying back shares.
3.) These good economics are shown by a combination of the following:
– Consistent improvements on the company
– High returns on shareholders’ equity
– Strong earnings
– A consumer monopoly (which will be discussed later in detail)
– Good management
4.) Always invest while the price is low in order to increase return
5.) First choose which company to invest in, and then let the price and the required rate of return determine when or if to buy.
6.) Investing at the right price in a good business should produce a minimum rate of return of 15%.
Along with these rules are some more specific codes Buffet follows:
Investing should always be approached with a business mentality – i.e. All emotion should be purged from investing.
Always attempt to learn and master one industry, and then do not stray from this industry.
Stocks do not represent so much a market price, as much as a distinct company with certain operational standards behind it.
Dividends are best utilized when reinvested into the company. This is due to tax avoidance on these payouts. Also, corporations can often reinvest this money at a higher rate than can an individual, although they must be reinvested prudently.
Holding a stock is better than withdrawing from it, for tax-avoidance reasons.
One topic Buffet especially cares about is the capability of a company to reasonably predict its earnings. Encompassed in this area is the company’s EPS (earnings per share) and the EPS annual growth rate.
Buffet is a large advocate of deciding on what company to buy before it hits a favorably low price, that is, “don’t aisle shop!” This idea of knowing the company you will be investing supports the idea that one should be knowledgeable of the industry in which it operates.
According to Buffet, there are two types of businesses: commodity type businesses and consumer monopoly types.
In commodity type businesses, the price of the product is the single most important factor and as a result, significant cash is spent on manufacturing improvements.
Commodity type businesses are often recognized by:
– Low profit margins
– Low return on equity, often less than 15%
– Difficulty with sustaining name brand loyalty
– Many competitors in the industry
– Excess supply
– Erratic profits
Consumer monopoly type businesses on the other hand are stable with predictable earnings. One key indicator of a consumer monopoly business is to ask whether another fictional company, with a huge amount of cash could compete with it.
These companies often have a high wealth in intangible assets, not in PPE (property, plant, and equipment) and other fixed long-term assets.
These companies are also nearly debt-free most of the time. This idea of NOT being leveraged is why Buffet is a large opponent of derivatives and why Buffet steered clear of the CDO and subprime market during the mortgage crisis.
Aside from many other guidelines and rules Buffet adheres when investing, there are 9 specific questions Buffet asks when investigating companies:
1.) Does it have a strong consumer monopoly?
– Does it have strong recognizable products? Does it have to be carried by the distributor, lest he lose money in opportunity costs?
– If involved in an acquisition, is the acquired company also a consumer monopoly?
2.) Are the earnings strong and rising?
3.) Is the company conservatively financed?
4.) Does it have a high return on equity?
– ROE should consistently be at least 15%
– A healthy ROE indicates good management
5.) Does the company reinvest its earnings?
6.) How much money is spent maintaining current operations?
– If a company must use its money to constantly update operations, this is a sign bad sign as that money could be going towards share buybacks or acquisitions
7.) Does it reinvest money in new opportunities?
– Good management will often use excess capital to buy back shares
– One of the most important aspects of management is how profitably it employs its retained earnings
– Warren prefers minor expenses into research and development
8.) Can the company adjust prices for inflation?
9.) Will the value added by retained earnings increase the market value of the firm?
– Personally, this is the most important question for me. I am interested in the relationship between the inherent value of a company and its effect on the stock price.
Buffet believes that one sometimes discovers these companies as “conceptual toll bridges.”
1.) Businesses with products that are used up quickly and with brand-name appeal. These are sorts of products that effectively lose money for the merchant because they are always bought. Trademarks and copyrights have immense carrying power. Some examples of companies that carry these sorts of products are:
Coca cola, Hershey’s, Wrigley’s gum, Advil, Gillette, Hanes, etc.
Pharmaceutical companies often have these characteristics
A good way to identify these products is to walk through a supermarket and identify popular products.
2.) Communication businesses
Advertising has created conceptual toll bridges in today’s environment
Newspapers work similarly
3.) Typically these conceptual toll bridges apply more to services than products
As I mentioned in my last post, I would like to thank ALL of you who have been reading and commenting on this blog. Initially, I did not know where I would go this or who it would cater to but with your support and ideas, I know that we can cultivate a great atmosphere where we can exchange ideas and whatnot. Keep posting your comments and let us stir our minds towards greatness!!