Monthly Archives: January 2013

7 lessons Tony Soprano could learn from Warren Buffett

Posted on January 24, 2013 by admin

There might not seem to be much connection between Warren Buffett and Tony Soprano – one, a wise and legendary investor, the other a violent and impetuous mob boss from HBO’s The Sopranos. Still, “business is business” – a sentiment Warren and Tony might both agree upon – and, after recently re-watching the series, we couldn’t help but feel that Tony Soprano could have benefited from some advice from the Sage of Omaha.

Here are seven lessons we feel that the New Jersey mob boss could have learned from the master.

Lesson 1: Don’t throw away the moat

Warren Buffett likes a business to have a “moat” around it: a competitive advantage that makes it difficult for others to compete and that allows it to have some control over its pricing. As an example, the Coca Cola “moat” is its primacy in soda drinks, its customer loyalty, and that any general retailer of soda drinks needs to stock Coke. With Gillette, the moat is that it is a market leader with a product that needs constant replacing.

At the start of the series, the Soprano family had its moat; it was the predominant organised crime outfit in North Jersey, its products were reasonably cheap in unit prices, and there was a constant need for replacement or repetition – weekly garbage pick ups, gambling, stolen credit cards, protection, loan sharking.

Then, what does Tony do? In Season 2, he becomes involved in a joint enterprise with the Lupertazzi family in large construction projects. These bring him a host of problems – infighting with the other partners, building approvals and delays, and reduced liquidity. The problems continue through following seasons, and a by-product of the venture is growing bad blood between Tony and Phil Leotardo, under-boss of the Lupertazzi family and eventual boss.

LESSON: If Tony had heeded the investment principles of Warren Buffett, he would have stuck with his original product line, probably avoiding the eventual gang war with Phil, the decimation of the Family and his own possible whacking.

Lesson 2: Stick to good managers

It is essential, says Buffett, to have good managers running businesses that you invest in.

Tony Soprano made some poor choices with his managers. In Season 2, he gave the management of one of his crews to Richie Aprile, the brother of Tony’s former Don, even though he neither liked Richie nor trusted him. Richie’s plans to oust Tony from leadership came to an end when he was whacked by Tony’s sister in a lover’s tiff.

Tony then gave the management of that crew, after a short hiatus, to Ralph Cifaretto, even though he knew Ralphie to be gambling excessively, snorting too much coke and beating strippers to death. This too ended when Tony killed Ralph, because Ralph destroyed in an arson hit the racehorse, beloved by Tony, that they co-owned.

LESSON: had Tony listened to Warren and employed good and competent managers, two men and a horse might still be alive.

Lesson 3: Know the business

Warren Buffett believes that you need to understand any business in which you invest.

In various episodes of The Sopranos, Tony’s cousin Christopher, who fancies himself as a film script writer, tries unsuccessfully to get into the movie business, a business that he does not understand. In Episode 7 Season 2, he believes that he is negotiating with a Hollywood director to sell him a script, but does not realise that the director is only playing him for Christopher’s anecdotes about criminals so that he can put them in his own script. In Episode 7, Season 6, Christopher has another unsuccessful attempt to break into the film industry before resorting to type and robbing a famous film star of her goodies.

Christopher robs Lauren Bacall for her awards basket

LESSON: Christopher’s only film success comes late in Season 6 when he scripts a film for Carmine Lupertazzi Jr, a criminal with a good understanding of the film industry through his experience in making pornographic movies.

Lesson 4: Avoid debt that you can’t pay back out of earnings

A primary factor in Buffett’s decision whether to invest in a company or not is the ability of the business to pay back debt out of earnings. Buffett sensibly believes that the longer it would take to pay back a debt from profits, the riskier the business is. Benjamin Graham had a similar view (the current ratio).

In Season 6 of The Sopranos, Tony gambles recklessly and racks up large gambling debts to his friend and loan shark Hesh at a time when business is bad, earnings are down and relations between the Sopranos and the Lupertazzi Family are quickly deteriorating. Tony’s inability to repay the debt not only causes mental anguish and loss of concentration on the problems of the Family but threatens his long time friendship with Hesh to the extent that he contemplates killing Hech.

LESSON: Had Tony not lost the plot by getting into debt that he could not repay from profits, he may have focussed more on his core business and avoided the debilitating gang war that concludes the series.

Tony’s gambling problem demonstrated a poor attitude to debt - something Buffett counsels against (warning: some swearing and nudity)

Lesson 5: Only retain earnings when they can be used productively

Buffett believes that earnings should be distributed to shareholders unless they can be used productively by, for example, buying back the company shares if they are selling below intrinsic value, or increasing shareholder earnings by more than they could do themselves if they had the money.

In various episodes of The Sopranos, we see Tony hiding his excess cash in closets, his mother’s hatboxes, or giving them to the Russian Mafia to be hidden in a secret bank account. Unless the Russian bank deposits are paying really good rates of interest, or the funds are being laundered so that Tony can get them repatriated and invested in legitimate businesses, the value of the money will be eaten away by holding charges and depreciation. And the money in the closet and Mom’s hatbox are doing no good.

LESSON: if Tony had done something productive with his excess earnings as Buffett suggests, he would not have lost the money he stored in the duck feed bin by the swimming pool which wife Carmela stole when she was angry at Tony in Episode 8 Season 4.

Lesson 6: Stick with the brand that the customers know

Warren Buffett believes in the value of a good brand and his big investments show it – Amex, Coke, See’s Candies.

In Episode 5 of Season 3 of The Sopranos, Tony and his friend and restaurateur Artie Bucco discuss going into business together, making a range of sauces based on Artie’s own well-loved family recipes. Artie wants to distribute the sauces under the brand name Vesuvio, the upmarket and well-known restaurant that he owns. Tony, ever the controller, wants to name it after Satriales, the pork store that he owns in Kearney, New Jersey.

LESSON: The venture does not go ahead but Tony should have had the business sense to know that a sauce bearing the name of a famous restaurant would be more likely to appeal to a discerning public than one name after a shabby meat market.

Lesson 7: Know when to keep and when to sell

The Sage of Omaha’s preferred position is to keep his interest in a business forever but that does not mean that he will not sell when the time is right – when his original investment thesis is no longer valid.

In Episode 8 Season 6, Tony owns some real estate in his old neighbourhood. He receives an offer to sell but refuses the offer for sentimental reasons. After looking around, he realises that the neighbourhood has changed – ethnic gangs and yuppies are moving in - and it no longer has the meaning for him that it once had.

LESSON: Tony must have actually listened to Warren Buffett this time around because, when the buyer ups the price, Tony, realising the basis for his ownership is no longer there, takes the offer without a second thought. Of course, the sexual favors offered by the estate agent may have been a factor.

When the neighborhood changed and the price was right, it was time for Tony to sell

Posted in Warren Buffett |

What Warren Buffett likes to read

Posted on January 23, 2013 by admin

From time to time, Warren Buffett makes book recommendations in his annual letters to shareholders. These are some of them.

Poor Charlie’s Almanack: The Wit and Wisdom of Charles T. Munger (2010 letter to shareholders)

Seeking Wisdom: From Darwin to Munger, by Peter Bevelin (2006 letter to shareholders)

Where Are the Customers’ Yachts: or A Good Hard Look at Wall Street, by Fred Schwed (2006 letter to shareholders)

Nuclear Terrorism: The Ultimate Preventable Catastrophe, by Graham T Allison (2004 letter to shareholders)

The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron, by Bethany McLean and Peter Elkind (2003 letter to shareholders)

In an Uncertain World: Tough Choices from Wall Street to Washington, by Robert Rubin and Jacob Weisberg (2003 letter to shareholders)

The Intelligent Investor: The Definitive Book on Value Investing. A Book of Practical Counsel, by Benjamin Graham and updated by Jason Zweig (2003 letter to shareholders)

Although we have not yet reviewed Poor Charlie, the fact that Warren recommends this just about every year in his letter to shareholders suggests that it would make essential reading. Because of this, and our fond regard for the way Charlie Munger does business, we think we had better read it soon and post a review.

The Benjamin Graham book, updated by Zweig, is necessary reading to anybody who seeks to value invest. It forms part of our essential reading and we have it by our bedside. Our review is here.

And Warren’s favourite newspaper is the Omaha World-Herald which he devours each day. He told CNBC, tongue in cheek we suspect, that he reads it with the same avidity as other men read Playboy.

Posted in Book reviews, Warren Buffett |

Buffett’s annual letter to shareholders and analysis: 2011

Posted on January 23, 2013 by admin

Buffett’s annual letter has been published in association with the annual report of Berkshire Hathaway. The full letter can be accessed here and the annual report accessed here. These are some of the highlights.

Berkshire financial results

The per share book value of the Class A and B shares in the company rose by 4.6 per cent in the year, giving a compound growth of 19.8 per cent for the 47 years since Buffett took control. Buffett pointed out that the book value has risen from $19 to nearly $100,000 in that time. Not bad!

Buffett’s own highlights

1. He is confident that his eventual successors (and Munger’s) will do a good job - Todd Combs and Ted Weschler and he is allowing each of them to play with a billion dollars the coming year. And he has backups.

2. Berkshire has bought Lubrizol, a chemical company run by a superb manager and that company is buying other businesses.

3. All Berkshire’s main businesses - BNSF, Iscar, Lubrizol, Marmon and MidAmerican Energy - had record years.

4. Despite big payouts, the insurance companies still did well.

5. Berkshire made two big investments - $5 billion in preferred stock in Bank of America and a further 700 million shares of IBM at $7.14. They now own 13 per cent of Amex, 8.8 per cent of Coke, 5.5 per cent of IBM and 7.6 per cent of Wells Fargo

6. The $2 billion spent on bonds in Energy Future Holdings was a bummer. Unless gas prices go up, the investment is shaky. Some companies paid back loans made by Berkshire with a resulting loss of income to be hopefully replaced by the investment in Lubrizol.

7. Buffett’s prediction of the housing market coming back was wrong but he remains hopeful. The recovery may be long and painful but will come about. “Today, household formations are consistently exceeding housing starts”. Supply and demand is a constant economic principle.

The price of Berkshire Hathaway shares

Buffett says to look at their intrinsic value as represented by the book value of a share and gives a comparative table in the annual report.

Share repurchases

Berkshire bought back some shares during the year because his criteria for share repurchasing by a company were met - the company has the funds to do so and the share prices is materially lower than the value of a share. This is the only way existing shareholders gain from a buy back. Buffett used an IBM share repurchase as an example:

When Berkshire buys stock in a company that is repurchasing shares, we hope for two events: First, we have the normal hope that earnings of the business will increase at a good clip for a long time to come; and second, we also hope that the stock underperforms in the market for a long time as well. A corollary to this second point: “Talking our book” about a stock we own – were that to be effective – would actually be harmful to Berkshire, not helpful as commentators customarily assume.

Let’s use IBM as an example. As all business observers know, CEOs Lou Gerstner and Sam Palmisano did a superb job in moving IBM from near-bankruptcy twenty years ago to its prominence today. Their operational accomplishments were truly extraordinary. But their financial management was equally brilliant, particularly in recent years as the company’s financial flexibility improved. Indeed, I can think of no major company that has had better financial management, a skill that has materially increased the gains enjoyed by IBM shareholders. The company has used debt wisely, made value-adding acquisitions almost exclusively for cash and aggressively repurchased its own stock.

Today, IBM has 1.16 billion shares outstanding, of which we own about 63.9 million or 5.5%. Naturally, what happens to the company’s earnings over the next five years is of enormous importance to us. Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for the day: What should a long-term shareholder, such as Berkshire, cheer for during that period?

I won’t keep you in suspense. We should wish for IBM’s stock price to languish throughout the five years.

Let’s do the math. If IBM’s stock price averages, say, $200 during the period, the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%.

If IBM were to earn, say, $20 billion in the fifth year, our share of those earnings would be a full $100 million greater under the “disappointing” scenario of a lower stock price than they would have been at the higher price. At some later point our shares would be worth perhaps $11 ⁄2 billion more than if the “high-price” repurchase scenario had taken place.

On buying businesses

As you know, when Buffett buys a business, he invests in the people who run it as well as the business itself and this has influenced his reluctance to get rid of these businesses when they under-perform. He explains this by saying that where he gives a commitment to a vendor who remains in the business that he will see it through through thick and thin, he will stick with that commitment. However, when it comes down to the nitty-gritty and there is no hope for improvement, he will cut his losses. He estimates that this has only happened twice in 47 years.

Nebraska Furniture Mart

Another big year for Rose’s baby. Record earnings and a new store coming up in Dallas. The company is in its third generation of Blumkin management.

Berkshire’s plus $1 billion dollar investments in listed companies

It owns the following percentage in these companies.

American Express Company 13.0 %
The Coca-Cola Company 8.8 %
ConocoPhillips 2.3%
International Business Machines Corp 5.5%
Johnson & Johnson 1.2%
Kraft Foods 4.5%
Munich Re 11.3%
POSCO 5.1%
The Procter & Gamble Company 2.6%
Sanofi1.9%
Tesco 3.6%
U.S. Bancorp 4.1%
Wal-Mart Stores, Inc1.1%
Wells Fargo & Company 7.6%

According to Buffett, the banking industry has recovered and he is more than happy with how Wells Fargo has recovered from its mistakes. And he has faith in IBM.

Derivatives

Berkshire will not be making any major new investments in derivatives.

The choices for investors

There are three types of investment according to Buffett:

a) Investments denominated in a given currency, such as bank deposits, cash funds, mortgages and which are supposedly safe. These investments are not risk free because their value can be eroded by inflation, government policy and the actions of speculators.

b) Assets that are not productive and where increase in value depends upon somebody else buying the asset at a higher price, such as tulips during the great Tulip Boom or technological stocks during the buying frenzy of the Dot-Com boom. The risk here is that price rises depend upon an ever increasing pool of speculators. Gold falls within this category even though it is productive in the sense that it has industrial use but industrial demand for gold is limited and secondary to its use as a holding asset.

c) Assets that are productive – businesses, farms, mines etc – and these are the best assets to hold so long as you only buy them on sound investment principles. ‘Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment. ‘

Posted in Berkshire Hathaway, Warren Buffett |

Warren Buffett on debt

Posted on January 23, 2013 by admin

Warren Buffett does not like debt

Warren Buffett does not like debt and does not like to invest in companies that have too much debt, particularly long-term debt. With long-term debt, increases in interest rates can drastically affect company profits and make future cash flows less predictable.

In 1982, Warren Buffett noted that Berkshire Hathaway preferred to buy companies with little or no debt and has repeated this mantra on many occasions. He adopts the same philosophy for his company, preferring to avoid debt but where necessary going into it on a long-term basis only with fixed rates of interest and to obtain the finance before they need it.

What Warren Buffett says about debt

Warren Buffet acknowledges that debt can effectively increase the return on equity in a company but warns against it. In 1987, he said this:

Good business or investment decisions will eventually produce quite satisfactory economic results, with no aid from leverage.

It seems to us both foolish and improper to risk what is important (including, necessarily, the welfare of innocent bystanders such as policyholders and employees) for some extra returns that are relatively unimportant.

Benjamin Graham on Debt

There are various approaches to looking at a company’s debt. Benjamin Graham, in The Interpretation of Financial Statements, defined some important terms:

Current assets - Assets which either are cash or can be readily turned into cash or will be converted into cash fairly rapidly in the normal course of business. Include cash, cash equivalents, receivables due within one year and inventories.

Current liabilities - Recognised claims against the enterprise which are considered to be payable within one year.

Shareholders’ equity - The interest of the stockholders in a company as measured by the capital and surplus.

The current ratio or the liquidity test

Benjamin Graham believed that the current ratio, the ratio of current liabilities to current debt was important in looking at a company’s financial position. In theory, the higher the ratio, the more comfortable, financially, is the company. This has been called the test of liquidity.

Benjamin Graham said this about the current ratio:

When a company is in a sound position, the current assets well exceed the current liabilities, indicating that the company will have no difficulty in taking care of its current debts as they mature.

There are several reservations here:

A company with too high a ratio may not be using its surplus funds wisely
Cash businesses, such as supermarkets, generally require a lower ratio than businesses that have protracted periods for customer payments.

Again, Benjamin Graham:

What constitutes a satisfactory current ratio varies to some extent with the line of business …

In industrial companies a current ratio of 2 to 1 has been considered a sort of standard minimum.’ David Hey-Cunningham believes that a reasonable rule of thumb measure is 1.5 to 1.

The formula is:

Current assets
Current liabilities

The Quick Ratio

Benjamin Graham also looked at the Quick Ratio, a similar calculation but excluding inventory. Again, the size of the ratio will depend upon the business: companies with inventories that can readily be converted into cash probably do not need as high a ratio as those with longer-term inventories. But it was important to Benjamin Graham:

In every case, however, the situation must be looked into with some care to make sure that the company is really in a comfortable current position.

The formula is:

Current assets - inventory
Current liability

David Hey-Cunningham writes about the acid test, which uses the same ratio as above, but does not include any bank overdraft in current liabilities.

Debt to equity ratios

This shows the proportion of debt to shareholders’ equity. Debt can be either the total debt or more commonly long-term (interest bearing) debt. David Hey-Cunningham gives the rule of thumb test as 0.5 to 1. The formula is generally quoted as:

Long-term debt
Shareholder’s equity

Warren Buffett and long-term debt

Warren Buffett speaks only generally of his approach to debt. Mary Buffett and David Clark have concluded that he focuses on long-term debt, a conclusion that is supported by his public comments. They believe that his concern lies with the company’s ability to repay its debts, should the need arise, from its profits; the longer the time period, the more vulnerable is the company to external changes and the less predictable are its future earnings.

The formula for such a calculation is:

Number of years to pay out debt = Long term debt
Current annual profit

Company examples

If we apply this formula to Johnson and Johnson, for example, we find, using Value Line, that for 2002, the long-term debt of the company was $2022 million and the profit for that year was $6610 million. Dividing the first figure by the second, we can calculate that at that rate the company could pay off its long-term debt in .3 of a year.

If we apply the same formula to McDonald’s Corporation, we find, using Value Line, that for 2002, the long-term debt of that company was $9703 million and the profit for that year was $ 1692 million. Dividing the first figure by the second, we can calculate that at that rate the company could pay off its long-term debt in 5.73 years.

Buffett on the US national debt

To some extent. Buffett applies the same principles when he considers the problem America is facing with its national debt. In a reported interview, he said that it was not the size of the debt that should cause concern but the ratio of the national debt to the gross national product (GNP). This defines the ability of a country to pay its debts: the higher the ratio, the more difficult it becomes and vice versa. In effect, he is applying a similar benchmark to sovereign debt as he does to a company in which he might invest - it is not the amount of the debt, but how quickly and realistic it is to pay the debt out of income.

He is hopeful however, pointing out that America has a lower debt to GNP ratio than at other times in its history (about 100% now compared to 109% after World War 2, but the economy needs to grow to minimize the problem because if the debt remains the same, higher earnings means a quicker theoretical repayment time.

Posted in How Buffett invests |

Warren Buffett: a short biography

Posted on January 21, 2013 by admin

Early life

Buffett was born in 1930 in Omaha, Nebraska, the son of a stockbroker and Congressman, and has become probably the world’s most successful investor.

As a boy, irrespective of his family background, he delivered newspapers to make extra money and this probably sparked his interest in the media where he has made several successful investments including the Washington Post Company, a stock that has made him a lot of money and which he vows never to sell.

Imbued with a determination to make good and an entrepreneurial nature, Warren dabbled in several part time businesses but his destiny was chartered early in the piece when, after graduating from the University of Nebraska, he studied business at the Columbia Graduate Business School under the legendary Benjamin Graham.

Working with Benjamin Graham

He tried to get a position with Graham’s firm and was at first unsuccessful. He finally got the job and, as he generously acknowledges, learned a lot about stock investment from The Master.

Graham eventually retired and Buffett started a limited partnership in Omaha, using capital contributed by family and friends. The partnership was a great success and Buffett is said to have averaged an annual rate of return for the partnership in excess of 23 per cent, far in excess of the market.

Buying Berkshire Hathaway

Buffett, after several years, decided to wind up the partnership, returning the lucky investors their capital and their share of the profits, and bought an interest in Berkshire Hathaway, a textile company, giving his original investors the the chance to invest. The smart ones did so.

Buffett’s early days at Berkshire Hathaway were not great. The company was in an industry facing real challenges from exports and high manufacturing costs. Warren Buffett had not, however, forgotten what he had learned under Graham, and arranged for the company to buy out two Nebraska insurance companies.

This was the start of Buffett’s interest in insurance and the rise to financial fame of both himself and Berkshire Hathaway. The insurance game is a hard one but under Buffett, the company has become, not only a successful share investor, but a leading provider of insurance.

Buffett and Charlie Munger

Buffett struck up a friendship with Charles T Munger, a lawyer and investor and Charlie Munger eventually joined Warren at Berkshire Hathaway as his Vice-Chairman, alter ego, and friend. Warren Buffett is always the first to acknowledge the contribution that Charlie Munger has made to Berkshire Hathaway. (Listen to an interview with Charlie Munger, or read our biography)

Under Buffett and Munger, Berkshire Hathaway has become an investment giant that wholly owns a number of successful companies that include:

Geico Corporation
Nebraska Furniture Mart
See’s Candy Shops
Lubrizol
MidAmerican Energy
Clayton Homes
Shaw Carpets

Warren Buffett, the man

Warren Buffett, the man, is just as hard to define as Warren Buffett, the investor. He projects a homespun frugality but one suspects that he plays his personality as close to the chest as he does his investment secrets. He always claims that it is his partner, Charlie Munger, who keeps his feet planted firmly in the ground.

Warren Buffet has become a legend and is generally ranked, along with his mentor, Benjamin Graham, first in a stellar cast of investors that includes Peter Lynch, John Neff, and Philip Fisher.

Best Warren Buffett biography

The most detailed biography of Buffett is The Snowball: Warren Buffett and the Business of Life, written by Alice Schroeder, who was given considerable access by Warren. It contains many facts not previously known about his personal and business life and is a necessary read, despite its length and occasional tedium. We also highly rate Buffett, The Making of an American Capitalist, by Robert Lowenstein.

Posted in Biographies, Warren Buffett |

Review: Value investing, by Janet Lowe

Posted on January 21, 2013 by admin

This book is a little gem for anybody who has difficulties in understanding the investment philosophy of Benjamin Graham.

Lowe, who has written extensively on Graham, explains many of the investment terms and strategies given by Graham in his writings and relates them to current and up to date business situations. She explains to the reader what value investment is and its connection to both company growth and intrinsic value.

A particularly good chapter is the one on how to identify growth from the income statements because, as readers are well aware, Warren Buffett’s particular gift has been in finding companies selling at Graham prices but with great growth potential.

This book has been criticised as being too simple for anyone with a sound knowledge of investment principles. We agree; it is for those people who do not yet have an understanding of Graham and Buffett investment techniques. For those in this niche, it is a good start.

Another criticism is that the author wrongly suggests that Buffett supports diversification in stocks. Technically, this is true. Warren has on several occasions suggested that investors concentrate on just a few stocks. This does not however mean that Buffett is against diversification per se. If you look at the investments of Berkshire Hathaway, you will find, although only a few stocks, a wide diversification across industries.

The book is easy to understand for even the most basic of investors, and is well researched. The index, like many these days, leaves a lot to be desired. HIGHLY RECOMMENDED FOR BEGINNING INVESTORS.

Purchase at Amazon.com
Value Investing

Posted in Book reviews |

Understanding the company

Posted on January 21, 2013 by admin

Buying the business

Warren Buffett believes, as did Benjamin Graham, that investors should look upon share investment as buying a part of a business. Investors should take the same approach to buying shares as they would if they were buying a business. The only difference is that instead of buying the whole of the business, or a partnership in the business, they are only buying a tiny share. Just to explain this further; whether you buy a business for yourself, or whether you buy shares in a company that runs a business, you are doing the same thing - buying into a business. The only difference is in the percentage of the business that you own.

A prudent investor never buys a business that they do not understand. Similarly, a prudent share investor should never buy shares in a company whose business they do not understand.

What Warren Buffett says about buying a business

In 1977, Warren Buffett told shareholders in Berkshire Hathaway that their company would only invest in a business that the directors could understand.. He has repeated this message many times since. In 1992, he expanded on this theme:

[W]e try to stick with businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change we’re not smart enough to predict future cash flows. Incidentally that shortcoming doesn’t bother us.

Warren Buffett companies

In 2002, Berkshire Hathaway disclosed that it had substantial minority shareholdings in the following listed corporations:

The Coca Cola Company (see case study)
American Express
The Gillette Company
H and R Block Inc
M and T Bank
Moody’s Corporation
The Washington Post Company
Wells Fargo and Company

With the exception perhaps of M & T Bank, these are all not only brand name companies but also businesses that are relatively easy to understand. Some examples:

The Coca Cola Company is the world’s largest beverage company, making and distributing worldwide such products as Coke, Fanta, Sprite, Evian and Minute Maid. It has been in business many, many years and is perhaps the world’s most recognised name.

American Express is a world-recognised name and makes its money through the sale of financial services and its brand name credit card. It has been in business a very long time and has a simple business model that even the most unsophisticated investor should be able to understand.

H & R Block is a worldwide firm that makes its money preparing tax returns for people either unable or unwilling to do it themselves.

In 2012, Berkshire Hathaway included in the businesses that it own: MidAmerican Energy, CTB, TTI and ISCAR. Again thee businesses are fairly easy to understand if you put in the time. MidAmerican sells electricity and gas, CTB does farm equipment, TTI primarily sells electronic components and ISCAR focuses on tools.

Compare these easily understood companies to say General Electric with its complex business structure and its multiple activities over the years that have included electronics, energy distribution, television, movies, financing, plastics, health care, financing, and the rest. It may be and is a great company but it is not easy to understand.

Warren Buffett and Keynes

In Warren Buffett’s own words, he did not invest in these companies, and many other successful investments, without acquiring as full a knowledge as possible about the company, its business, its management, and its financial position. He has advised individual investors to do the same, as did the great economist and successful investor John Maynard Keynes.

As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about … - JM Keynes

Why Warren Buffett did not invest in Microsoft

As Warren Buffett has said, he knows and admires Bill Gates and the Microsoft Corporation but he never invested in it because he did not understand the way that the company works.

Complex companies

Take however, a company like Unilever NV. This is a corporation that has been around a long time, has a worldwide reputation and market, and is successful. But how easy is it to understand the way it operates?

It seems to have two parent holding companies, one in Great Britain, and one in The Netherlands. It operates as one company but each of the two holding companies owns shares in operating subsidiaries. The director component of both holding companies is the same and there are agreements that equalise dividends and set trading ratios for their respective shares. The business may be good but this complex structure is just too difficult for the average person to understand.

Knowing a company

Knowing a company involves research as well as personal experience and successful investors approach share investment the way that they would the purchase of a business.

They buy a business in an industry area that they know or that they have learned about, they investigate the financials, they look at how the business operated in the past, they weigh up future potential, and they then make a reasoned decision to buy at the price offered or not buy.

Just as the cobbler should stick to his last, investors should stay with what they know. They should not stray into areas beyond their expertise. As Warren Buffett said in 1992:

What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know.

Robert Hagstrom has looked extensively at Warren Buffett’s investments over the years and agrees that Buffett has made it his business to understand the business of the companies where he puts the money of Berkshire Hathaway. According to Hagstrom, Buffett:

understands the revenues, expenses, cash flow, labor relations flexibility and capital-allocation needs of each of Berkshire’s holdings.

Hagstrom argues that the prudent individual investor should do no less.

Personal experience

A careful investor will use information services to cull potential investments but will, before investment, reach their own conclusions based on the original source materials issued by the company and other primary evidence.

Anecdotal evidence and personal experience can also be useful to an investor. There are various anecdotes of Warren Buffett, in early days, making personal visits to company offices and asking for information. Not all investors can do this but they can relate their personal experience of a product or service to their investment decisions.

Posted in How Buffett invests |

The essential Warren Buffett library

Posted on January 21, 2013 by admin

The top 5 Buffett books

Some of our subscribers have asked us to nominate the best five books about Warren Buffett and his investment style. There is a large field but, here goes, in order of preference.

1. The Intelligent Investor, by Benjamin Graham

It is significant that so many top investors, including Buffett, pay homage to the man considered the father of security analysis. Benjamin Graham has written prolifically but he tried to encapsulate it all in this book which he wrote for the lay investor. It is easy to read and easy to understand and nobody even thinking of value investing should be without it.

The book introduces the reader to Graham’s two overriding principles of successful investment – Mr Market and the Margin of Safety. What is perhaps even more relevant is Graham’s explanation of the difference between investment and speculation.

The latest edition is a revised edition with chapter commentaries and footnotes that place Graham’s tenets into the context of today’s markets and company operations. These have been written by Jason Zweig, senior editor of Money.

We would adapt the teachings of Benjamin Graham and say that anyone who puts money into the market without seriously understanding The Intelligent Investor must be a speculator, not an investor. ESSENTIAL

Purchase at Amazon.com:

The Intelligent Investor: The Definitive Book on Value Investing. A Book of Practical Counsel (Revised Edition)

2. The Essays of Warren Buffett, by Lawrence A Cunningham

If you want to know about Warren Buffett and his investment secrets, you need to read and understand what he has said about investment strategies.

The absolute way to do this is to read his public announcements on the Berkshire Hathaway, but this can be heavy going. You have to wade though pages of purely company stuff and, when you come to the gems, you have to relate them to something that he may have said years before or years later.

Cunningham’s book makes this task a whole lot easier. He has collected what he believes to be the relevant thoughts of Buffett and put them together in topics. Thus, you can select your topic, for example Economic Goodwill, and read together Warren’s various sayings over the years. The author helps the reader understand these comments with a well written and easy to follow Introduction.

A wise investor does not rely totally on what others believe Buffett does. They should read his own words and make their own informed judgment. ESSENTIAL

Purchase at Amazon.com:
The Essays of Warren Buffett: Lessons for Corporate America, Second Edition

3. The Interpretation of Financial Statements, by Benjamin Graham and Spencer Meredith

There are thousands of companies on the New York Stock Exchange alone and no individual investor can analyse every company for investment. The way to intelligent stock selection is to cull listed stocks into a much smaller group. Having done this, the investor must then analyse in detail potential investment targets, using publicly available information about company operations and financial statements.

Not many of us, however, are accountants or financial analysts, and if we want to look at a balance sheet, we need to understand financial terms and the role they play in company analysis. Short of doing a course in company accounting, the best way to srart is to read and understand Benjamin Graham’s classic work The Interpretation of Financial Statements, co-written with Spencer Meredith.

In this book, Graham in his inimitable way takes us through a company’s balance sheet, explaining the terms used (with real examples) and the importance that they have in finding out the true financial position of a company. He clears away the mystique from such concepts as ‘liquidating value’, ‘maintenance and depreciation’ and ‘net tangible assets’.

This book also acts as a primer for his more extensive work Security Analysis, co-written with David Dodd. ESSENTIAL.

Purchase at Amazon.com:
The Interpretation of Financial Statements

4. The New Buffettology, by Mary Buffett and David Clark

This book attempts to explain in very easy to understand terms the methods that Warren Buffett uses in selecting companies for investigation, analysis of fundamentals, stock selection and price calculations.

The book does not carry the authority of the Sage of Omaha nor does it pretend to do so. One of the authors is his former daughter in law and we have to assume that some of the book’s contents relate to things that she learned from the master investor.

That aside, the investment principles set out in the book all make good investment common sense from any perspective and are rules that any intending investor would be wise to consider.

The book contains case studies of past Buffett investments, looks back at why they may have been chosen, and traces their path to increased profitability after selection.

The authors conclude the book with a set of tests for selecting appropriate stocks, finding their intrinsic value and calculating a price that could be paid with a suitable Margin of Error.

The authors have also compiled a companion publication that contains all their recommended formulas and worksheets: Buffettology Workbook. HIGHLY DESIRABLE

Purchase at Amazon.com:
The New Buffettology: The Proven Techniques for Investing Successfully in Changing Markets That Have Made Warren Buffett the World’s Most Famous Investor

5. Buffett by Roger Lowenstein

This is not a book that concentrates solely on Buffett’s investment methods or style. It is mixture of biography and method analysis.

Neither a hagiography nor a hatchet job, the book tells us that Warren Buffett is much more complex than the simple homespun figure that he often appears to be.

If all the reader wants from a book is something to help them discover Buffett’s investment secrets, there are other and better books available. Where this book has investment value is in the way it shows that Buffett has been able to combine the conservative margin of safety approach of Benjamin Graham with the unorthodox approach of a contrarian investor.

Well written and well indexed, this book does not necessarily require the close attention that other Buffett books do. Read it for relaxation and interest, not as an investment tool. HIGHLY RECOMMENDED.

Purchase at Amazon.com:
Buffett: The Making of an American Capitalist

Posted in Book reviews |

Review: The Snowball - Warren Buffett and the business of life

Posted on January 21, 2013 by admin

There have been many books written about Buffett and I have read most of them. They generally gloss over his life but try to extract his investment principles by deduction from some of the trades that he has made.

This book is different. It examines Warren’s life in some detail and interposes the tale with comments directly from Buffett himself and from others in his life. What is important however is that it looks in exquisite detail at many of the deals he has made, giving the reader the opportunity of working out his investment principles for themselves. This way you get to make up your mind how he does it.

Unlike many of the other Buffett books, Schroeder also shows us the occasional error of judgment and, like Buffett, you can also learn from these.

This book tells us all about the big and well-publicised deals - Coca Cola, Washington Post, Salomons. But it also details the many smaller and lesser-known ones - the shirt factories, the share-an-airplane company and others. I particularly liked the chapter on Rose Blumkin and the Nebraska Furniture Mart. I think that the amazing Rose may be one of the few people that had Buffett’s measure. And the story of Warren’s early career as a race handicapper is a blast.

This is one of the best biographies that I have read in years.

These are perilous times but I believe that a close reading of this book, together with a re-reading of Buffettology by Mary Buffett will give you a good insight into the way Buffett does it. Plus, I would also re-read The Intelligent Investor by Benjamin Graham, the man Buffett says taught him the basic principles of investment.

Purchase The Snowball: Warren Buffett and the Business of Life at Amazon.com

Posted in Book reviews |

Review: The New Buffettology, by Mary Buffett and David Clark

Posted on January 21, 2013 by admin

This book is essential reading for anyone who wants to know more about Warren Buffett and how he does what he does.

The authors look at the companies Buffett has invested in over the years and what he has said about investment principles, and use this to draw up a series of tests and principles that they claim he puts in place when selecting investments.

We cannot say with any certainty that these tests and principles totally and accurately reflect the way that Warren Buffett does business. We can however say that they make good and logical sense to us.

For example, the authors assert that Buffett only looks at companies with consistently high rates of return on equity, preferably rising, and give mathematical tests and equations for assessing this. This seems to accord with everything that Warren Buffett has ever publicly said and makes sense.

In the early part of the book, Mary Buffett and David Clark analyze some of Warren’s historical investments and come up with a series of guiding principles on what to buy and when to buy it. They include important factors such as brand name companies, information sources, and company management.

Later in the book, the authors set out a series of financial and other equations for assessing likely investments, and the price that an investor can pay and still have Graham’s famous ‘margin of error’.

Generally, these equations and calculations can easily be done by the average reader, with the assistance of a financial calculator, such as the Texas Instruments Solar Financial Calculator. One equation, that using book value to predict earnings growth, did give us some difficulty at first but proved do-able after a couple more readings.

The authors also produce a Buffetology Workbook that contains all the steps the reader needs to make the calculations suggested in the principal book.

This is a must-have book for any reader wanting to tap into the Buffet investment secrets.

Purchase The New Buffettology at Amazon.com

Posted in Book reviews |

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