Topic: The Warren Buffett school of Investing. Posted: 21/Aug/2006 at 11:25pm
Warren Buffett: How He Does It
Did you
know that a $10,000 investment in Berkshire Hathaway in 1965, when
Warren Buffett took control of it, grew to be worth over $50 million by
2003? By comparison, $10,000 in the S&P 500 would have grown to
only $500,000. Whether you like him or not, Buffett's investment
strategy, known as value investing, has been one of the most successful
ever. Here we look at how Buffett amassed this fortune solely from
investing.
What Is the Buffett Investing Philosophy? Value
investing looks for stocks whose prices are low for their companies'
supposed intrinsic worth, which is determined by an analysis of certain
characteristics and fundamentals of companies. Mirroring the mentality
and shopping style of a bargain hunter, value investors looks for
products that are beneficial and high quality but cheap in price. In
other words, the value investor searches for stocks that he or she
believes are undervalued by the market. Like the bargain hunter, the
value investor tries to find those items that are valuable but not
quite recognized as such by the majority of other buyers.
Warren
Buffett takes this value investing approach to another level. Many
value investors aren't supporters of the Efficient Market Hypothesis
but trust that the market will eventually properly start to favor those
quality stocks that were, for a time, undervalued. Buffett, however,
doesn't think in these terms. He isn't concerned with the supply and
demand intricacies of the stock market. In fact, he is not really
concerned with the activities of the stock market at all. He chooses
stocks solely on the basis of their overall potential as companies--he
looks at each company as a whole. Holding these stocks for the extended
long term, Warren Buffett seeks not capital gain but ownership in
quality companies that are highly capable of generating earnings. When
Warren Buffett invests in a company, he is not concerned whether the
market will eventually recognize the company's worth; he is concerned
with how well that company can make money as a business.
So How Does Buffett Find Low-Priced Value? Here
we look at some of the questions that Buffett asks himself when he
evaluates the relationship between a stock's level of excellence and
its price. Keep in mind that these are not the only things that he
analyzes:
1. Has the company consistently performed well? Sometimes
ROE is referred to as "stockholder's return on investment." It tells
the rate at which shareholders are earning income on their shares.
Warren Buffett always looks at the return on equity (ROE) to see
whether or not a company has consistently performed well in comparison
to other companies within the same industry. ROE is calculated as
follows:
= Net Income / Shareholder's Equity
Just
having a high ROE last year isn't enough. The investor should view the
ROE from the past five to ten years to get a good idea of the
historical growth.
2. Has the company avoided excess debt? The
debt/equity ratio is another key characteristic that Warren Buffett
carefully considers. Buffett prefers to see a very small amount of
debt, which means earnings growth is being generated from shareholders'
equity. The debt/equity ratio is calculated as follows:
= Total Liabilities / Shareholders' Equity
This
ratio indicates the proportion of equity and debt the company is using
to finance its assets, and the higher the ratio, the more debt--rather
than equity--is financing the company. A high level of debt compared to
equity can result in volatile earnings and large interest expenses. For
a more stringent test, investors sometimes use only long-term debt
instead of total liabilities.
3. Are profit margins high? Are they increasing? The
profitability of a company depends not only on having a good profit
margin but also on consistently increasing this profit margin. This
margin is calculated by dividing net income by net sales. To get a good
indication of historical profit margins, investors should look back at
least five years. A high profit margin indicates that the company is
executing its business well, but increasing margins means that
management has been extremely efficient and successful at controlling
expenses.
4. How long has the company been public? Buffett
typically considers only companies that have been around for at least
ten years. As a result most of the technology companies that have had
their IPOs in the past decade wouldn't get on Mr. Buffett's radar. It
makes sense that one of Buffet's criteria is longevity: value investing
means looking at companies that have stood the test of time but are
currently undervalued. Never underestimate the value of historical
performance, which demonstrates the company's ability (or inability) to
increase shareholder earnings. Do keep in mind, however, that the past
performance of a stock does not guarantee future performance--the job
of the value investor is to determine how well we can trust that the
company has a capacity to perform as well as it did in the past.
5. Do the company's products rely on a commodity? Initially
you might think of this as a radical approach to narrowing down a
company, but Buffett tends to shy away (but not always) from companies
whose products are indistinguishable from competitors, and those that
rely solely on a commodity such as oil and gas. He does not put his
money into companies that rely on the price of an underlying commodity.
If the company does not offer anything different than another firm
within the same industry, be wary as a value investor.
6. Is the stock selling at a 25 percent discount to its real value? This
is the kicker. Finding companies that meet the other five criteria is
one thing, but determining whether they are undervalued is the key for
value investing, and finding a company that is trading at a 25 percent
discount is not always easy. To check this, we must determine the
intrinsic value of a company by analyzing a number of business
fundamentals, including earnings, revenues, and assets. A company's
intrinsic value is usually higher than its liquidation value, which is
what a company would be worth if it were broken up and sold today--the
liquidation value doesn't include intangibles such as the value of a
brand name, which is not directly stated on the financial statements.
Once
Buffett determines this intrinsic value of the company as a whole, he
compares it to its current market capitalization, which is the current
total worth (price) of the entire company. If his measurement of
intrinsic value is at least 25 percent higher than the company's market
capitalization, Warren Buffett sees the company as one that has value.
Sounds easy, doesn't it? Well, Buffett's success, however, depends on
his unmatched skill in accurately determining this intrinsic value.
While we can outline some of his criteria, we certainly have no way of
knowing exactly how he gained such precise mastery over calculating
value.
Conclusion Well, as you have
probably noticed, Warren Buffett's investing style, like the shopping
style of the bargain hunter, reflects a practical, down-to-earth
attitude. This attitude Buffett maintains toward also his lifestyle and
overall philosophy on life: he doesn't live in a huge house, he doesn't
collect cars, and he doesn't take a limousine to work. The
value-investing style is not without its critics, but whether you
support Buffett or not, the proof is in the pudding. As of 2003, he
holds the title of the second richest man in the world, with a net
worth of over $30 billion (Forbes 2003). If you choose to practice this
kind of investing style, keep in mind that it takes time to do the
proper analysis and to get good at it
www.halwasiya.uni.cc
“Wining is not everything, it is the only thing”
I have read buffet and graham but the problem is I cannot see the way they saw. They had a very unique way of investing which with all credit to the general investot can only be read and appreciated but rarely followed.
Very rarely will you get a company growing at 25% and selling at less then intrinsic value. When you get that share the markets are down and there is no money to be invested we are already loaded on.
Joined: 02/Sep/2006
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Posted: 17/Sep/2006 at 8:04pm
Asked what advice he could provide to young people on the verge of careers in managing investments, Buffett boiled down his principles into four cardinal rules:
1. Understand the business in which you are investing. "You can't make money in stocks unless you understand the business," he said. "I look for businesses within my circle of competence." Having a large circle of competence is less important than having one with a well-defined perimeter.
2. Look for sound fundamental economics. Investors should seek out companies that have a sustainable economic advantage — a phenomenon Buffett called "a castle with a moat around it." Consider Coca Cola, for example. The company's brand name has represented enjoyment for generations, which no competitor can buy for millions of dollars. "Share of market follows share of mind," noted Buffett.
3. Find competent leadership. Companies with a sustainable economic advantage need honest, capable and hardworking leaders to retain their lead. Berkshire-Hathaway's managers have one instruction: Widen the moat. That keeps the castle valuable.
4. Buy at the right price. Purchases must be made at the right price if they are to pay off.
Buffett cited example after example to show how he had used these principles to make investment decisions during his career. As a young investment manager, he took Moody's manuals and went through them page by page until he found the companies he sought. A bus company in Bedford, for example, had $100 a share in cash, but its stock was being traded at $40 a share. Buffett found such deals because he went looking for them. "No one will tell you about them," he said. "You only get told about things someone is pushing for some reason." Buffett invested in companies like Coca Cola and The Washington Post for similar reasons. Berkshire-Hathaway built its empire on the success of these investments.
Asked why he has not retired despite his phenomenal wealth, Buffett said the reason is that he has more fun doing what he does than anything else. "The fundamental thing is that the process should be fun," he said. "I had just as much fun when I had $10,000 to invest as I do now. It's crazy to do things for your resume. It's like saving up sex for your old age.You should do what you enjoy as you go along, and work with people you admire. I look forward every day to the next day. I'm wired for this game."
Life can only be understood backwards—but it must be lived forwards
Joined: 02/Sep/2006
Location: India
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Posts: 9319
Posted: 29/Sep/2006 at 11:19pm
Basantjee
I came across an article where Warren Buffet tries to explain how he learnt the lessons in investing.
I bought first stock at age 11. I bought 3 shares of Cities Service Preferred at $38 Ľ . My sister followed me and did the same. The price then declined to $27 and sister complained every day on the way to school. When the stock recovered to $40, she and I sold. I had a $5 profit. The stock then rose to $200. The lesson I learned was not to get involved with others on investments, or else their emotions will spillover.
---------------------------------------
By the way, seems that your gem of a comment went unnoticed:
When Arjun was asked by Dronacharya what did he see on the tree he replied "The eye of the bird. Acharya"
Edited by kulman - 29/Sep/2006 at 11:21pm
Life can only be understood backwards—but it must be lived forwards
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Posted: 29/Sep/2006 at 11:31pm
Yes, and the trick is to learn the lesson rather then complaint about the mistakes. I have seen one very peculiar behaviour with investors. They never want to board a train that has not started to move and the moment the speedometer hits 60kmph they are ready to jump in. Now among all the stocks that we discussed no one would bother to buy the ones that have not moved and once they make their first 40% move people would start to get in when they should be doing the exact reverse of that.
'The Thoughtful Investor: A Journey to Financial Freedom Through Stock Market Investing' - A Book on Equity Investing especially for Indian Investors. Book your copy now: www.thethoughtfulinvestor.in
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Posted: 12/Oct/2006 at 9:37pm
Just a sobering thought on this issue. Today ,with the stupendous success of Warren Buffet, almost ever investor and his aunt have been through the books and principles of WB. Stories about his sucesses in Coke and Berkshire Hathaway are now folklore in the punter's (forgive me for using this word in a WB article!!) world. And yet how many duplicates or even miniature replicas has the world produced of W B? The harsh truth is that just as there have been only one Bradman in cricket with all the cricketing manuals, so also there is only one W B. We ordinary mortals can however strive to work on those basic principles.
I feel that the most important difference that exists between WB and the rest is the conviction behind his descisions. After the "Go-Go-" years of the 20s' the the depression of the 30s most investors would have lost both confidence and conviction in thier investment descisions. (the investors panic reactions in the two large falls in our markets is a case to point!!) ,unlike the inimitable W B
Best to set realistic goals to our investments and enjoy the ride than to wait for the destination... Happy investing!
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