E1FFIRS
Date:Jan19,2010
Time:10:56am
E1FFIRS
Date:Jan19,2010
Time:10:56am
Buffett
BeyondValue
E1FFIRS
Date:Jan19,2010
Time:10:56am
E1FFIRS
Date:Jan19,2010
Time:10:56am
Buffett
BeyondValue
WhyWarrenBuffettLooksto
GrowthandManagement
WhenInvesting
PremC.Jain
JohnWiley&Sons,Inc.
E1FFIRS
Date:Jan19,2010
Time:10:56am
Copyright©2010byPremC.Jain.Allrightsreserved.
PublishedbyJohnWiley&Sons,Inc.,Hoboken,NewJersey.
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LibraryofCongress
Cataloging-in-PublicationData:
Jain,PremC.1950–
Buffettbeyondvalue:whyWarrenBuffettlookstogrowthandmanagementwheninvesting/PremC.Jain.
p.cm.
Includesbibliographicalreferencesandindex.
ISBN978-0-470-46715-2(cloth)
1.
Investments.2.
Investmentanalysis.3.
Buffett,Warren.I.
Title.
HG4521.J2642010
332.6–dc22
2009041474
PrintedintheUnitedStatesofAmerica
10987654321
E1FTOC
Date:Feb4,2010
Time:2:24pm
Contents
Preface
ix
Acknowledgments
xv
PartOne
IntroductionandBackground
1
Chapter1
TheThrillofInvestinginCommonStocks
3
Chapter2
1965–2009:LessonsfromSignificantEventsin
BerkshireHistory
9
PartTwo
BuffettInvesting=Value+Growth
23
Chapter3
ValueInvesting—It’sLike
BuyingChristmas
CardsinJanuary
25
Chapter4
GrowthInvesting
43
Chapter5
IntrinsicValue
57
Chapter6
BuffettInvesting=Value+Growth
69
v
E1FTOC
Date:Feb4,2010
Time:2:24pm
vi
contents
PartThree
OtherPeople’sMoney
87
Chapter7
Insurance:OtherPeople’sMoney
89
Chapter8
Reinsurance:MoreofOtherPeople’sMoney
99
Chapter9
TaxDeferment:Interest-FreeLoansfrom
theGovernment
109
PartFour
SuccessinRetailing,Manufacturing,
andUtilities
113
Chapter10
IfYouDon’tKnowJewelry,KnowYourJeweler
115
Chapter11
CompeteLikeMrs.B
123
Chapter12
WhyInvestinUtilityCompanies?
129
Chapter13
HighProfitsinHonest-to-Goodness
ManufacturingCompanies
137
PartFive
Risk,Diversification,andWhentoSell
143
Chapter14
RiskandVolatility:HowtoThinkProfitably
aboutThem
145
Chapter15
WhyHoldCash:LiquidityBringsOpportunities
155
Chapter16
Diversification:HowMany
BasketsShould
YouHold?
161
Chapter17
WhentoSell
169
PartSix
MarketEfficiency
175
Chapter18
HowEfficientIstheStockMarket?
177
Chapter19
ArbitrageandHedgeFunds
185
E1FTOC
Date:Feb4,2010
Time:2:24pm
Contents
vii
PartSeven
Profitabilityand
Accounting
193
Chapter20
M=Monopoly=Money
195
Chapter21
WhoWinsinHighlyCompetitiveIndustries?
205
Chapter22
Property,Plant,andEquipment:GoodorBad?
211
Chapter23
KeytoSuccess:ROEandOtherRatios
217
Chapter24
AccountingGoodwill:IsItAnyGood?
223
PartEight
Psychology
229
Chapter25
HowMuchPsychologyShouldYouKnow?
231
Chapter26
HowtoLearnfromMistakes
243
PartNine
CorporateGovernance
249
Chapter27
Dividends:DoTheyMakeSenseinThisDay
andAge?
251
Chapter28
ShouldYouInvestinCompaniesThat
RepurchaseTheirOwnShares?
257
Chapter29
CorporateGovernance:Employees,Directors,
andCEOs
263
Chapter30
LargeShareholders:TheyAreYourFriends
273
Conclusion
B=Baseball=Buffett
277
Appendix
ASummaryoftheBook
281
Notes
283
AbouttheAuthor
295
Index
297
E1FTOC
Date:Feb4,2010
Time:2:24pm
E1FPREF
Date:Jan19,2010
Time:11:46am
Preface
Thisbookisforeveryonewithaseriousinterestinlearningabout
stockmarketinvestingusingprinciplesespousedbyWarren
Buffett.Justover20yearsago,whileteachingattheWharton
School,IstumbleduponanessaybyWarrenBuffettthat
motivatedme
tocarefullyinvestigatehisinvestmentstyle.1IwasintriguedwhenIrealizedthattherewasafundamentaldifferencebetweenBuffett’sattitude
towardinvestingandtheacademicapproach.Whileacademicsgenerally
anchorontheimpossibility
ofmakingabove-averagereturns,Buffett
proposesjusttheopposite.Hearguesthatwithacarefulstudyofcompanyfundamentalsandmanagementquality,investorsdefinitivelycanearn
above-averagereturns.Hisoutstandinglong-termrecordsupportshis
claim.WhenfacedwithBuffett’srecord,mostacademicseitherdismiss
itasanoutlierorbrandhimageniuswhocannotbecopiedorexplained.
Iwantedtoknowiftherewasasystematicwayofunderstandingand
emulatinghisinvestmentphilosophy.
Mostauthors,includingacademics,characterizeBuffettasavalue
investor.Buffettisnotjustavalueinvestor—atleastnotinthepopularsensethatthe“value”monikerisused.Buffett’spubliclytradedcompany,BerkshireHathaway,hasgrownatanannualizedrateofabout20percent
inassets,revenues,networth,andmarketvaluefor44years.Hisper-
formanceisclosertowhatwouldbeexpectedfromasuccessfulgrowth
investor.Unlikeotherbusinessmenwhomayhavealsoamassedgreatfor-
tunes,Buffettstandsalonebecausehislong-term
successreflectsgrowth
ix
E1FPREF
Date:Jan19,2010
Time:11:46am
x
preface
ofhisbusinessand
investmentsinseveraldifferentindustrieswithouteverridingahottrend.ThereisanothermajordifferencebetweenBuffett
andothersuccessfulinvestors,whichisactuallythemainreasonIchose
tostudyhimdiligently.WarrenBuffettisamanofthehighestlevelof
integrity.Heknowsthathehasaspecialgift,andinsteadofkeepingittohimself,hehaschosentosharehisimmenselyvaluableexperienceswith
anyonewhocarestodosomeresearch.Aremarkableteacher,Buffett
haswrittenaconsiderablebodyofmaterialonhisideasandprinciples,
whichallowsforcarefulexaminationofhisstrategiesandmotivations.
ThekeyreasonforBuffett’sunparalleledsuccessisnotonlyhisability
tostayresolutewiththeprimaryvalueinvestingprincipleofmaintain-
ingalowdownsideriskbutalsohisskillatpairingit
withthegrowth
investingprincipleofputtingmoneyintocompanieswithsustainable
growthopportunities.Thus,hecombinestheprinciplesofboththe
valueandgrowthinvestmentstrategies.Yet,hedoesnotinvestinhigh-
techcompanies,assomanygrowthinvestorsdo.Hisgrowthstrategyis
bestunderstoodbystudyingthebusinesseshehaspurchasedatBerkshire
Hathaway.Buffettbuysgoodbusinessesthatalreadypossessoutstand-
ing,high-integritymanagement.Hereliesonthe
sameprinciplesfor
investingincommonstocks.Ielaborateonhisinvestmentprinciples
throughoutthebookalongwiththespecifictopicscoveredineachchap-
ter.Theseprinciplesareusefulwhetheryouareinvestinginabullmarketorabearmarket.
BuffettandContemporaryTeachingsat
BusinessSchools
Mygoalasateacher-researcherisnotonlytoexplorewhatBuffett
practicesbutalsotofindanswerstowhyhispracticesaresuccessful.
In1997,mydesireto
understandwhyBuffett’sinvestmentstyleworksandhowhisstrategiesblendwiththelessonsfromcontemporaryfinanceledmetodevelopanewcourseatTulaneUniversity.Thiscoursetooka
newapproachtofinance,wherestudentsstudiedBuffett’swritingsand
decisionsinconjunctionwith
modernfinanceresearch.Thestudents
alsoanalyzedalargenumberofbusinesses.In1999,Tulanecontributed
$2millionfromtheuniversity’sendowmentfundtocreateaportfolio
E1FPREF
Date:Jan19,2010
Time:11:46am
Preface
xi
tobemanagedbystudentsundermyguidance.IleftTulanein2002for
GeorgetownUniversity,butProfessorSheriTicecontinuestoteachthe
increasinglypopularcourseatTulane.
Fromtheoutset,itisimportanttorecognizethatBuffett’sideasare
notalwaysatoddswithmodernfinancetheories.Forexample,thecon-
ceptsofdiscountingcashflowsandnetpresentvaluearetaughtinall
businessschools.Resemblingthenetpresentvalueconcept,concepts
likeintrinsicvalueandmarginofsafetyareatthecoreofBuffett-styleinvesting.Furthermore,themuch-talked-aboutconceptofdiversificationisdiscussedinasomewhatsimilar,althoughnotidentical,fashion
bothbyinvestmenttextsandbyBuffett.Thereisplentyofcommonality
betweenthebusinessschoolcurriculumandBuffett’sapproach.How-
ever,thisbookcoversideasfromBuffettthatgobeyondwhatprofessors
generallyoffer.Mygoalistoprovideadditionalinsightsto
leadyou
towardamorepracticalapproachtoinvestinginthestockmarket.
FocusonImportantQuestions
OnekeytraitthatmakesBuffettsuccessfulishisabilitytofocus.To
remainfocused,Ipresent
manysectionsofthebookinaquestion-
and-answerformat.ThisSocraticstyleforcesonetopinpointimportant
questionsthatfellowinvestors,students,andcolleagueshaveaskedme
overtheyears.AtBerkshireHathawayannualmeetings,manyofwhich
Ihaveattendedoverthepast20years,WarrenBuffettandCharlie
Munger(chairmanandvicechairmanofBerkshireHathaway,respec-
tively)answerquestionsfromtheaudienceforseveralhours.Buffett
alsousedaquestion-and-answerformatin2003when
heaccepted
myinvitationtoaddressGeorgetownUniversityMBAstudentsand
faculty.
AlthoughthisbookconcentratesonBuffett’sinvestingstyle,Ibring
inrelatedideasfromotherinvestorsandacademic
researchtohelp
improveyourinvestmentstrategies.Forexample,nodiscussiononinvest-
ingiscompletewithoutincorporatingthepioneeringandstillrelevant
worksofBenjaminGrahamandDavidDodd.Similarly,Idrawfromthe
thoughtsofPhilipFisherandPeterLynchtodiscussgrowthinvesting
strategies.
E1FPREF
Date:Jan19,2010
Time:11:46am
xii
preface
NoonecanteachBuffett’sideasbetterthanBuffetthimself.Clearly,
heknowsathingortwoaboutinvesting.InMarch2008,ForbesmagazinerankedBuffettastheworld’swealthiestmanwithanestimatedpersonal
wealthof$62billion.2I
wrotehimaletterin1997suggestingthatfuturegenerationswouldthankhimifheweretowriteabook.Heresponded,
“Idefinitelyhaveabookinmind,thoughmuchofwhatIhavetosayhas
beencoveredintheannualreports.”WhilewewaitforBuffetttowrite
hisinvestmentbook,Idecidedtosharemyownanalyses.Tounmaskhis
thoughts,IcarefullystudiedBerkshireHathaway’sannualreportsfrom
thepast50years,his1958to1969partnershipletters,andasmanyofhisotherwritingsasIcouldfind.Ihavebenefitedimmenselyfromthiseffortandhavedonemy
besttocaptureBuffett’sinvestmentideasinthisbook.
HowMuchBackgroundDoYouNeedto
UnderstandBuffett’sPrinciples?
Buffettdoesnotrecommendsophisticatedmathematicalmodels.He
writes,“Toinvestsuccessfully,youneednotunderstandbeta,effi-
cientmarkets,modernportfoliotheory,optionpricing,oremerging
markets.”3Withthissentimentinmind,Ihavemadecertainthatyoudo
notneedanyknowledgeofmathematicalfinanceto
benefitfromthis
book.ConsistentwithBuffett’steachings,myexperiencetellsmethat
theuseofmathematicalmodelstopickindividualstocksisnotparticu-
larlyhelpful.Itmayevenbeharmfulbecauseitcanleadyoutobecome
overconfidentinyourabilities.Asthefinancialcrisisin2008–2009has
shown,over-relianceonmathematicalmodelscanresultinafalsesense
ofsecurityintheunderstandingofriskandreturn.
Someknowledgeofaccountingandfinanceis
essentialtofollowthis
book,butmostpeopleinvestinginthestockmarketalreadyunderstand
suchtermsasearnings,dividends,andreturnonequity.Myobjectiveistoshowhowtointerpretthosetermssothatyoucanusethemeffectivelytoimproveyourinvestingstyle.Ifyouhavenoknowledgeof
basicinvestmentterms,youmayfindsomesectionsofthisbookalit-
tleadvanced.Eventhen,youwillseethatthereismoretopickinga
stockthanbeingawhizinmanipulatingnumbers.Ifstockpickingcould
indeedbeformulatedasamathematicalmodel,mutual
fundmanagers
E1FPREF
Date:Jan19,2010
Time:11:46am
Preface
xiii
couldsimplyhireabunchofrocketscientistsandearn
superiorreturns.
Buttheevidenceisjusttheopposite:Itappearsthatinvestorswhouse
simpleprinciplesgenerallydobetterthanthosewhorelyheavilyon
mathematicalmodels.
ToconcentrateonBuffett’sinvestingprinciples,Irestrict
mydiscus-
siontoBuffett’sinvestment-relatedideas,howwecanlearnfromthem,
andwhytheywork.Othershavealreadyreviewedhisinterestinglife
story.4Idoubtthatyouneedtobeasfascinatedbybridgeorbaseballasheistobecomeasuccessfulinvestor.
Similarly,youneednothavebeen
borninOmaha,Nebraska,orsharehistasteinfood.Evenhisfriend
andbusinesspartnerCharlieMungerdoesnotagreewithallofBuffett’s
philosophicalideas.WhileBuffettisaDemocrat,MungerisaRepubli-
can.Youneednotbeeither.BykeepingthebookfocusedonBuffett’s
investmentphilosophies,Ihighlightonlytheissuesrelevanttoinvesting.
WhatCanYouLearnfromThisBook?
Thisbookisdividedintoninepartsand30chapters.Thereiscontinuity
acrosschapters,butyoucanreadmostofthemindependently.
InPartI(Chapters1and2),mymainobjectiveistoconvinceyou
thatinvestingislikesearchingforburiedtreasure.OnereasonBuffett
issuccessfulisthatheenjoysthisprocess,andyouare
morelikelyto
besuccessfulifyoutreatitasagameandhavefunwithit.Next,I
chronologicallyoutlineseveralimportanteventsinBerkshire’shistorytodrawinsightsintoBuffett’sphilosophy.Suchahistoricalbackgroundis
usefultokeeptheremainder
ofthebookinperspective.
PartII(Chapters3to6)explainsbasicinvestmentstrategies,so-called
valueinvestingandgrowthinvesting.Usingconcreteexamples,Iexplainhowyoumaycomputeintrinsicvalueandmarginofsafetybeforeyouinvest.
ParticularlyinChapter6,I
explainwhyBuffett’sstrategiesshouldnotbeclassifiedasvalueinvestinginthetraditionalsense.Hedoeswhatismostlogicalandfrequentlycombinesvalueandgrowthinvestingstrategies
effectively.Ingeneral,itisamistake,andwouldlimityourimagination,topigeonholeBuffett’sapproachintoanysingle
investingstyle.Hedoes
whatismostrationaltocreatevalueinthelongrun.Forlackofabetterterm,Isimplycallhimarenaissanceinvestor.
E1FPREF
Date:Jan19,2010
Time:11:46am
xiv
preface
InPartIII(Chapters7to9),IlookathowBuffettusesinsurance
togeneratecashflowsforotherinvestments.TounderstandBuffett,you
musthavesomeunderstandingofthe
insurancebusiness,whichisthe
mainstayofBerkshireHathaway.
InPartIV(Chapters10to13),IdiscussseveralofBuffett’sinvest-
mentsinretailing,utilities,andmanufacturing.Theseexamplesprovide
furtherinsightintohisemphasisongrowthandmanagementquality.In
PartV(Chapters14to17),IemphasizeBuffett’sopinionsconcerning
severalclassictopics,suchasdiversificationandrisk.
InPartVI(Chapters18and19),IdiscussBuffett’sthoughtsonmarket
efficiencyandthewaysinwhichyoumayincorporatehisthoughtsinto
yourdecisionmaking.
InPartVII(Chapters20to24),Ireviewseveralimportantissues
relatedtoprofitabilityandaccounting.Althoughthesechapterswillnot
makeyouanaccountant,theywillprovideyouwithaperspectivethat
isnotcommonininvestingcircles.
InPartVIII(Chapters25and26),Ifocusonpsychologybecauseto
beasuccessfulinvestor,youmustunderstandyourselfandthebiasesthatplayarolein
yourdecisionmakingandthedecisionmakingofothers.
PartIX(Chapters27to30)isdevotedtocorporategovernance,
Buffett’sthoughtsonCEOsandothermanagers,andwhyheemphasizes
appropriatecompensationstructurethroughoutafirm.Theconclusion
ofthebookdiscussesBuffett’semphasisondevelopingasuitabletem-
peramentforwinninginthemarket,justasabaseballplayerneedsto
developatemperamentforwinningonthediamond.
Overall,thebookwillallowyoutodiscoverthatBuffetthasachieved
successbyemphasizingtheimportanceofhigh-qualitymanagersmore
thananyothermetric.Hecallshismanagersthe“All-Stars”anddiscussestheiraccomplishmentslavishlyinBerkshireannualreports.Bycontrast,
mostresearchandteachingsinbusinessschoolsusefinancialnumbersas
thekeymetricforfinancialsuccessandunderstandingbusinesses.My
objectiveistodevelopyourunderstandingbeyondtheideasyoumay
havelearnedinyourcollegecourses,gleanedbyreadingarticlesinthe
popularmedia,orpickedupthroughanyotheroutlets.My
motivation
isnotjusttoproviderulesforinvestingbutalsotohelpimproveyour
mind-setforinvesting.Havingtherightmind-setispivotal,whether
youareanindividualinvestor,astudent,anacademic,oraprofessional
portfoliomanager.
PremC.Jain
E1FLAST
Date:Jan19,2010
Time:11:56am
Acknowledgments
WhenIinitiallynarratedWarrenBuffett’ssuccessstory,my
father,alwaysaphilosopher,
remindedmewhatIfre-
quentlyaskedhimwhenIwasachild:“Why?”Theanswer
isthatIamgrateful.IamgratefultomystudentsatWharton,Tulane,
andGeorgetownoverthepast25yearswhoaskedinnumerablequestions
andhelpedmefocusmythoughts.Mycolleagues,everskepticalaspro-
fessorsare,gavemethebenefitoftheirexplanationsandunderstanding
ofdifferencesbetweenhowacademicsthinkandhowbusinessmenand
moneymanagersthink.Iamsincerelygratefultomy
longtimefriend
LarryWeiss,whoreadanearlyversionoftheentirebookandwent
throughseveralchaptersoverandoveragainasIdevelopedmyideas.
MyspecialthanksgotomyfriendsValentinDimitrov,acarefulreader
andatrustedco-author,forhisdiscussionswithmeformanyyearsabout
Buffett’sprinciplesandforhisongoingcommentsonthemanuscriptat
differentstages,andNancyPitts,whoreadeverywordwithacriticaleye,askedmanyquestions,andhelpedimprovethemanuscript.IthankElisa
DiehlandCindyLeitnerforcarefullycopyeditingtheentiremanuscript
atdifferentstages.
Ihavebenefitedfrommycolleagues’andfriends’knowledgeabout
investingandBuffett.Theylistenedpatiently,sometimesarguedand
discussed,gavedetailedcomments,andcontributedtothebookin
manyways.Forthis,IthankReenaAggarwal,BillBaber,DaleBailey,
GaryBlemaster,JenniferBoettcher,JimBodurtha,RandyCepuch,
xv
E1FLAST
Date:Jan19,2010
Time:11:56am
xvi
acknowledgments
PreetiChoudhary,GeorgeComer,GeorgeDaly,HemangDesai,Bill
Droms,JasonDuran,AllanEberhart,PatriciaFairfield,ThereseFlana-
gan,AlokeGhosh,JackGlen,ZhaoyangGu,IngridHendershot(babyb),
JimHeurtin,ManishJain,SaurabhJain,VarunJain,S.P.Kothari,
AmitKshetarpal,SubirLall,CharlesLee,JeffMacher,
AnanthMad-
havan,JimMarrocco,JerryMartin,AlanMayer-Sommer,JohnMayo,
ChuckMikolajczak,VishalMishra,LenkaNaidu,KusumNarang,
KeithOrd,SandeepPatel,LeePinkowitz,DennisQuinn,Sundaresh
Ramnath,KorokRay,PietraRivoli,SriniSankaraguruswamy,Carole
Sargent,MissieSaxon,JasonSchloetzer,PamelaShaw,PaulSpindt,
EmmaThompson,SheriTice,CathyTinsely,JoaquinTrigueros,Joanna
ShuangWu,andTeriYohn.IamcertainIhavenot
includedeveryone,
andIapologizetothosewhosenamesshouldalsoappearhere.
IthankWarrenBuffettforallowingmetousecopyrightedmaterial
fromhisletterstoshareholdersandothersources.Formyinitialeducationandensuinggifts
inlife,IcreditmyteachersinanelementaryschoolinasmalltowninIndia.Allmyearningsfromthisbookwillbedonated
tochildren’seducation.Mostimportant,Iamespeciallygratefultomy
parents,mybrotherSubhash,andmythreesistersGunmala,Kanak,and
Manjuandtheirfamiliesfortheirunwaveringloveandsupport.
P.C.J.
E1PART01
Date:Dec10,2009
Time:4:13pm
PartOne
INTRODUCTIONAND
BACKGROUND
InChapter1,Iexplainwhyitiseasytobeattheprofessionalmutual
fundmanagersandhow,withsomeeffort,youcanalsooutperform
themarketasawhole.Idemonstratethatinthelongrun,rewards
fromplayingthegameofinvestingarelarge.InChapter2,Iuseimpor-
tanteventsfromBerkshireHathaway’shistoryasabackdropforvarious
investinglessonsthatcanbelearnedfromWarrenBuffett.
1
E1PART01
Date:Dec10,2009
Time:4:13pm
E1C01
Date:Jan18,2010
Time:3:29pm
Chapter1
TheThrillofInvesting
inCommonStocks
It’snotthatIwantmoney.It’sthefunofmakingmoneyand
watchingitgrow.1
—WarrenBuffett
WarrenBuffetthasoftenmentionedthatheenjoysrunning
BerkshireHathawayandhasfunmakingmoney.Iassume
thatyoutoowanttoearnhighratesofreturnonyour
investmentswhilehavingfundoingit.ItisnotdifficulttodoifyoumastercertainprinciplesthatBuffettfollows.Youplaybaseball,golf,bridge,
orthestockmarketbecauseitisenjoyable.Butyouenjoythegame
evenmorewhenyoudefeattheopponent,especiallywhenyoubeata
seeminglysuperiorplayer.Canyouwininthegameofinvesting?Yes,you
can,solongasyouarewillingputsomeeffortintoit.Andnotonlycan
youwin;thethrillofthegamearisesbecauseyoucan
winoften.You
haveweakopponents:“Mr.Market,”whosuffersfromup-and-down
moods,andprofessionalmoneymanagers,whocanbeoutperformed
justaseasily.2Thisgameisnotasdifficultasmostpeoplethink.Itisasmuchfunasatreasurehunt.
BerkshireHathawayisjustoneofthe
treasuresIhavediscovered.Thisintroductorychapterwillconvinceyou
thattherewardsfrombecomingabetterinvestorareenormous.Laterin
3
E1C01
Date:Jan18,2010
Time:3:29pm
4
introductionandbackground
thebook,IexplainBuffett’sprinciplesandwhytheywork,sothatyou
mayusethemtoearnthose
rewardsbyinvestinginthestockmarket.
Howa1PercentAdvantageBecomes
a100PercentGain
OnlyoneinfiveactivelymanagedmutualfundsbeatstheStandard&
Poor’s(S&P)500index.Thus,ifyouinvestin
activelymanagedmutualfunds,youroddsofbeatingthemarketareonlyone-in-five.Theseodds
areindeedlow.Averysimpleapproachtoimproveyouroddsisto
investinindexfundsbecausetheirreturnswillbeclosetothemarket
returns.Byinvestinginindex
fundsinsteadofmutualfunds,yourodds
ofbeatingthemarketimprovefromone-in-fivetofour-in-five.Butwhy
stopthere?Ifyouhavesomemoneytoinvestforthelongrun,whynot
investincommonstocks?Withcommonstocks,youcanimproveyour
returnsevenmore,especiallyifyouenjoytheprocessandputsomeeffortintolearningtheprinciplesthatmasterinvestorslikeBuffetthavelaid
out.Anothergreatinvestor,PeterLynch,echoesthisviewpoint:“[A]n
amateurwhodevotesasmallamountoftimetostudycompaniesin
anindustryheorsheknowssomethingaboutcanoutperform95per-
centofthepaidexpertswhomanagethemutualfunds,plushavefun
doingit.”3
Howmuchskilldoyouneedtobemuchbetteroffthaninvesting
inactivelymanagedmutualfunds?Inthelongrun,notmuch!Letme
explain.Basedonalonghistoricalrecord,theexpectedreturnonthe
marketisabout7percentto10percentperyear.Forsimplicity,let’suse10percentasabenchmark.Then,yourreturnfromanaveragemutual
fundwillbeonly8percentbecauseabout2percentgoestowardexpenses
inrunningthemutualfund,whichincludesthemanagementfees.Ifyou
invest$1,000withamutualfundandthemutualfundgivesyouareturn
of8percentperyear,yourinitialinvestmentof$1,000
willbecome
$6,848in25years;thatis,youwillhaveanetgainof$5,848.
Assumethatyouareabletodevelopjusta1percentreturnadvantage
overthemarketinthegameofinvestingorpickingstocks.Remember
thatyoualsodonotincurthe2percentexpensesinfeesandcharges
whenyouinvestinmutualfunds.With1percentabovethemarket,or
E1C01
Date:Jan18,2010
Time:3:29pm
TheThrillofInvestinginCommonStocks
5
35,000
30,000
5%
25,000
10%
20,000
15%
15,000
Dollars
10,000
5,000
0
0
1
2
3
4
5
6
7
8
910111213141516171819202122232425
YearsfromInitialInvestment
Figure1.1
Growthof$1,000after25orIntermediateYearsatDifferentRates
ofReturn
11percentperyear,yourinitial$1,000investmentwillbecome$13,585
attheendof25years,whichisanetgainof$12,585.Thus,yournet
gainismorethantwicewhatyouwouldhavehadifyouhadinvestedin
mutualfunds.Itisalmostunbelievable,butthenumbersdonotlie.Even
ifyoudecidenottoputallyourmoneyunderyourownmanagement
andinvestallofitinindividualstocks,youmayfinditworthwhileto
takechargeofsomeofyourowninvestments.Ifnothing
else,itwillbe
agreatlearningexperienceandanewsourceofexcitement.
Anadditionaladvantageofinvestinginindividualstocksisthatyou
willpaylowertaxes.Ifyoupickyourinvestmentscarefullyanddonotsellthemforalongtime,youpay
substantiallylessintaxesthanifyouhad
investedinmutualfunds.Thus,evenifyoudonotdevelopa1percent
advantageoverthemarket,youwillcomeoutsubstantiallyaheadwhen
youjudiciouslyinvestinindividualstocksratherthanmutualfunds.
Figure1.1showswhat$1,000willbecomein10,15,20,and25years
ifyouearn5percent,10percent,or15percentperyear.Notethatif
youcanearn15percentperyear,youradvantageoverthemarketis
enormous.A$1,000initialinvestmentwillbecome
$32,919in25years
ata15percentannualrateofreturn.
The2008–2009stockmarketcrashmayhavemadeyoupessimistic
aboutinvesting.However,historytellsusthatyouhaveanadvantage.
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introductionandbackground
Thiseventactuallyoffersyouagreatopportunitytofindgoodstocksto
investin.Buffettrecently
wroteintheNewYorkTimesthatforhispersonalaccount,heisbuyingcommonstocksinthismarket.4Another
legendaryinvestorwithanoutstandingrecordoverseveraldecades
writes,“OneprinciplethatIhaveusedthroughoutmycareeristoinvest
atthepointofmaximum
pessimism.”5So,spendsometimelearningto
investwisely.Let’sfirstlookatreturnsyouwouldhaveearnedifyouhadinvestedinBuffett’scompany,BerkshireHathaway.
HowMuchWouldYouHaveEarnedIfYou
HadInvestedwithBuffett?
Inthepast30yearsendingin2008,BerkshireHathawayhasgivenan
annualizedreturnofover23percentperyear.Thisistwicetherateof
returnyouwouldhaveearnedwiththeDowJonesIndustrialAverageor
theS&P500index.Obviously,WarrenBuffett’s
performanceisincred-
ible.Intermsofdollaramounts,ifyouhadinvested$1,000inBerkshire
Hathawayabout30yearsago,yourinvestmenttodaywouldamountto
about$500,000.Thelessonisclear:LearnfromWarrenBuffett’sinvest-
mentphilosophy,whichisdescribedthroughoutthisbook.Youmay
notbeabletoattainhislevelofsuccess,butyoudonothavetobe
WarrenBuffetttoearnrespectablereturnsinthestockmarket.Ifyou
canreplicateeven,say,one-fourthorone-thirdofthe
advantagehehas
overthemarket,youwillearnveryhighlong-termreturns.Theaver-
ageinvestorislikelytobearelativelysmallinvestor.Itiseasiertobeatthemarketwithsmalleramountsofmoneythanwithlargeinvestments.
WhenBuffettranhispartnershipsinthelate1950s
tolate1960s,his
returnswereevenlarger.Now,Buffettcannotinvestinsmallercompa-
niesbecausetheBerkshireportfolioissolarge.Butasmallinvestorhastheadvantageofbeingabletoinvestinsmallercompanies.ForBerkshire
asawhole,returnswere
higherwhenthecompanywassmaller,buteven
overthepast15years,theaverageannualizedreturnhasbeen12percent
comparedwithonlyabout6percentfortheS&P500index.
Youneverknow:Youmighthavetheskillstopicktherightstocks
andbecomeasgoodaninvestorasWarrenBuffett.Aslongasyouare
notreckless,thereislittledownsideintryingtofindoutwhetheryou
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TheThrillofInvestinginCommonStocks
7
havesomeoftheskillstobesuccessful.OnegreatthingaboutBuffettisthathehaswrittengenerouslyaboutwhathedoesandhowhedoesit.If
youhavepatienceandthewillingness,let’sstart
learningaboutbusinessesandinvestingfromthemaster.
Conclusions
Buffetthasoftendescribedhisinvestingphilosophyassimplebutnoteasy.
Itissimpleinthesensethatallyouneedtodoistoidentifyoutstandingbusinessesthatarerunbycompetentandhonest
managersandwhose
commonstockissellingatareasonableprice.Buthowdoyouthat?
Thisbookmakestheprocessofdiscoveringthosebusinessesaseasyas
possible.
E1C01
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E1C02
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Time:3:50pm
Chapter2
1965–2009:Lessons
fromSignificantEvents
inBerkshireHistory
Historyisphilosophyteachingbyexamples.
—Thucydides,anancientGreekhistorian
WhenWarrenBuffetttookcontrolofBerkshireHathaway
in1965,itwasasmalltextilemanufacturingcompanyin
NewEngland.Theprospectsofthetextileindustryatthe
timewereratherbleak.BuffetthastransformedBerkshireintoalarge
insurance,utility,manufacturing,andretailingconglomerate.In44years,thecompany’sbookvaluehasgrownfrom$19to$70,530perclassA
share,andthestockpricehascorrespondinglygrownfromabout$8
to$96,600.ThefollowinglistofsignificanteventsinBerkshirehistory
servestwopurposes.First,itisimportanttolearnfromtheexamples
othershaveset;andsecond,itpresentsaquicklookat
manyofBuffett’sprinciples.Inlaterchapters,wewillexploretheseprinciplesfurther.
9
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introductionandbackground
1965:NotThrowingGoodMoneyafterBad
EventWarrenBuffettislistedasaBerkshiredirectorforthefirsttime,althoughheisnotyetthechiefexecutiveofthecompany.Startingto
accumulateBerkshiresharesin1962at$7.60pershare,
Buffettacquired
acontrollinginterestinthecompanyby1965withanoverallaverage
costof$14.86pershare.
LessonRevenuesatBerkshirehavebeendeclining,from$64million
to$49million,intheprior16years.However,thecompany
didnot
investmuchtopropupthedecliningtextilebusiness.Thedecisionnottoinvestinadecliningbusinessisagoodexampleoftheoften-usedmaxim:
“Don’tthrowgoodmoneyafterbad.”Berkshire’scashflowsareinstead
usedforbuyingitsown
sharesbackintheopenmarketandforinvestinginothersecurities.Themainlessonisthatoneshouldbecarefulininvestinginacompanythatisusingitscashflowstosustainadyingbusiness.
1967:InvestinYourCircleofCompetence
EventBerkshiremakesitsdebutintheinsurance
businessbyacquiringtwoinsurancecompaniesfor$9million:NationalIndemnityCompany
andNationalFireandMarineInsuranceCompany.Bothcompaniesare
basedinOmahawhereBuffettlives.
LessonBuffettprobablyhadalong-termplantoslowly
developthe
insurancebusiness.Thisisanearlyperfectexampleofhowalongjourneystartswithasmallfirststep.Heinvestswithinhiscircleofcompetence:insurance.
1973:CashFlowIsKing
EventBerkshireincreasesitsinvestmentinBlueChipStamps.
LessonInthetradingstampbusiness,thecompanyreceivescashin
advanceforstamps:anIOU.Thecompanydoesnothavetopayinterest
ontheseIOUs,anditcanusethecashthusreceivedforinvestments
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1965–2009:LessonsfromSignificantEventsinBerkshireHistory11
inotherbusinesses.ThisisagoodexampleofBuffett’sphilosophyof
generatingcashflowwithlittlerisk.Theinsurance
businesshassimilar
characteristics.
1977:SuccessfulGrowth
EventTheinsurancebusinesscontinuestogrowatafastpacethroughexpansionandacquisitions.Buffettreportsthatintheprior10years,
insurancepremiumsgrewby
about600percent,from$22millionto
$151million.
LessonBuffett’sexcellentknowledgeoftheinsuranceindustryhelpshimtoidentifytopmanagersandthendelegatethemtorunindividual
units.Notethatinsurancewasnotafast-growing
industry.Outstanding
managersarethekeytosuccessfulgrowth.Investwiththemwhenyou
findsuchopportunities.
1980:BuyingSharesafterPricesFall
EventBerkshireinitiallyinvestedinGEICOin1976whenGEICO
wasclosetobankruptcy.BerkshireincreasesitsholdinginGEICOto
7.2millionshares,equaltoanequityinterestofabout33percent.
LessonBuffettexplainshisinvestmentsinGEICOandAmerican
Expressasfollows:
GEICO’sproblemsatthattimeputitinapositionanalogoustothatof
AmericanExpressin1964followingthesaladoilscandal.Bothwere
one-of-a-kindcompanies,temporarilyreelingfromtheeffectsofa
fiscalblowthatdidnotdestroytheirexceptional
underlyingeconomics.
TheGEICOandAmericanExpresssituations,extraordinarybusiness
franchiseswithalocalizedexcisablecancer(needing,tobesure,askilledsurgeon),shouldbedistinguishedfromthetrue“turnaround”situation
inwhichthemanagersexpect
—andneed—topulloffacorporate
Pygmalion.1
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introductionandbac
kground
Buffetthasemphasizedthatmostturnaroundcandidatesdonotsuc-
ceed.However,GEICOandAmericanExpressareexceptionsbecause
theunderlyingbusinesseswerehealthy.Youshouldbuysharesaftera
precipitousfallinpricesonlywhenyoucanassessthatthecompany’sproblemsaretemporary.
1984:ReportedVersusTrueFinancialResults
EventBuffettdescribeshowestimatesoflossesintheinsurancebusinesscanbesubstantiallydifferentfromthefinaltally,and,therefore,reportedearningsaresubject
tochange.In1983,reportedunderwritingresults,
basedonestimatesin1983,indicatedalossof$33million;butayear
later,correctedfiguresturnouttobe$51million,about50percentmorethantheoriginalestimate.
LessonThefollowingstoryexplainsthatwhenmanagers
planto
manipulateearnings,itisnotdifficult.
Amanwastravelingabroadwhenhereceivedacallfromhissister
informinghimthattheirfatherhaddiedunexpectedly.Itwasphysically
impossibleforthebrotherto
getbackhomeforthefuneral,buthetold
hissistertotakecareofthefuneralarrangementsandtosendthebill
tohim.Afterreturninghome,hereceivedabillforseveralthousand
dollars,whichhepromptlypaid.Thefollowingmonth,anotherbill
camealongfor$15,andhepaidthat,too.Anothermonthfollowed,
withasimilarbill.When,inthenextmonth,athirdbillfor$15was
presented,hecalledhissistertoaskwhatwasgoingon.“Oh,”shesaid.
“Iforgottotellyou.WeburiedDadinarentedsuit.”2
Preparationoffinancialstatementsrequiresalargenumberofestimates.
Whenanalyzingacompany,youshouldexamineseveralyears’worth
offinancialstatements,notjusttherecentones.
1985:CapitalExpenditures
EventBerkshireHathaway
closesitstextileoperations,whichwasitsmainbusinesswhenBuffetttookcontrolofthecompanyin1965.
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1965–2009:LessonsfromSignificantEventsinBerkshireHistory13
LessonBuffettwrites:“It[is]inappropriateforevenanexceptionallyprofitablecompanytofundanoperationonceitappearstohaveunendinglossesinprospect.”3Asanexample,BuffettstatesthatBurlington
Industries,anothertextilecompany,unsuccessfullyinvestedmorethan
$200pershareonthe$60
stock.Hewrites,“Whenamanagementwith
areputationforbrilliancetacklesabusinesswithareputationforpoor
fundamentaleconomics,itisthereputationofthebusinessthatremains
intact.”4Whenyouseeacompanymakingnewinvestmentsinadying
business(e.g.,theautoindustryintheUnitedStatesinrecentyears),youshouldnotinvestinthatcompany.
1986:CorporateJetsandOtherLuxuries
EventInsmallprint,Buffettwrites,“Weboughtacorporatejetlastyear.”5
LessonCorporatejetsareveryexpensiveandcostalot
tooperate
andmaintain,or,asBuffettputsit,“costalottolookat.”Whileit
seemsappropriateforBuffetttoacquireacorporatejet,heclearlyfeelsuncomfortable.AsBenjaminFranklinsaid,“Soconvenientathingitis
tobeareasonablecreature,sinceitenablesonetofindor
makeareasonforeverythingonehasamindtodo.”6Asaninvestor,youcanlearn
aboutacompany’strueculturefromitsspendingpractices.
1988:HoldingPeriodofanInvestment
EventBerkshirebuys14.2millionsharesofCoca-Colafor$592mil-
lion.WithrespecttothisfirstmajorpurchaseofCoca-Colastock,Buffettstatesthathisfavoriteholdingperiodisforever.Hefurtherstates,“Wecontinuetoconcentrateourinvestmentsinaveryfewcompaniesthat
wetrytounderstandwell.”7HealsorecallsMaeWest,“Toomuchofa
goodthingcanbe
wonderful.”8
LessonInabout10years,themarketvalueoftheCoca-Colastock
holdingwillincreasetenfold.OnereasonBuffettcanholdinvestments
forlongperiodsisthatheinvestsonlyincompaniesthatheunderstands
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introductionandbackground
andthathaveoutstandingmanagement.WithrespecttoCoca-Cola’s
CEO,Buffettwrites:
Throughatrulyrareblendofmarketingandfinancialskills,Roberto
[Goizueta]hasmaximizedboththegrowthoftheproductandthe
rewardsthatthisgrowthbringstoshareholders.Normally,theCEO
ofaconsumerproductscompany,drawingonhisnaturalinclinations
orexperience,willcauseeithermarketingorfinancetodominatethe
businessattheexpenseoftheotherdiscipline.WithRoberto,themesh
ofmarketingandfinanceisperfectandtheresultisa
shareholder’s
dream.9
Excellentinvestmentopportunitiesarefewandfarbetween.When
youfindsuchstocks,youshouldbuyalotandholdthemfora
longtime.
1989:LookingFoolishVersusActingFoolish
EventIn1989,twonaturaldisastersaffectedtheinsuranceindustrysignificantly.First,HurricaneHugocausedbillionsofdollarsofdamage
intheCaribbeanandtheCarolinas.Second,withinweeks,California
washitbyanearthquakecausinginsureddamagethatwasdifficultto
estimate,evenwellaftertheevent.
LessonBeforethe1989naturaldisasters,premiumsintheinsuranceindustrywereinadequate.Unlikemanyothers,Buffettstayedawayfrom
unprofitablebusinesses.Immediatelyaftertheearthquake,thetableswereturned.Givenitsstrongfinancialposition,BerkshireHathawayoffered
towriteupto$250millionofcatastrophiccoverage,advertisingtheofferintradepublications.
AsBuffettexplains:“Whenratescarryanexpectationof
profit,we
wanttoassumeasmuchriskasisprudent.Andinourcase,that’salot.”10
Takinglargeriskswithadequatepremiumsisprofitableinthelongrun
butmayappearfoolish.Tothis,Buffettresponds:“Wearewillingtolookfoolishaslongaswedon’tfeelwehave
actedfoolishly.”11Thekeylessonistoactrationally,regardlessofhowitappearstoothers.
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1965–2009:LessonsfromSignificantEventsinBerkshireHistory15
1990:PessimismIsYourFriend
EventForthebankingindustry,1990wasadisastrousyear.FearsofaCaliforniarealestatedisastercausedthepriceofWellsFargostocktofallbyalmost50percent.Buffettpurchasedanadditional4millionsharesin
WellsFargo,increasing
Berkshire’sholdingtoabout10percentofthe
bank’soutstandingshares.
LessonBuffettwrites:“Themostcommoncauseoflowpricesis
pessimism—sometimespervasive,sometimesspecifictoacompanyor
industry.”12Butyoualso
needtobecareful,Buffetcautions:“Noneof
thismeans,however,thatabusinessorstockisanintelligentpurchase
simplybecauseitisunpopular;acontrarianapproachisjustasfoolish
asafollow-the-crowdstrategy.Whatisrequiredisthinkingratherthan
polling.Unfortunately,BertrandRussell’sobservationaboutlifeingen-
eralapplieswithunusualforceinthefinancialworld:Mostmenwould
ratherdiethanthink.Manydo.”13In2008–2009,whenthestockmar-
ketwasdownbyabout40percent,Buffettwrites,
“Wheninvesting,
pessimismisyourfriend,euphoriatheenemy.”14
1991:Risk
EventMidway,PanAm,andAmericaWestenterbankruptcy,making
1991adisastrousyearfortheairlineindustry.BuffettestimatesthatBerkshire’s
investmentof$358millioninU.S.Airhaddeclinedby35percent
to$232million.Onlyayearearlier,BuffetthadwrittenthattheU.S.Airinvestment“shouldworkoutallrightunlesstheindustryisdecimated
duringthenextfewyears.”15
LessonThereisalwaysrisk
ininvesting,whetheryouinvestinairlinesorAIG.Itispossibletoloseasignificantpercentageeveninfixed-incomesecurities,althoughtheyaregenerallylessrisky.Thereisyet
anotherlessonabouttheairlineindustry:“Despitethehugeamountsof
equitycapitalthathavebeeninjectedintoit,theindustry,
inaggregate,haspostedanetlosssinceitsbirthafterKittyHawk,”16writesBuffett.
AfterhisexperienceswithU.S.Air,Buffettseemstohavedecidedthat
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introductionandbackground
investingintheairlinesindustryisnotinhiscircleofcompetence.Ifyouinvestinyourcircleofcompetence,youarelikelytoavoidhighlyrisky
investments.
1992:StockSplits
EventBerkshire’sstockpricecrossesthe$10,000markforthefirsttime.
LessonAstockpricelevelshouldnotbeusedasanindicatorofpotentialreturns.Astocksplitisnothelpfulforalong-terminvestor.Buffettstates,“Overall,webelieveourowner-relatedpolicies—includingthe
no-splitpolicy—havehelpedusassembleabodyofshareholdersthatis
thebestassociatedwithanywidelyheldAmericancorporation.”17In
theend,whatmattersistheperformanceofthecompany.Donotinvest
inacompanyjustbecauseithashadastocksplit.In2009,
Berkshire
announcedthatitwouldsplititsclassBsharesfor50:1inconnection
withitsacquisitionofBurlingtonNorthernSantaFe.Withoutthesplit,
smallBurlingtonshareholderswouldnotreceiveBerkshiresharesina
tax-freeexchange.
1993:IdentifyingExcellentCEOs
EventBuffett’sadmirationforMrs.B,NebraskaFurnitureMart’sCEO,iswell-known.Inadmiration,hewritesthefollowing:
Mrs.B—RoseBlumkin—hadher100thbirthdayonDecember3,
1993.(Thecandlescostmorethanthecake.)Thatwasadayonwhich
thestorewasscheduledtobeopenintheevening.Mrs.B,whoworks
sevendaysaweek,forhowevermanyhoursthestoreoperates,found
theproperdecisionquiteobvious:Shesimply
postponedherparty
untilaneveningwhenthestorewasclosed.
ShecametotheUnitedStates77yearsago,unabletospeakEnglish
anddevoidofformalschooling.In1937,shefoundedtheNebraska
FurnitureMartwith$500.
Lastyear,thestorehadsalesof$200million,
alargeramountbyfarthanthatrecordedbyanyotherhomefurnish-
ingsstoreintheUnitedStates.Ourpartinallofthisbegantenyears
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1965–2009:LessonsfromSignificantEventsinBerkshireHistory17
agowhenMrs.BsoldcontrolofthebusinesstoBerkshireHathaway,
adealwecompletedwithoutobtainingauditedfinancialstatements,
checkingrealestaterecords,orgettinganywarranties.Inshort,her
wordwasgoodenoughforus.
Naturally,IwasdelightedtoattendMrs.B’sbirthday.Afterall,she’s
promisedtoattendmy100th.18
LessonBuffetthasoftenemphasizedtheimportanceofasoundtrackrecord.Obviously,Mrs.Bdidnotneedahigh-leveluniversitydegreeto
runabusinesssuccessfullyoveralongperiodoftime.Buffettsawagreatopportunityinherabilitiesanddidnothesitatetobecomeherpartner.
InvestwithCEOswhohaveanexcellenttrackrecord.
1994:ExtraordinaryResultsinOrdinaryBusinesses
EventBuffettdiscussestheextraordinarysuccessofScottFetzer,aBerkshiresubsidiarythatwasacquiredin1986for$315million.He
writes,“HadScottFetzer
beenonthe1993500list—thecompany’s
returnonequitywouldhaverankedfourth.YoumightexpectthatScott
Fetzer’ssuccesscouldonlybeexplainedbyacyclicalpeakinearnings,amonopolisticposition,orleverage.Butnosuchcircumstancesapply.”19
ThenwhatdoesexplainScottFetzer’ssuccess?
LessonBuffettoffersthisexplanation:“ThereasonsforRalph’s[ScottFetzer’sCEO]successarenotcomplicated.BenGrahamtaughtme45
yearsagothatininvestingitisnotnecessarytodoextraordinarythingstogetextraordinaryresults.Inlaterlife,Ihavebeensurprisedto
findthatthisstatementholdstrueinbusinessmanagementaswell.Whata
managermustdoistohandlethebasicswellandnotgetdiverted.ThatispreciselyRalph’sformula.”20Onceagain,similartotheexampleofMrs.
B,learningtoidentifyexcellentmanagersthroughtheirtrackrecordwillhelp
youagreatdealinearningsuperiorreturns.
1995:CorporateAcquisitions
EventIn1995,BerkshireacquiresHelzberg’sDiamondShops.Inthisconnection,Buffettwrites,
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introductionandbackground
Jeffwasourkindofmanager.Infact,wewouldnothaveboughtthe
businessifJeffhadnotbeentheretorunit.Buyingaretailerwithout
goodmanagementislikebuyingtheEiffelTowerwithoutanelevator.21
LessonUnlikeBuffett’sacquisitions,mostacquisitionsdonotworkwellbecausetheydonotcomewithexcellentmanagementandgood
underlyingbusinesseconomics.Themergersareoftenmotivatedby
hubrissoaptlyexplainedbyPeterDrucker:“Dealmakingbeatswork-
ing.Dealmakingisexcitingandfun,andworkingisgrubby.Running
anythingisprimarilyanenormousamountofgrubbydetailwork...
dealmakingisromantic,sexy.That’swhyyouhave
dealsthatmakeno
sense.”22Buffetthasregularlyquestionedtheacquisitionpracticesofmostmanagers,andsoshouldyou.
1996:SellingTooEarly
EventBerkshireHathawaybecomesthe100percentownerofGEICO
whenitpurchasestheshares
—about50percent—thatitdidnotalready
own.AlthoughBuffettfirstpurchasedGEICOsharesin1951onhis
personalaccount,hesoldthosesharesin1952,onlytolamenthisdecisionlater.Heboughtbackintothecompanyovertheyearsstartingin1976.
LessonBuffettexplainsthatalthoughhemadeaprofitwhenhesoldhisGEICOsharesfor$15,259in1952,“inthenext20years,theGEICO
stockIsoldgrewinvaluetoabout$1.3million,whichtaughtmealessonabouttheinadvisabilityofsellingastakeinanidentifiablywonderful
company.”23Onapersonalaccount,IfirstpurchasedmyBerkshireshares
in1987andsoldwithinayear,onlytoregretthatdecisionlater.IhavesincepurchasedmoreofBerkshireshares,anditiscurrentlymylargest
holding.Donotsellagoodstockforasmallprofit.
1996:HiringPractices
EventThe79-year-oldfounderandCEOofFlightSafetyInternational,AlUeltschi,sellshiscompanytoBerkshireHathaway.Alhashadalife-longaffairwithaviationandactuallypilotedCharlesLindbergh.Buffett
explainshishiringpracticesasfollows:
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1965–2009:LessonsfromSignificantEventsinBerkshireHistory19
AnobservermightconcludefromourhiringpracticesthatCharlieand
IweretraumatizedearlyinlifebyanEEOCbulletinonagediscrimina-
tion.Therealexplanation,howeverisself-interest.It’sdifficulttoteachanewdogoldtricks.ThemanyBerkshiremangerswhoarepast70
hithomerunstodayatthesamepacethatlongagogavethemreputa-
tionsasyoungsluggingsensations.Therefore,togetajobwithus,just
employthetacticofthe76-year-oldwhopersuadedadazzlingbeauty
of25tomarryhim.“Howdidyouevergethertoaccept?”askedhis
enviouscontemporaries.Thecomeback:“ItoldherIwas
86.”24
LessonWhatmattersistheperformanceoftheindividual,andonlyonthatbasisshouldapersonbejudged,notonthebasisofage.AsBuffett
furtherexplains,“Almaybe79,buthelooksandactsabout55.Hewill
runoperationsjustashehas
inthepast:Weneverfoolwithsuccess.
Ihavetoldhimthoughwedon’tbelieveinsplittingBerkshire’sstock,
wewillsplithisage2-for-1whenhehits100.”25Ignoreageandother
prejudiceswhenevaluatingthosewithwhomyoushouldinvest.
1997:Patience
EventBerkshirereportsalargenontraditionalinvestmentof$4.6billioninlong-termzero-coupontreasurybonds.Ifinterestrateswereto
rise,Berkshirewouldloseheavily;andiftheinterestratesweretofall,Berkshirewouldmakeoutsizedgains.WhydidBuffettmakesuch
an
unconventionalinvestment?
LessonBuffettfirstexplainstheneedfordisciplinewhenthereisexuberanceinthestockmarket.
Underthosecircumstances,wetrytoexertaTedWilliamskindof
discipline.Inhisbook,The
ScienceofHitting,Tedexplainsthathecarvedthestrikezoneinto77cells,eachthesizeofabaseball.Swingingonlyatballsinhis“best”cell,heknew,wouldallowhimtobat.400;reaching
forballsinhis“worst”spot,thelowoutsidecornerofthestrikezone,
wouldreducehimto.230.In
otherwords,waitingforthefatpitch
wouldmeanatriptotheHallofFame;swingingindiscriminately
wouldmeanatickettotheminors.26
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introductionandbackground
Buffettdecidednottoswing—thatis,nottomakeadditionalinvest-
mentsinthestockmarketin1997.However,healsomakesitclearthat
“juststandingthere,dayafterday,withabatonmyshoulderisnotmy
ideaoffun.”27Patience,althoughnoteasy,isnecessaryforsuccessin
investing.Whenstockpriceappearshighrelativetofundamentals,stay
awayfrominvesting.
1999:TakingResponsibility
EventBerkshirehastheworstabsoluteperformanceofBuffett’stenuretodateand,comparedwiththeS&P500index,theworstrelativeperformanceaswell.BuffettgiveshimselfaDincapitalallocation.
LessonItisaneverydaymattertoseecorporatemanagersblaming
otherswhentheircompany’sperformanceisbelowpar.Ifnotother
individuals,theguiltypartyisfrequentlytheclimateortheinterestrates.
Instead,withrespecttothe1999results,Buffettwrites:
EvenInspectorClouseaucouldfindlastyear’sguiltyparty:yourChair-
man.Myperformanceremindsmeofthequarterbackwhosereport
cardshowedfourFsandaDbutwhononethelesshadanunderstand-
ingcoach.“Son,”hedrawled,“Ithinkyou’respendingtoomuchtime
onthatonesubject.”My“onesubject”iscapital
allocation,andmy
gradefor1999mostassuredlyisaD.28
Donotblameothers.Whenyoutakeresponsibilityforyourfailed
investments,asBuffettoftendoes,itiseasiertolearnfromyourmistakesandavoidrepeatingtheminthefuture.
2000:SellinginEuphoria
EventBuffettmentionsthatthe“long-termprospectforequitiesingeneralisfarfromexciting.”29
LessonWithhindsight,onecanconcludethatBuffettshouldhave
soldsomeoftheholdingsbeforethestockmarketstartedtodecline
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1965–2009:LessonsfromSignificantEventsinBerkshireHistory21
in2000.TheCoca-Colasharestradedatpricesashighas$85pershare
in1998.Tenyearslater,in2009,Coca-Colastockpriceisabout$45per
share.AsBuffetthasrecognized,thestockmarketdoesbecomeeuphoric
periodically,andthemainlessonisthataninvestorshouldsellinthosecircumstances.
2001:NotLosingFocus
WhenDisasterStrikes
EventOnSeptember11,2001,terroristsattacktheWorldTradeCen-
terinNewYorkandthePentagoninWashington,DC.
LessonBuffettestimatedthatinsurancelossessurroundingtheeventsofSeptember11were$2.2billion,oneofthelargestinBerkshirehistory.
EvenBerkshiredidnotanticipateaterroristattackandhadnot
protecteditselffromsuchamegadisaster.OnSeptember26,hewroteto
hismanagers:“Whatshouldyoubedoinginrunningyourbusiness?Just
whatyoualwaysdo...almostalloperating
decisionsthatmadesenseamonthagomakesensetoday.”30Essentially,Buffettsuggeststhatsuch
disasterscouldactuallypresentopportunitiesformanagerstoexpand
theirbusinesses.
2002:FinancialWeaponsofMassDestruction
EventUsingEnronasanexample,Buffettdiscussespossibilitiesofhugelossesfromderivativecontractsandhisdecisiontoclosedown
thederivativebusinessthatcamewiththeacquisitionofGeneralRein
1998.
LessonBuffettwrites,“Wetrytobealerttoanysortof
megacatastropherisk,andthatourposturemaymakeusundulyapprehensiveabout
theburgeoningquantitiesoflong-termderivativescontracts.”Hewas
remarkablyprescientinstating,“Inourview,derivativesarefinancial
weaponsofmassdestruction,carryingdangersthat,while
nowlatent,are
potentiallylethal.”31InvestorsinlargecompanieslikeEnron,WorldCom,
AIG,BearStearns,LehmanBrothers,FreddieMac,andFannieMaelost
allormostoftheirinvestmentsbecausethesecompaniesindulgedheavily
E1C02
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introductionandbackground
inderivativesthattheycouldhavedonewithout.Theimportantlesson
foranaverageinvestoristhatoneshouldavoidinvestingincompanies
withdifficult-to-understandbusinessmodelsorfinancialstatements.
2008-2009:MarketCrashes
EventDuringaspanofsixmonthsfromSeptember2008toMarch
2009,BerkshirestockclassAexperiencespricesashighas$150,000per
shareandaslowas$75,000,representingadeclineof50percent.The
marketasawholeexperiencesasimilardownturn.
LessonAsBuffettpointsout:“Amidthisbadnews,
however,never
forgetthatourcountryhasfacedfarworsetravailsinthepast....Withoutfail,however,we’veovercomethem.”32Thisisnotthefirsttimethat
Berkshire’sstockpricehasgonedownby50percent.Ithashappened
threeothertimessince
Buffetttookcontroloverthecompanyin1965.
Inrecentyears,from1998to2000,Berkshire’sstockpricedroppedby
about45percent,from$79,000to$44,000.Berkshirewasagoodbuy
aftersuchadecline.WhileIrecommendthatyoudoyourhomework,
late2009,inmyopinion,isstillagoodtimetobuyBerkshirestockand
stocksinotherconservativelyfinanced,prominentcompanies.
Conclusions
Fromitsfirstacquisitionoftwosmallinsurancecompaniesin1967,
BerkshireHathawayhasexpandeditsinsurancebusinessandbecome
oneofthelargestinsuranceoperationsintheworld.Theeventsand
milestonesofthepast44yearsdiscussedinthischapterreflectmanyof
Buffett’sdecisionsandpractices.Hislongand
successfultrackrecordandhiswillingnesstosharehisthoughtsmakeitpossibleforustostudyhisideasindepth.Therestofthebookisdevotedtodevelopingagood
understandingoftheinvestingprinciplesthatBuffettbothespousesand
exemplifiesandwhythoseprincipleswork.
E1PART02
Date:Dec10,2009
Time:4:15pm
PartTwo
BUFFETTINVESTING=
VALUE+GROWTH
Thephrasevalueinvestingpopularlymeansaninvestingstylebased
onfinancialratiossuchasprice-to-earningsormarket-to-book.
Bycontrast,ingrowthinvesting,oneseekstodiscovercompaniesthatarelikelytogrowatafastpaceinthefuture.InChapters3and4,Idiscussvalueinvestingandgrowthinvesting,respectively.Bothinvestingstyleshavemerits.Chapter5focusesonthe
conceptofintrinsicvalue,
thevalueyouassigntoastockbasedonitsassetsandearnings.InChapter6,IexplainhowwecanbestlearnfromBuffettbyviewinghimasan
integratorofbothvalueandgrowthinvestingprinciples.
23
E1PART02
Date:Dec10,2009
Time:4:15pm
E1C03
Date:Jan29,2010
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Chapter3
ValueInvesting—It’sLike
BuyingChristmasCards
inJanuary
[W]ehadlearnedfromBenGrahamthatthekeytosuccessful
investingwasthepurchaseofsharesingoodbusinesseswhenthe
marketpriceswereatalarge
discountfromunderlyingbusiness
values.1
—WarrenBuffett
Ifyoulovebargains,youwilllovevalueinvesting.Valueinvesting
isregardedasthecornerstoneofBuffett’sinvestingstrategy.Value
investingissimilartobuyingsomethingwhileit’sonsale.Anevery-
dayexampleofvalueinvestingisbuyingChristmascardsinJanuaryat
abouthalfthepriceofthesamecardsamonthearlier,inDecember.IfyoubuyChristmascardsinJanuaryandusethemthefollowingChristmas,
youwillhaveimplicitlyearnedareturnofabout100percentonyour
investment.Ifyoutendtocomeupwithsuchideas,implementthem,
andcomputeyourpotentialreturns,youareanaturalvalueinvestor.For
valueinvestinginthestockmarket,youbuywhenprices
arelowrelative
tofundamentals(e.g.,earningsandbookvalue),andthenwaitforprices
tomoveup.
25
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buffettinvesting=value+growth
Moststocksdonotsellforbargainprices,justasmostitemsinthe
localmalldonotsellforbargainprices.Gooddealsarenotavailableeveryday.
Aninvestormustbepatientandwaitforsuchopportunitiestoarrive.
Youneedpatiencetowaitforatrulyoutstandingvalueopportunity,and
youneedevenmorepatienceafteryoupurchaseastock.Itoftentakes
timeforpricetoreflectvalue.Inthecaseof
Christmascardinvesting,
youneedtowaitaboutayear.Inthestockmarket,thewaitisoftenevenlonger.
ThestockmarketalsohascomplicationsthatdonotariseinChrist-
mascardinvesting.WeknowthatChristmasarrivesfaithfullyevery
DecemberandthatanopportunitytoinvestinChristmascardsarrives
soonafter.Ontheotherhand,goodopportunitiesinthestockmarketdo
notannouncetheirarrival.Norcanyoualwaysanticipatetheindustryor
geographiclocationinwhichopportunitiesmightarise.
Furthermore,
youwillneverknowforsurethatanopportunityisstaringatyou.There
isnoguarantee:Youalwayshavesomechanceofendingupwithabad
outcome.Whilevalueinvestingisnotaseasyasitlooksatfirstglance,youcanbecomeagoodvalueinvestor
withtimeaslongasyoucarefully
followthephilosophydevelopedbyBenjaminGraham.
ValueInvestingandTwoEssentialPrinciples
BenjaminGrahamdevelopedthecoreprinciplesforinvestinginfinancial
securities.Tothebestofmyknowledge,heneverusedthetermvalue
investingtodescribehisapproach.FromwhatIcandetermine,hedidnotgiveanynametotheinvestingprincipleshedeveloped.Nomatter
whathecalledit,heisgenerallyknownasthefatherofvalueinvesting.
Muchhasbeenwrittenaboutvalueinvestinginthepastfewdecades,
butauthorsdefineitindifferentways.Thecommonelementsacross
variousdefinitionsfrombothpractitionersandacademicssuggestthat
valueinvestingimpliesaninvestingstylethat
emphasizesusingfinancialratiossuchastheprice-to-earningsormarket-to-bookratios.Theterm
valueinvestingisalsocommonlyinvokedwhenonedoesnotinvestinfast-growingcompaniesorstickstoconservativelyfinancedcompanies.
Avalueinvestorissomeonewhofocusesfirstand
foremostonpreserving
capital.Earninghighreturnsisdesirablebutsecondary.
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27
Howeffectiveisvalueinvestingasameansforgeneratinghigh
returns?Doesthisstylegenerateabove-marketreturns?Buffett’sinor-
dinatesuccessisgenerallyattributedtovalueinvesting.However,asI
willdiscussinthenextfewchapters,Buffett’sinvestingstyledoesnot
fitthepopular,butlimiting,definitionofvalueinvesting.Furthermore,weshouldnotrelyonevidencefromafewsuccessstoriestoconclude
thatvalueinvestinggenerateshighreturns.Anecdotalevidencedoesnot
proveaproposition;itcanonlyofferexamples.Withoutthescientific
evidenceprovidedbyresearch,wecanbeincorrectlyconvincedbyanec-
dotes.Academicresearch,aswewillseeinthischapter,stronglysupportsvalueinvesting,andthus,thereismorethananecdotalevidence
tosupportthemeritsofvalueinvesting.Butfornow,let’sfocusonthetwo
mostsignificantprinciplesemergingfromthevalueinvestingliterature,
primarilyfromGraham’svoluminouswritingsandinparticularfromhis
famousbookTheIntelligentInvestor.2Iexplainwhy
theseprinciplesworkandwhatmakesthemimportant.
Principle1:PriceShouldNotBeHighRelativetoaCompany’s
AverageEarningsoveraNumberofYears
Thefirstprincipleessentiallyrelatestothemostoftendiscussedratio
inthefinancialworld,theprice-to-earningsratio,orsimplytheP/E
ratio.ThemarketP/Eratiorosefrom18intheearly1990stoabout
30intheearly2000sasinterestratesdeclinedsteadilyduringthesame
period.Asinterestratesincreasedstartingintheearly
2000s,themarketP/Eratiodeclinedbacktobelow20.Duringthemid-1970stoearly
1980s,themarketP/Eratiowentdowntoaslowas7to9becauseof
highinterestratesandeconomicslowdown.Intermsofspecificnumbers,
afterevaluatingthecurrent
conditionsin1972,BenjaminGrahamstates,
“Wesuggestthatthis[P/E]limitbesetat25timesaverageearnings,andnotmorethan20timesthoseofthelast12-monthperiod.”3
Therearetwolessonsthatwecanlearnfromhistory.First,itisgen-
erallyagoodideatoavoid
investinginstockswhenthemarketP/Eratio
ishigh,sayhigherthan20.Second,wecanextendthesameargumentto
individualstocks,withonecaveat.Youshouldexamineacompany’sP/E
ratiooveranumberofyears,bylooking,perhaps,atthepriceinrelationtothepast
fiveto10years’earnings.Ifyouuseonlyrecentearnings,
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buffettinvesting=value+growth
50
45
Priceto10-yearaverageearnings
Averagefrom1881to2009
40
35
30
25
20
15
Price-to-earningsratio
10
5
0
1881
1889
1897
1905
1913
1921
1929
1937
1945
1953
1961
1969
1977
1985
1993
2001
2009
Year
Figure3.1Price-to-EarningsRatiofrom1881to2009
acompanymayhavealowP/Eratiobecauseearningsaretemporar-
ilyhigh,oritmayhaveahighP/Eratiobecause
earningsaretempo-
rarilylow.
Figure3.1showsthehistoryofthemarket’sP/Eratiowhereearnings
aredefinedastheaverageofthepast10years’earnings.Theaverage
ratioovertheentiretimeis16.3.4Thelatestratioof18.9
attheendofOctober2009isslightlyhigherthantheaverage.Youcanseethatwhen
theratioisveryhigh,itreversestowardtheaverageandfrequentlygoessubstantiallybelowtheaverage.Justbecausetheratioiscurrentlynear
theaveragedoesnotimplythatitcannotgoanyloweror
higher.Overall,thischartsuggeststhatiftheratioisveryhigh,asitwasin2005–2007,itisnotagoodtimetoinvest.Ontheotherhand,whentheratioisvery
low,itisagoodtimetoinvest.
SeveralsuccessfulinvestorshaveusedtheP/Eratioasthecoreof
theirinvestmentstrategy,includingJohnNeff,whoiswellknownfor
successfullymanagingbillionsofdollarsthroughtheVanguardWind-
sorFundformorethan30years—averylongtimeinthemutualfund
managementbusiness.Veryfewmutualfundmanagers
havemanaged
largeportfoliossuccessfullyforsuchalongperiod.WhywasJohnNeff
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29
sosuccessful?“WereliedonrelentlessapplicationsoflowP/Esympa-
thies,abettedbyattentiontofundamentalsandaliberaldoseofcommon
sense.”5
Investorsmayalsouseothervaluationratiossuchasthemarket-to-
bookortheS&P500earningsasafractionofgrossdomesticproduct
(GDP),whichBuffetthasreferencedinhiswritings.Attheaggre-
gatelevel,itdoesnotmatterwhichratioyouexamine.The
results
aresimilar.Attheindividualstocklevel,whetheryouusetheP/E
ratioorthemarket-to-bookratiooranotherratioentirely,youshould
dependonthenatureofthecompany’sbusinessandtheavailabilityof
suitabledata.
Principle2:EachCompanySelectedShouldBeLarge,Prominent,
andConservativelyFinanced
ThisprincipleisstraightfromGraham.Herecommendsinvestinginlarge
andprominentcompaniesbecauseitisnoteasytoevaluatesmalland
less-knowncompanies.Theirfinancialstatementsarelessreliable,and
theymaybemoreeasilyaffectedbyunforeseencircumstances.Inother
words,theriskinvolvedininvestinginsmallandless-
knowncompanies
ishigh.“WhereshouldIstarttolookforworthwhilecommonstocks?”
youmayask.Buffettoftenrecommendsthatanaverageinvestormay
startwiththeValueLinesheets.ValueLineusuallydoesnotfollowsmallcompanies.Thus,thefirst
criterionofinvestinginlargecompaniesis
easilymet.ValueLinealsoprovidesastock’shistoricalrecordovertheprior20years.Theavailabilityofalongtrackrecordisusefulbecause
youcandecidewhetherthecompanyisprominent.Youmayreadthe
ValueLinedescriptionofthecompanyandthendecidewhetheryouwanttoconductadditionalresearch.
RegardingGraham’spositionthatacompanyshouldbeconserva-
tivelyfinanced,itispossibletodiscussatgreatlengthwhatexactlythistermmeans.However,whetherthecompanyisconservatively
financed
willbeimmediatelyclearfromacursoryexaminationofitsshort-and
long-termdebtlevelsinrelationtoitstotalassets,oritsdebt-to-equityratio.Tomakelifesimpleforinvestors,ValueLineranksstocksonascaleofsafety,fromonetofive.Coca-Cola,amajorholdingofBerkshire
Hathaway,usuallyhasthehighestsafetyrankingofone.Alarge,
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buffettinvesting=value+growth
establishedcompanysuchasCoca-Cola,withamarketcapitalization
ofabout$100billionattheendof2008,hasonlyabout$3billion
oflong-termdebt.Itisnotdifficulttoconcludethatthecompanyis
conservativelyfinanced.
BerkshireHathawayhasalwaysbeenconservativelyfinanced.Whyis
conservatismimportant?Becauseitisdifficulttopredictwhenfundswillbesuddenlyneededforprofitableinvestmentsorforclaims.Aconservativelyfinancedcompanycanraisefundsinshortorder,andaliquidity
crisisintheeconomywouldnotaffectthecompany.Forexample,in
2008,largeandprominent(butnotconservativelyfinanced)companiessuchasCiticorp,GoldmanSachs,andGeneralElectricsufferedsignificantly,andseveralothersweremerged,declaredbankruptcy,orwereon
thevergeofbankruptcy.On
theotherhand,BerkshireHathawayused
thisasanopportunitytoinvestincompaniessuchasGoldmanSachsand
GeneralElectric.Thus,inthelongrun,conservativelyfinancedcompa-
niesarelikelytoproducehigherreturnsastheyareinapositiontotakeadvantageof
suchopportunities.
WhileIconsiderthesetwoprinciplesorguidelinestobemostimpor-
tant,theyareprinciplesandnotspecificrules.Forexample,notalllargecompaniesmaylendthemselvestosoundfinancialanalysisbecauseof
thecomplexityoftheir
business.Itmaynotbeeasytodefinewhich
companyisprominentandwhichisnot.Thus,youwillhavetouse
afairamountofjudgmentinselectingyourinvestmentseveninyour
applicationoftheseprinciples.
OtherHelpfulGuidelinesforValueInvesting
Tohelpyouwithnarrowingyourfieldofinquiry,Idiscusssomeofthe
morecommonconceptsthatBuffettandothervalueinvestorshaverelied
onoverthedecades,conceptsthathavewithstoodthetestoftime.
ASharpDeclineintheStockMarket
Asharpdeclineinthestockmarketgenerallypresentsagoodinvestment
opportunity.Inmid-1973,afterthemarkethaddeclineddramatically,
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31
BerkshireHathawayboughtalargestakeof1.9millionsharesinthe
WashingtonPostCompany(WPC).Youmightthinkthat
onlyBuf-
fettcouldseethatthecompanyofferedsuchagoodopportunity.He
suggestedjusttheopposite:“Calculatingtheprice/valueratiorequired
nounusualinsights.Mostsecurityanalysts,mediabrokers,andmedia
executiveswouldhaveestimatedWPC’sintrinsicvalueat$400to$500
million,justaswedid.Andits$100millionstockmarketvaluewas
publisheddailyforalltosee.”6In2009,evenaftera50percentdeclineinitspriceinrecentyears,WPCistradingatabout$400pershare,and
ithaspaidregulardividends.Berkshire’sinvestmenttranslatesintoan
annualizedreturninexcessof15percentperyearincludingdividends,
anexcellentreturncomparedtoabout9percentinthemarketduring
thisperiod.
Dependingonyourlevelofrisktolerance,itisreasonabletoargue
thatyoushouldincreaseyourinvestmentinthestockmarketwhenever
thereisa20percentcorrectionfromreasonablepricelevels.Itisnot
thepricedeclinepersethatisimportant;itisthepricein
relationtoearnings,asthesecondprinciplementionedearlierrequires.Perhapsa
marketP/Eofabout12suggestsopportunitiesbasedonthefactthatthe
long-runmarketP/Eaverageisabout16.Ofcourse,suchaninvestment
shouldnotbefortheshorttermbecausethedecline
couldcontinue
foraconsiderabletime.Youshouldcertainlygaugethevaluationsofthe
marketasawholeinrelationtoitsfundamentals.Ifthedeclinecontinues,youmaythinkaboutincreasingyourinvestment.Thus,insomecases,
youwillhavetowaitalong
whileforthestockmarkettocomeback.
Patience,onceagain,isaprerequisiteforearningsuperiorreturns.
In2008,theS&P500indexdeclinedbyabout37percentand
evenBerkshireHathaway’sstockpricedeclinedby32percent.Arethere
opportunitiesinthismarket?Buffettthinksso.Inanop-edarticleintheNewYorkTimes,October17,2008,hewrote:“I’vebeenbuyingAmericanstocks.ThisismypersonalaccountI’mtalkingabout,inwhich
IpreviouslyownednothingbutUnitedStatesgovernmentbonds.”Of
course,noone—noteven
WarrenBuffett—cantimethestockmarket
perfectly.SinceOctober17,whentheS&P500indexstoodat940,it
declinedtoaslowas676,oradeclineof28percent,byearlyMarch2009.
Thesearetryingtimesforinvestorsallovertheworld.ItisdifficulttobeE1C03
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optimisticinrecessionarytimes.However,“wheninvesting,pessimism
isyourfriend,euphoriathe
enemy.”7
TheIndustryThatLeadstheDecline
Thestockmarketdeclinein2008and2009waspervasiveacrossmany
industries,althoughfinancialstockshavebeenhitespeciallyhard.Such
pervasiveslidesare
uncommon.Usually,a10percentto20percent
declineisledbyoneorafewindustries.Inthoseinstances,theindustrythatleadsthedeclinemayleadtherecoveryandofferearlyinvesting
opportunities.Forexample,inthefallof1998,Russiafacedapayment
crisisanddefaultedonitsdebt.TheU.S.stockmarketwentdownby
about20percent,ledbythefinancialandtechnologysectors.Thesame
sectorsthenprovidedthemostgainsinthefollowingyear.Ingeneral,
whenamarketdeclineisledbyoneortwoindustrial
sectors,itisworthwhiletopayspecialattentiontogoodcompaniesinthosesectors.Even
inthesesituations,itisimportanttokeepinmindthatyoushouldinvestonlyifyouarecomfortablewiththefundamentalsofthecompany.
DuringtheRussiandefaultcrisis,thestockpriceof
MerrillLynch
declinedfromahighof$102pershareinJuly1998to$42persharein
October1998,a60percentdrop.Inmyview,itwasasubstantialdecline
andofferedanopportunityforhigherreturnsinthefuture.Thefollowingyear,MerrillLynch’sstockprice
wentupbyabout100percent.Merrill
Lynch’sbusinesswasnotdifficulttoanalyzeatthetime.(Itsbusiness
becamemorecomplexseveralyearslater.)Itwasnottheonlycompany
thatofferedthiswonderfulopportunity.Youcouldhaveboughtinto
anyofthewell-knownfinancialcompaniesanddonewell.Theaverage
declineinthewell-knownstocksofCitigroup,ChaseManhattan,and
BankofAmericawasabout50percent.Andeachoneofthemservedup
a100percentreturnin1999.Althoughitisnoteasyto
timethemarket,
opportunitieslikethesearelargeenoughtoofferasubstantialmargin
ofsafety.During1998,Berkshirepurchasedabout1millionadditional
sharesofAmericanExpress,increasingitsholdingto50.5millionshares.
Thedecisiontopurchasewasprobablyinfluencedbythedeclineinthe
sharepriceofAmericanExpress.Duringthe2008–2009marketcrash,
AmericanExpress,onceagain,wentdownfrom$60persharetoabout
$10pershare,onlytoreboundto$40pershare
withinayear.
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WatchOutforTemptations
Valueinvestingdoesnotsuggestthatoneshouldinvestindiscriminately
whenacompany’sstockpricedeclinesandthestocklookscheaprelative
toitspriceafewmonthsearlier.Ifyoustartbuyingthingseverytime
youwalkintoastorethatishavinga50percentoffsale,youwillsoonbeindebtorbankruptcy.Allitemsonsalearenottrueinvestmentbargains
butareinsteadinvitationstocollectjunk,onlytobesoldatyournext
garagesaleforafractionofwhatyoupaid.Bewareofthesetempting,
yetmisleading,so-calledbargains.
Kmarthasoftenappearedasabargainstock.TheriseofWal-Martas
asuccessfulretailerledtothedeclineofKmart’sstockpriceintheearly1990s.AteverystageofKmart’spricedecline,thestockappearedtobe
abargainifyoulookedatitsP/Eratio.Afteralmostadecade,thestockpricewasonlyabout$9pershare,havingdeclinedfromahighof$27in
theearly1990s.Itcontinuedtolookinexpensiverelativetoitsearningspershare—andunfortunately,IinvestedinKmart.IprovedGraham
right:“Observationover
manyyearshastaughtusthatthechieflosses
toinvestorscomefromthepurchaseoflow-qualitysecuritiesattimesoffavorableconditions.”8DuringthetimethatKmart’sstockpricewas
declining,themarketwentupabout300percent,andWal-Martwasa
phenomenalsuccess,amassingagainofabout700percent.IfIhadmade
afewtripstoKmartstoresanddugdeeperintoitsfinancialstatements,
itwouldhaveoccurredtomethatKmartwasalow-qualitycompany
relativetoWal-Mart.Andlow-qualitycompaniessuch
asKmartdonot
survive.In2002,Kmartwentbankrupt.
Often,companiesgetintotroubleandtheirstockpricesfall
significantly.Theyappeartobegoodturnaroundcandidates.Most
turnarounds,however,donot
endupsuccessful,andyoushouldnot
betemptedtoinvestinthem.Thus,alowpriceisnotagoodindicator
forinvesting.Outstandingturnaroundstories,suchasthatofChryslerinthe1970s,giveinvestorshopethatothercompaniesintroublemayturn
aroundinthesamemanner.However,unlessyouareinapositiontosee
thattheturnaroundisindeedhighlyprobable,youshouldnotinvestin
turnarounds.
TheprincipleofavoidingturnaroundsislikeavoidingChristmastree
(asopposedtoChristmascard)investing.TowardtheendofDecember,
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buffettinvesting=value+growth
Christmastreesareavailableatthrowawayprices,ifnotforfree.Fromaninvestmentperspective,buyingaChristmastreeattheendoftheseason
isawasteofmoney.Thepriceislow,butthevalueisevenlower.Ina
fewdays,whenthetreehasturnedbrownandsheditsneedles,itwill
havetobethrownaway.
DoesValueInvestingReallyWork?
Afterthisdiscussionofvalueinvesting,youmightaskifthereisreliableevidenceinsupportofvalueinvesting.Academicshaveaskedthisquestionforalongtimebecausetheyareusuallynotsatisfiedbyanecdotal
evidence.Buffetthasaddressedthisissuehead-on.SpeakingatColumbia
Universityin1984,hepresentedtheperformancerecordsofsevendis-
ciplesofBenjaminGraham.Healsoincludedtheperformanceoftwo
pensionfundsforwhichhehadhelpedselectmanagers
withvalueorien-
tation.Theresultsshowthatvalueinvestorsdoverywell.Buffettwrites:
“[I]fyoufoundanyreallyextraordinaryconcentrationofsuccess,you
mightwanttoseeifyoucouldidentifyconcentrationsofunusualcharac-
teristicsthatmightbecausalfactors.Scientificinquirynaturallyfollowssuchapattern.”9Inthiscase,themaincommoncharacteristicwasthe
valueinvestingapproachthatalltheGrahamdiscipleshadfollowed.
ItisnotsurprisingthatBuffett’sfindingsdidnothaveanyeffecton
thegeneralacademicopinion,atleastuntilrecently.Academicsusually
relyonevidencefromverylargedatasetsandareconvincedonlywhen
astrategyhasbeenshowntoworkoverlongperiods.Inotherwords,an
academicstudywouldconcludeinfavorofan
investmentstrategyonly
ifevenamonkey(computer)couldreplicatethestrategy.Inmyopinion,
thisisnotnecessarilyaverygoodapproachtoadvanceourknowledge,
butitistheacademicstandard.Nevertheless,recentacademicresearch
seemstohaveturnedthecornerinfavorofvalueinvesting.
AcademicResearchEvidence
Academicresearchisbasedonanalyzinglargesetsofdatausingextensivecomputerpower.Weshouldkeepinmindthatitisalmostimpossibletoprogramacomputertoidentifywhat
BenjaminGrahamcalls
“large,prominent,andconservativelyfinanced”companiesoridentify
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high-qualitymanagement.Forexample,howwouldacomputerknow
thattheCEOofBerkshireHathawayisagoodmanager?Forthisreason,
qualitativevariablesareallbutignoredinmostacademic
studiesortheirtreatmentissimplistic.Indefenseofacademicstudies,thegoodnewsis
thatthosestudiesmeetthehighestpossiblestandardsofanystudiesof
largedatasets,andeverythingaboutthemethodologyisclearlylaidout.
Hence,theydoprovideusreliablestatisticalresultstoponder.
Researchhasshownthatevensimplevalueinvestmentstrategies,
suchasinvestinginlowP/Estocks,produceoutstandingreturnsovera
numberofyears.Theseresultshavebeenreplicated
bymanyresearchers
overdifferentperiodsandare,thus,reliable.Therefore,itcanbe
concludedthataninvestorwhoimplementssimplevalueinvestment
strategiesandusesotherdiscerningqualitativevariablesshouldobtain
evenbetterreturns.Grahampointsoutthat“[an]investorshouldstart
withthelow-multiplier[i.e.,lowP/E]idea,butaddotherquantita-
tiveandqualitativerequirementstheretoinmakinguphisportfolio.”10
ManyapparentlowP/EstockssuchasKmartand
BethlehemSteelwould
nothavebeenselectedbycarefulvalueinvestorsbecausethecompanies
wereneitherprominentnorconservativelyfinanced.Inthenextsec-
tion,Idiscusstwosetsofstudies.Ifirstpresentadiscussionofstudiesthatcompareperformancesof
portfoliosconstructedbyhighversuslow
P/Estocks,andthenIcompareperformancesofportfoliosconstructed
byhighmarket-to-bookversuslowmarket-to-bookstocks.
PerformanceofHighversusLowP/EStocks
Themostprominentofrecentstudiesonvalueinvestingwasconducted
byProfessorsJosephLakonishokfromtheUniversityofIllinoisand
AndreiShleiferandRobertVishnyfromtheUniversityofChicago.11
TheyformedportfoliosbasedonP/Eandseveralother
ratiostoexamine
annualstockreturnsfrom1963to1990.InTable3.1,Ipresentresults
fromasimilaranalysisIconductedthatincludesreturnresultsuntil2007.
Thetablefirstshowsreturnsto10differentportfoliosofstocksformed
annuallyonthebasisofP/Eratios.Portfolio1iscomposedof10per-
centofthestockswiththehighestP/Eratios,ortheextreme-glamour
stocks.12Similarly,Portfolio10iscomposedofstockswiththelowest
P/Eratios,ortheextreme-valuestocks.
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Table3.1
EvidenceThatValue
InvestingWorks
ReturnsonPortfoliosofStocks
ReturnsonPortfoliosofStocksBased
BasedonMarket-to-Book
onPrice-to-Earnings(P/E)Ratios
(M/B)Ratios
Portfolio
Return
Portfolio
Return
number
(%peryear)
number
(%peryear)
HighestP/E
1
9.4
HighestM/B
1
9.5
stocks
stocks
2
10.4
2
11.5
3
12.1
3
12.3
4
11.8
4
12.6
5
11.3
5
12.0
6
12.9
6
12.5
7
14.4
7
13.5
8
14.2
8
13.5
LowestP/E
9
13.8
LowestM/B
9
14.5
stocks
stocks
10
15.9
10
16.0
TheportfoliosofthelowestP/Estocksbeattheportfoliosofthe
highestP/Estocksbyaconsiderablemargin.Thecorrespondingreturns
are15.9percentversus9.4percentperyear.Lakonishokandcolleagues
showthatoverafive-yearperiodafterformationoftheportfolios,the
extreme-value(lowestP/E)stocksearna138.8percentreturnincom-
parisontoa71.1percentreturnfortheextreme-
glamour(highestP/E)
stocks.Thus,overafive-yearperiod,thelowestP/Estocksoutperform
thehighestP/Estocksbyafactorofalmosttwotoone.Evenifyoudid
notinvestinonlythelowestP/Eportfolio,theperformanceisgenerally
betterforthelowerP/EstocksthanforthehigherP/Estocks.These
resultssupportBenjaminGraham’sideasonvalueinvesting,whichshould
encourageyoutofollowhisapproach.
PerformanceofHighversusLowMarket-to-BookStocks
Theaccountingvalueofacompany’scommonstockasreportedon
thebalancesheetisknownasthebookvalue.Itisbasedonaccountingrulesandprocedures.Ontheotherhand,thepricepershare,orthe
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37
marketvalue,receivesalotofattentionandisdeterminedbythemarket.
Generally,ifacompany’searningsareexpectedto
increaseatahighrate,themarketpriceissubstantiallyhigherthanthebookvalue.Aninvestor
shouldask:“Howhighshouldthemarketpricebeincomparisontothe
bookvalueinordertoinvest?”Thereisnogeneralformulatoanswer
thisquestion.Therefore,an
investorshouldexaminethehistoricalratiosofthesamefirmaswellastheratiosofotherfirmsinthesameindustry.Ifthemarketpriceissubstantiallyhigherthanthebookvalue,itislikelythatthepriceistoohighforavalueinvestortochoosethestock.Ontheotherhand,ifthemarketpriceisnotveryhigh,thevalueinvestorshouldlookfavorablyandpossiblyinvestinthestock—
keepinginmindGraham’s
viewthatthecompanyshouldbelarge,prominent,andconservatively
financed.
TheresultsofacomprehensivestudyconductedbyEugeneFama
andKennethFrenchoftheUniversityofChicago
supporttheideathat
investinginlowmarket-to-bookratiostocksresultsinhigherreturns.13
FamaandFrenchexaminedmonthlyreturnsforalargenumberofstocks
fromJuly1963toDecember1990,aperiodofmorethan27years.I
replicatetheiranalysisusingrecentdata,andthoseresultsarepresentedinTable3.1.Theextreme-valueportfolioincludes10percentofthelowest
market-to-bookstocks,whereastheextreme-glamourportfolioconsists
of10percentofthehighestmarket-to-bookstocks.Thedifferencein
returnsacrossthetwoextremedecileportfoliosisabout6percent.Usingthemarket-to-bookmetric,Lakonishokandcolleaguesalsoreportresults
forafive-yearstrategyinwhichthestocksareheldforfiveyearsonce
theportfoliosareformed.Theyfindthatforafive-yearholdingperiod,
theextreme-valueportfolioearns146.2percentasopposedtoonly56.0
percentfortheextreme-glamourportfolio.Theconclusionfromthese
studiesisthatthevalueinvestmentstrategyworkswellenoughthatyou
shouldbeabletobeatmostoftheprofessionalmoney
managerswho
focusonshort-termresults.
ThePowerofMultipleVariables
BeyondtheP/Estrategyorthemarket-to-bookstrategy,researchershave
examinedportfoliosformedonthebasisofseveralothervariables.In
particular,portfolioformationsbasedoncash-flow-to-priceandgrowth
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buffettinvesting=value+growth
inpastsalesorassetssupportthevalueinvestingapproach.Itisbettertobuyhighcash-flow-to-pricethanlowcash-flow-to-pricestocks,and
similarly,itisbettertobuystockswithlowpastgrowthinsalesthanhighpastgrowthinsales.Inaddition,whentworatiosareusedsimultaneously,theresultsareevenstronger.
Usingtwovariables(e.g.,growthinsalesandP/E),Lakonishok
andcolleaguesformninestockportfolios.Thestocksareindependently
sorted,inascendingorder,intothreegroupsofbottom30percent,mid-
dle40percent,andtop30percentbasedoneachofthe
twovariables.
Returnspresentedarecompoundedfive-yearpost-formationreturnsand
assumeannualrebalancingofthesenineportfolios.Theimportantcon-
clusionfromthisanalysisisthatavalueinvestmentstrategybasedjointlyonpastperformance(growthin
sales)andexpectedfutureperformance
(P/Eormarket-to-bookratio)produceshigherreturnsthanstrategies
basedexclusivelyononevariable,suchastheP/Eratio.
FrequentlyAskedQuestions
Anyinvestingstrategythathasbeenshowntoworkshouldbelookedat
morecarefullythroughprobingquestions.Inthissection,Idiscussthreefrequentlyaskedquestions,whicharerelevantwheneveraninvestment
strategyisbeingevaluated.Thisdiscussionshouldhelpyoubetterappre-
ciatetheevidenceandhelpyouthinkaboutevaluatingotherstrategies
thatyoudevelopyourself.
HowLongDoesItTakeforValueInvestingtoYieldSuperiorReturns?
Theresultsshowthatwhilereturnsarenotoutstandinginthefirstyear
aftertheportfoliosareformed,theyarenotdiscouraging.Thevalue
strategydoesworkinthefirstyear,butthedifferenceofabout4percentto6percent(dependingonthestudy)isnotremarkable.Insubsequent
years,thedifferenceislarger.Lakonishokandcolleaguesshowthatbythe
fifthyear,thedifferenceisalmost8percentperyear,whichissubstantiallylargerthanthefirst-yearfigure.
Theseresultsshowthatittakesseveralyearsofpatiencetobenefit
fullyfromthevaluestrategy.Aninvestorneedstobeextremelypatient
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aftertheportfolioisformed.Theanalysesperformedarebasedonthe
assumptionthattheportfoliosarenotbalancedfrequently.Oneimpor-
tantpointtorememberisthatifanindividualstockintheportfoliogoesupinpriceandnolongerqualifiesasalowP/Estock,itshouldnotbe
soldimmediately.Itshouldbeheldatleastuntilsuchtimeastheentireportfolioisreevaluated.Bynomeansam
Isuggestingthatyoushould
putallyourhard-earnedmoneyinsuchastrategyinonego.Aswith
anystrategy,youshouldslowlylearntheinsandouts,investalittleatatime,anddevelopyourskills.
Onenicesideeffectofthisanalysisisthatonceaportfolioisfully
formed,youneednotmonitortheportfolioonaregularbasis.Ideally,
theinvestorshouldnotcomebacktoevaluatetheportfolioforseveral
years.Ihaveoftendescribedthisstrategyas“lesseffortisbetterthanmoreeffort,”or,succinctly,“lessismore.”Avalueinvestorshouldspendmoretimeatthebeachthan
attheoffice.Isvalueinvestingreallyaseasyasitsounds?Yes,itis,butitwon’tbeifyoudonothavethepsychologicalresolvetorefrainfromtouchingtheportfolioforalongtime.Todevelopthepsychologicalresolve,youprobablyneedtoanalyzebyyourselfthe
historicaldataofthestocksinyourportfoliotobecomecomfortable
withtheirpastperformanceandtheresultspresentedhere.
Suchananalysiswillalsomakeyoumorecomfortablewiththevalue
strategy.Then,youwillindeedenjoythetimeyousavebynotwatch-
ingyourportfolioconstantly.Overall,totrulybenefitfrom
thevalue
investmentstrategy,youshouldnotunderestimatetheeffortneededtolearnaboutthestrategy.Youneedtopracticealot.Ifitwerepossible
todevelopthepsychologicalresolvebyreadingafewarticlesorbooks,
enoughinvestorswouldhave
followedthevalueinvestmentstrategyto
makeitsbenefitsgoaway.Thatpromptsthequestion:Doyouhavethe
righttemperamentforvalueinvesting?Thereisonlyonewaytofind
out.Practice.
AretheP/EandOtherValue
StrategiesLikelytoWorkintheFuture?
Aninvestorshouldalsoaskorthinkaboutwhetherastrategythathas
workedinthepastwillcontinuetoworkinthefuture.Noonecan
guaranteethat.However,giventhatpeoplegenerallygetexcitedabout
glamourstocksandnewinvestorscontinuallycometothemarket,such
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buffettinvesting=value+growth
strategiesarelikelytoworkinthefuture.Asmentionedbefore,enoughpeoplewilllackthepsychologicalresolvetoholdthesameportfolio
andnottradeoften.DavidDremanwroteabookin1977thatexplains
theP/Estrategyindetail.Beforethat,GrahamandDodddiscussedthis
topicintheirbooks.Atallthesepoints,areaderwouldhavewondered
ifthestrategywouldworkinthefuture.AsshownbyLakonishokand
colleagues’research,areaderwouldhavedoneverywellindeedifhe
orshehadadoptedthevaluestrategyevenafterthe
publicationofthe
Dremanbook.Dremaneventuallywroteanotherbook,publishedin
1998,thatconfirmedhisearlierfindings.14
Clearly,therewillbeyearsinwhichtheP/Eorothervalueinvest-
mentstrategieswillnot
work.Theinvestorhastohavepatienceinthose
yearsandremaininvested.Anothermainproblemliesinthefactthatif
youweretoexaminethetypesofstocksthatareintheextreme-value
portfolios,youwouldfindthemhighlyunattractive.Often,theso-called
extreme-valuestocksdefinedinthesestudiesaresmallandhavehigh
financialleverage.Thus,eventheseacademicstudiesdonotdofulljus-
ticetowhatGrahamproposesyoushoulddoasoutlinedintheprinciples
discussedearlier.Overall,itisgratifyingthatGraham’s
principlesarevin-dicatedbymodernacademicwork.Ifyouareavalueinvestor,youmay
continuetopracticeyourstrategyandtrytomakeitbetterbyreading
BuffettandotherdisciplesofGraham.
AreValueInvestmentStrategiesRiskier?
Thisisalegitimatequestionbecause,astheoldsayinggoes,ifadeal
lookstobetoogoodtobetrue,itprobablyis.Thedealsexplainedin
theprevioussectionintermsofvalueinvestmentstrategiesseemtobe
toogoodtobetrue.Athoughtfulinvestorneedsto
takeintoaccount
thepossibilitythatthereasonthatvalueinvestmentstrategiesoffersuchexcellentreturnsisthattheyareriskier.Ifthatweretrue,ascientificinquirywouldshowthat.Ifvalueinvestmentstrategiesweremorerisky
andproducedhighreturns,theinvestorshouldatleastbe
awareofthat
possibilityand,indeed,bemorecareful.
BenjaminGrahamaddressedtheissueofriskinhisbookIntelli-
gentInvestor.Hestatesthat“ifagroupofwell-selectedcommon-stockinvestmentsshowsasatisfactoryoverallreturn,asmeasuredthrougha
fairnumberofyears,thenthisgroupofinvestmentshasprovedtobesafe.”15
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41
Lakonishokandcolleaguesaddressthenotionofriskbyexamining
five-yearreturnstoportfoliosformedineachyearstartingin1968.In
afive-yearholdingperiod,theaveragedifferencebetweenthereturns
ontheextremevalueandglamourportfoliosis84.2percent.16Whatis
alsoremarkableisthatineachfive-yearperiodforwhichthisstudywas
conducted(1968to1985),aninvestorwouldhavebeenbetteroffusing
avaluestrategy.Inotherwords,itdoesnotmatter
whenyoustartonthevalueinvestmentstrategyaslongasyouwaitatleastfiveyearsbeforeyoucomparetheresultsofavalueinvestmentstrategyagainstotherstrategies.Furthermore,Lakonishokandcolleaguesalsoshowthatwhilevalue
investingdoessomewhatbetterduringthedown-marketmonths,itdoes
notdoappreciablyworseintheup-marketmonths.Overall,evidence
showsthatvalueinvestingdoesnotexposeaninvestortoexcessriskin
thelongrun.
Themodernrisk-basedmodelsintheacademicliteratureareunable
toexplainwhyvalueinvestmentstrategiesaresuperiortoothers.The
mostcommonlyusedacademicmodel,popularlyknownastheSharpe,
Lintner,andBlack(SLB)model,describesbetaasthemostappropriate
riskmeasure.AsImentionedbefore,FamaandFrench
showthatthe
resultscannotbeexplainedusingtheriskmeasurebeta.Theystate:“We
areforcedtoconcludethattheSLBmodeldoesnotdescribethelast50
yearsofaveragestockreturns.”
Thereisnoreliableevidence
toprovethatthetraditionalvalue
investingstrategiesareriskierthaninvestinginthestockmarketasa
whole.Valueinvestingyieldshigherreturnsbecausethesestrategiesare
contrariantothebehaviorofthetypicalinvestor.17
Conclusions
Thebasicideabehindvalueinvestingistopurchaseastockatasensiblepriceusingbenchmarkssuchasearnings,assets,dividends,andothers
thatyoumaydevelop.Inaddition,thecompanyshouldbeconservatively
financed.Anumberof
scientificstudiesshowthateventheuseofeasy-
to-followbasicfinancialratioscanrewardyouwell.
Valueinvestingstrategiesprobablyworkbecausesomanyinvestors,
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ofglamourstocks.Thevalueinvestorneedstohavesufficientpatiencetoinvestigatethecompanyandalsotowaitforafewyearsforthestrategy
towork.Manyinvestorsprobablydonothavethepatience.Ifhuman
behaviorisnotlikelytochange,superiorreturnswillcontinuetoflow
tothosewhoinvestbasedonfundamentals,havepatience,anddonot
giveintothelatestfads.So,youhavetoaskyourselfadifficultquestion.
Areyoureallyanydifferentfromtheaveragepersonwhoclaimstobea
valueinvestorbutfailstopracticethebasicprinciples?
Well,areyou?
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Chapter4
GrowthInvesting
[T]hegreatestinvestmentrewardcomestothosewho
bygood
luckorgoodsensefindtheoccasionalcompanythatoverthe
yearscangrowinsalesandprofitsfarmorethantheindustryas
awhole.1
—PhilipFisher
WarrenBuffettfreelyacknowledgesthatPhilipFisher’s
teachingsinfluencedhisinvestmentphilosophy.Fisher’s
philosophy,usuallyreferredtoasgrowthinvesting,isbased
onfindingoutstandingcompaniesandstayingwith
themthroughall
thefluctuationsofagyratingmarket.Growthinvestingisinvestingin
stocksofcompanieswhoseearningsareexpectedtogrowatahigher
thannormalrateoveralongtime,notonlyforthenextquarterorthe
nextyear.
Whenpeoplethinkofgrowthstocks,theyusuallythinkofMicrosoft,
Intel,Cisco,andothers.Whilemanyofthegrowthstockscomefrom
high-techindustries,notallofthemdo.Coca-Cola,Wal-Mart,andStar-
bucksarebutafewexamplesofnon-high–techgrowthstocks.Thus,
investinginthehigh-techsectorisnotsynonymouswithgrowthinvest-
ing.BuffettinvestedinCoca-Colawhenitwasmoreofagrowthstock
thanavaluestock.
43
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Coca-ColaasaGrowth
Stock
Attheendof2008,Coca-Colawasthesinglelargestcommonstock
holdinginBerkshire’sportfolio,amountingto16percentofthecommon
stockportfolio.Mostofthepurchasesweremadein1988and1989.At
theendof1988,Coca-Cola’sbookvaluepersharewas$1.07,whereas
thestockpricewas$5.70(splitadjusted),givingitamarket-to-book
(M/B)ratioof5.32.Also,fromtheprice-to-earnings(P/E)perspective,
Coca-Colawasabout35percentmoreexpensivethan
anaveragestock
intheS&P500atthetime(16.8forCokecomparedwith12.4for
theS&P500).PriortoBuffett’spurchase,thestockpricehadgone
up200percentfrom1978to1988.BuffettdidnotbuyCoca-Cola
stockbecauseitwasinexpensiverelativetoitsearningsorbookvalueorbecauseitspricehadfallensignificantlyowingtosomeproblematthe
company.
InTable4.1,IpresentCoca-Cola’searningspershareandbook
valuepersharetoexamine
itshistoricalgrowthbeforeBuffettdecided
topurchasethestock.BecauseoffrequentsharerepurchasesbyCoca-
Cola,thegrowthinunadjustedbookvalueissubstantiallyunderstated.
Toaccountforthis,thelastcolumnpresentsthegrowthinCoca-Cola’s
bookvaluepershareafteraccountingforthecompany’srepurchasesof
itsownshares.
Duringthe10yearspriortoBuffett’spurchase,Coca-Cola’searnings
persharegrewattherateof11.1percent,andbookvaluegrewatthe
rateof10.7percent.Coca-Cola’searnings-per-sharegrowthratewas
impressive:EarningsfortheS&P500firmsinthesameperiodgrew
attherateofonly7.1percent.Therefore,Coca-Cola’searningsgrew
almost50percentfasterthanthosefortheS&P500firms.
Itsstockpricegrewsimilarly,asmentionedearlier.Coca-Colaatthattimealreadyhad
aproventrackrecord,and,obviously,astocklikethatdoesnottradeatalowP/EorM/Bratio.AninvestorwouldbuyastocklikeCoca-Cola
onlyifhewereconvincedofitscontinuedgrowth.
Whenaninvestorbuysastockprimarilybecauseofhisconvic-
tionthatacompanywouldgrowformanyyearsinthefuture,heisa
growthinvestor.Buffett’spurchaseofCoca-Colaseemedtobetheresult
ofagrowthinvestingstrategy.Itworkedoutwell
forBerkshire.Many
investorsandwritersthinkthatwhenvalueinvestingworks,growth
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Table4.1
GrowthinCoca-Cola’sEarningsandBookValueperSharebefore
BerkshirePurchasedtheStock
Growthinbook
valuepershare
Percent
afteradjusting
Percent
Book
growthin
forthe
growthin
valueper
book
accounting
Earnings
earnings
shareas
valueper
effectsofshare
Year
pershare
pershare
stated
share
repurchases
1979
$1.13
11.9%
$5.18
10.5%
9.3%
1980
1.14
0.9
5.60
8.1
8.1
1981
1.21
6.1
6.12
9.3
8.3
1982
1.32
9.1
6.82
11.4
8.0
1983
1.37
3.8
7.14
4.6
6.7
1984
1.59
16.1
7.08
-0.1
9.4
1985
1.72
8.2
7.72
9.0
10.3
1986
2.07
20.3
9.13
18.3
13.3
1987
1.43
17.4
8.66
-5.1
14.3
1988
2.85
17.2
8.58
-0.9
19.1
10-year
average
11.1%
6.5%
10.7%
investingdoesnotwork,andviceversa.Suchmisguidedthinkinghas
comeaboutbecauseofatendencyintheprofessiontodivideagroup
ofstocksintotwo,andonlytwo,categories.Thistypeofmechanical
divisionofagroupofstocksleadstoerroneousinferences.Forexam-
ple,itisnotuncommontodividethe500stocksintheS&P500
indexintotwocategories—valueandgrowth—wherethe
valuecate-
goryincludes250stockswithabook-to-marketratiothatishigherthan
themedian.Theremaining250stocksareputintothegrowthcategory.
Insuchasystem,whenonecategoryoutperformstheoverallindex,
theothercategory,byvirtueofdesign,willunderperformtheoverall
index.
Growthinvestingisharderbecauseitisnotbasedonquantitative
formulassuchastheP/EorM/Bratios.BenjaminGrahampointsto
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reflectthepotentialgrowth.
Infact,inmostcases,whenthemarketsensesgrowth,thepricegoesupquickly.Inearly2009,evenafterapricedeclineofover30percent,Google’sP/Eratioisabout30.Forthebetterpart
ofthepreviousthreeyears,theratiohasbeenmuchhigher.Second,
theinvestor’sjudgmentofthefuturemayprovewrong.2
However,ifan
investorselectsstocksbasedonanaccurateassessmentofthecompany’s
future,growthinvestingcanbeverylucrative.
HowtoIdentifyGrowthStocks
Wal-Marthasbeenagreatgrowthstock,givingan
80,000percentreturn
overa38-yearperiodsince1970,whensharesfirstbecamepublicly
available,oranincredible35percentperyear.HowdidSamWalton
doit?
AccordingtoSamWalton:“Thereisonlyoneboss—the
customer.
Andhecanfireeverybodyinthecompanyfromthechairmanondown,
simplybyspendinghismoneysomewhereelse.”3Thesuccessofabusi-
ness,andhenceitsgrowth,dependsprimarilyonitscustomers.Tofind
agreatgrowthbusiness,youneedtoevaluateitfromacustomer’spoint
ofview.Onceyouaresatisfiedthatthecompany’ssalesandearningswillcontinuetogrowandthatyoucanbuythestockatareasonableprice,
buyandholditforalongtime.
Istartwithhownottoidentifyagrowthstockbecauseitisespeciallyimportantifyouhavebeenconsideringvalueinvesting.Youshouldnot
examinethefinancialfundamentalsimmediatelyafteryouhavediscov-
eredacompanythatmaygrowinleapsandboundsformanyyears.Do
notemphasizethefundamentalsmuch.Inotherwords,whenyoustart
thinkingaboutagrowthstock,donotstartthinkingaboutthehistor-
icalP/Eratioor,forthatmatter,anyotherquantitativemeasurethat
youmighthavelearnedinbusinessschool.Ifyoustart
thinkingabout
traditionalfinancialratios,youwillstartthinkingofvaluestocks,andyouwillprobablyneverpickagreatgrowthstock.Youwouldnever
havepickedsharesinMicrosoft,Wal-Mart,orHomeDepotifyouhad
lookedatthefundamentals
soonafterthecompanieswentpublic.Even
ifyouknewthesewereincrediblecompanies,youwouldhavemissed
theirtremendouspotential.I’mnotsuggestingthattraditionalfinancial
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ratiosarenotimportant;I’msimplysuggestingthatyoushouldnottry
toidentifyagrowthstockusingfinancialratiosalone.
ImportanceofTrack
Record:SalesandEarnings
Themostimportantdriverofgrowthinstockpriceisgrowthinearnings.
Futureearningsgrowthfrequentlydependsonpastearningsgrowth.To
convinceyourselfthatyoumustlookatthetrackrecord,thinkabout
fellowstudentsorcolleaguesatwork.Withhighprobability,youwill
discoverthatstudentswhogetconsistentlygoodgradesforanumberof
semesterscontinuetogetgoodgradesformanymoresemesterstocome.
Similarly,peoplewhodowellinajobcontinuetodo
wellformanyyears
tocome,althoughgoodgradesdonotnecessarilypredictwhowilldo
wellinajob!Thiscorrelationalsoappliestocorporations.Companies
thathavehadpositiveresultsforawhilearelikelytoexhibitthatkindofperformanceforyearsto
come,especiallywhenthemanagementteam
remainsinplace.Onceinawhile,thismaynotwork,butonaverageyou
willcomeoutawinnerifyouplaythegamebyemphasizingacompany’s
trackrecordofearnings.
Ashortrecordof,say,less
thanfiveyearsisprobablyadangerous
waytoidentifythefuturegrowthofacompany.Itisimportanttofocus
onalongertimespan.Greatgrowthcompaniesremainoutstandingfor
manyyearsaftertheirinitialspurtingrowth.Unlessyouknowalot
aboutthecompany,itisbesttoavoidinitialpublicofferings(IPOs).
WhileIPOsareoftenmarketedasgrowthstocks,theirlong-runperfor-
mancehasbeendismal.ProfessorsJayRitterandIvoWelchshowthat
formorethan7,000IPOsmadeover1980through
2005,theaverage
three-yearpost-IPOperformanceis20percentbelowthecorrespondingmarketreturns.4Generallyspeaking,IPOsareanythingbutgrowth
stocks.
Growthinearningsdoes,however,dependongrowthinsales,espe-
ciallyinthelongrun.ImentionedSamWalton’sfocusonthecustomer
becausethecustomeristhemaindriverforgrowthinsales.Ingeneral,
itisbesttokeepbothsalesandearningsinmindwhenthinkingabout
growthinvesting,notjustoneortheother.Onegood
approachtofind-
inggrowthstocksistoidentifysomegreatproductsandservices,asPeterE1C04
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buffettinvesting=value+growth
Lynchhasoftenemphasized.Still,youmustaskseveralquestionsbefore
youactuallybuystockinsuchcompanies.Youcanaffordtotakeyour
time.Greatcompanieswillgiveyoureturnsofseveralhundredpercent,
andifyoumisssomeofitinthebeginning,youshould
stilldowell.
Herearesomequalitativequestionsthatyoushouldtaketimetoaskand
answerbeforeyoudecidetoinvestinagrowthstock.
IsTherePotentialtoGrowSalesandEarningsforSeveralYears?
Thisisthemostimportant
question.Youshouldbothertoinvestigate
acompanythoroughlyonlyifithasthepotentialtogrowforseveral
years.Youcouldhaveboughtsharesofanoutstandingcompanysuch
asStarbucksalmostanytimefrom1992to2000forimpressivereturns.
ItseemedclearthatStarbuckswouldcontinuetogrowforalongtime
becausecustomersseemedhighlysatisfied.Ofcourse,wheneitherthe
pricebecomesexcessiveorwhenitisapparentthatgrowthhasslowed,
youshouldsellthestock.
One-timeeventsthathelpgrowcompaniesforashortperiodusu-
allyaffectpricessignificantly,butsuchchangesareoftentemporary.
Inthemid-1970s,againinthemid-1990s,andonceagaininthe
mid-2000swhenoilpriceswentupquickly,many
companiessup-
plyingoil-drillingservicesbecamehigh-growthcompanies.However,
theycouldnotsustaintheirgrowth.Forexample,GlobalMarine,
anotherwisewell-managedcompany,wastradingataround$35per
shareinlate1997,butoilpriceswentdownin1998,andGlobal
Marine’sstockpricequicklyretreatedtolessthan$8pershare.Acarefulinvestorlookingforanoutstandinglong-termgrowthcompanywould
haveavoidedGlobalMarinebecausethegrowthwasfromaone-time
event.
ThisconceptcouldalsobeappliedtotheInternetcrazeofthe1990s.
Atthattime,itwasdifficulttoknowwhichcompanieswouldhave
sustainablegrowth.Unlessyouwereinapositiontodeterminelong-
termgrowthwithsomedegreeofconfidence,youshouldhaveavoided
Internetcompanies.Notethatatthetimeofgoingpublic,evenMicrosoft
wasnotanoutstandinggrowthstockbecauseitwasnotclearthatthe
companycouldsustainitsgrowth.However,overtime,
itbecameclear
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thatMicrosoft’sproductswereimmenselysuccessful,
Microsoftwasa
nearmonopoly,andthenumberofcustomersforthoseproductswould
increaseformanyyearstocome.Atthatpoint,itwasagoodgrowth
stockworthinvestingin.
HowAreRelationswithEmployees?
Goodemployee-managementrelationsleadtohighcustomersatisfac-
tion.Acompanymayhavefineproducts,butunlessthecompany’s
employeesarehappy,customersatisfactionmaydisappearwithtime.A
conversationwiththeemployees—orsomeother
source—wouldreveal
agreatdealaboutemployee-managementrelations.Wal-Martdidnot
succeedonlybecauseithadlowerprices,butbecauseofoutstand-
ingmanagement-employeerelations.In1999,IattendedtheWal-Mart
shareholders’annualmeetinginFayetteville,Arkansas.Joiningmein
attendanceweremorethan10,000Wal-Martemployeeswhoarealso
shareholders.Ihaveneverseensuchenthusiasmfromtheemployees
ofacompany.Theycheeredoftenandendedthemeeting
withthe
well-knownWal-Martcheerthatstarts,“GivemeaW!”Italkedtoa
fewoftheemployeesandrealizedthattheunbelievableenthusiasmwas
genuine.
Theadvantagesofenthusiasticemployeesare
immense:Thecom-
pany’sexpensesarelowerbecauseitsemployeespilferless,customersarehappyandkeepcomingback,andinventorydoesnotstayonshelves
forlong(inventoryturnoverishigh).SamWaltoncalledemployees
“Wal-Martassociates,”and
mostareshareholders.5In2005and2006,
Wal-Mart’smanagement-employeerelationsdeterioratedoveremployee
healthcarebenefits.Thisprobablywasonereasonforadeclineinthe
company’sgrowthin2006.However,Wal-Marthasrespondedvigor-
ouslytocorrectthisproblemandimproveitsimage.
IsResearchandDevelopmentImportant?
Researchanddevelopment(R&D)isneededinallcompanies—notonlyhigh-techones—toimprovetheirproductsandservices.CompaniessuchasMcDonald’sandHomeDepotconstantlyimprove
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themselvesthroughcustomersurveys,researchinhumanrelations,mar-
ketresearch,andsociologicalresearch.HomeDepotwouldnotbea
greatsuccessstorywithoutitsresearcheffortsintoimprovingbuilding
materialsoritssurveysofcustomersonthequalityofChristmastree
needles.
R&Dinhigh-techcompaniessuchasMicrosoft,Cisco,andIntelis
clearlyevenmoreimportant,andthesecompaniescan’tsustaingrowth
withoutasignificantR&Deffort.Ifacompanyhasbeensuccessful
becauseofpastR&D,asimplebutmeaningful
questiontoaskiswhetheritiscontinuingthoseeffortsatthesamelevel.Whenthepersonalcomputerindustrywasrelativelynew,anumberofcompanies,including
KayproandCompuAdd,werehighlyprofitablebuthavesincedisap-
peared.Sometimes,companiesarehighlyprofitablebecausethey
copied
othersbutarenotinnovative.Withchangingtechnology,thesecom-
panies’growthfaltersatthenextjunctureofproductdevelopment.
Investorswhoextrapolatepastsalesgrowthintothefuturewithout
understandingtheneedforR&Dtosustainthegrowtharelikelyto
suffer.
YoumightthinkthatcompanieslikeWal-Martdonothavesignif-
icantR&Dexpenditures.Thatisnottrue.Wal-Marthasspentlarge
sumsofmoneydevelopingitshigh-techinventorycontrolsystemsand
oneofthemostup-to-datetransportationnetworks.Determiningwhich
companiesaresavvierinusingtheirR&Ddollarsisadifficulttaskforaninvestor.Merelybecauseacompanyoutspendsothercompaniesin
R&Ddoesnotimplythatitwillbringmoreblockbusterproductstothemarket.TheonlysolutionthatIknowofistoreadaboutthecompany
andlearnasmuchasyoucanfromvarioussources.
AcaseinpointisDellComputer,whichspentsubstantiallylesson
R&Dperdollarofrevenue
thanCompaqandIBM.Dellmaynotdo
basicresearch,butoneshouldnotimmediatelyconcludethatDellisleft
behindinproductinnovation.ThisisbecauseDelldependsmoreon
licensingpatents.Itspendslargesumsofmoneyondevelopmentandto
maintainthebestdirect-to-customermodel.DellhasbeenclosertoWal-
MartinitsbusinessplanthantoCompaqorIBM.MichaelDell’sbook
DirectfromDelldescribesDell’sR&Deffortstokeephiscompany’scostadvantageoverIBMandothers.6Thefocuswasnotonbasicresearch.
InsteadofcomparingR&Dexpensesacrosscompaniesinaneffortto
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pickthebestcompanies,youshouldevaluatethequalitativenatureof
R&Dexpensesandevaluatewhethertheyarekeepingupwithgrowth
inrevenues.
HowDoestheCompanyRespondtoChallenges?
Becauseoftheirculture,
somecompaniesadapttothechangingworld
fasterthanothers.Forsustainablegrowth,itisnecessarythatcompa-
niesrediscoverthemselvesoften.Formostcompanies,itisnoteasy
tochange,andevensomelargefirmsfailwhentheyencounternew
technologies.7
IBMdoesnotselltypewritersanymore.Diditsurpriseyouwhen
IBMsolditspersonalcomputerdivisiontoLenovoin2005?Notme.In
fact,IwonderedwhattookIBMsolong.IBMisnowaone-stopshop
forallsortsofcomputerhardware,software,andservices.Overtime,
IBMhasrediscovereditself.
Wal-Martisanothercompanythatseemstoadapttothetimes.Ini-
tially,itwasonlyadiscountstore.Later,itaddedSam’s,whichisa
buyer’sclub,andthengroceries.Wal-Marthasbeenexpandingoverseas
andishighlysuccessfulinChinaandMexico,butnotinGermany,Japan,
andKorea.InMexico,Wal-Mart’ssubsidiary(Wal-MartdeMexico)has
enteredthebankingindustry,openingbranchesinsideits
stores.Such
venturesdon’talwayshavetobesuccessful,butyouneedtomonitor
themforpotentialgrowth.Wal-Martispushinghardtobeasuccessful
Internetretailingcompany,andIwillnotbesurprisedifitbecomesan
InternetpowerhouseinthefuturetocompeteagainstAmazon.com.
Ifacompanyhasrediscovereditselfafewtimes,itsculturewillproba-
blyallowittocontinuedoingso.Thus,itisnecessarytotakealong-termperspectiveinselectingagrowthstock.Agrowthstockisnotnecessarilyayoung
company.WhentheInternetfirstarrived,Microsoftdidnot
considerittobeanimportantforce.However,Microsoftchangedits
opinionquicklyandremadeitself.Today,itisworkinghardtocompete
withGoogleonInternetsearchandadvertising.
Findingoutwhether
acompanyrediscoversitselfoftenrequiresaconsiderableamountof
research.Financialratiosjustdon’tcapturethesequalitativeaspectsofgrowthcompanies.However,theseeffortsarenecessaryifyouwantto
discoveroutstandinggrowth
companies.
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IsManagementQuality
Excellent?
PhilipFisher’sapproachisprobablythebestforjudgingthequalityofacompany’smanagement.Hesuggestsposingquestionstothecompany’s
consumers,suppliers,andemployeestogetagoodsenseofthequalityof
itsmanagement.Itisnot
impossibletodiscernthatWal-Mart,Google,
andSouthwestAirlineshaveexcellentmanagement.Also,eachyearFor-
tunepublishesalistoftheworld’smostadmiredcompaniesandBarron’spublishesalistoftheworld’sbestCEOs.Youmayknowsomeofthe
companiesinsuchlistswellandselectthemforfurtherinvestigationforinvesting.
Tomeasurethecommitmentofacompany’stopmanagement,find
outwhethertheseniormanagersowncompanysharesandwhetherthey
keepthesharestheyareawardedaspartoftheir
compensation.Ifthe
seniormanagersofacompanyselltheirsharessoonafterthesharesare
awardedoraftertheyexercisetheirstockoptions,youneedtoinvestigatethecompanycarefully.
Whyaresomemanagementteamsbetterthanothers?Idonot
claimtoknowtheanswertothisquestioninmostcases,buthereis
athought.EveryyearIaskgraduatingstudentsabouttheirpreferences
forthecompaniestheywouldliketoworkfor.Ithasalwaysamazed
mehowknowledgeableyoungpeopleare.Inthelate
1990s,thecom-
panyofchoicewasMicrosoft.Inthelate2000s,itisGoogle.Ifstudents,especiallytalentedones,chooseGoogleoverMicrosoft,thenGoogle’s
managementculturewill,overtime,changetoreflectthequalityofthe
peopleitemploys.Not
surprisingly,varioussurveysrevealthatmanyof
thesamecompaniesareidentifiedashavinggoodmanagementtimeand
againoveranumberofyears.Sincehigh-qualitymanagershavepridein
theircompaniesandthemselves,theyarelikelytotakestepstomaintain
thecompany’sreputation.
Hereisonemorecluetomanagementqualityorlackthereofthat
comesdirectlyfromBuffett’sprincipleofcirclesofcompetence.Whena
retailcompanyappointsanewCEOwithoutretailexperience,itraises
aredflagabouthisorherpotentialeffectiveness.Suchincongruous
appointmentsarecommon.Tothebestofmyknowledge,CEOsinBerk-
shiresubsidiariesallhaverelevantexperienceandenvioustrackrecords.
Avoidcompanyfinancialstatementsandother
documentstodecipher
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managementquality.Accordingtocompany
reports,allmanagersare
excellent!Thus,itisimperativetolookatothersourcesforinformationonmanagementquality.
HowImportantAreProfitMargins?
Whenprofitmarginsarehighandcanbemaintainedatthatlevel,growth
insaleswillproducebetterandbetterresultsasthecompanygrows.Oth-
erwise,growthinsaleswillnotbehighlyvaluable.AsPhilipFisherpointsout:“Allthesalesgrowthintheworldwon’tproducetherighttypeof
investmentvehicleif,overtheyears,profitsdonotgrowcorrespond-
ingly.Thefirststepinexaminingprofitsistostudyacompany’sprofit
margin.”8
Excellentgrowthcompaniesalmostalwayshavehighprofitmargins
relativetootherfirmsinthesameindustry.Forexample,onemight
assumethatWal-Martprobablyhassmallerprofitmarginsthanitscom-
petitorsbecauseitiswellknownforlowerprices.ThatisonereasongivenforKmart’slossofmarketsharetoWal-Martandfinallygoingbankrupt
in2002.YoumaybesurprisedtoknowthatWal-Mart’sprofitmargins
werehigher:3.4percentversus1.8percentbeforeKmartwentbankrupt.
Anexcellentcompanyrarelycompetesonpricealone.Thereareusu-
allyotherreasonsforitsexcellence.Myanalysisledmetobelievethat
Wal-Mart’shighprofitabilityispartlyduetoitsfocuson
highinventoryturnover.
Itisoftenarguedthatcompanieswithhighprofitmarginsattract
competition,andthus,theirhighprofitmarginswillultimatelygoaway.
Thetruthisnotthatsimple.Companieswithhigherprofitmarginscan
alwaysreducetheirpricestodrivethecompetitionawayandstillremain
profitable.WhilecompetitorssuchasAdvancedMicroDevicestryto
copyIntel’sproductstocompeteonprice,Intellowersthepriceofits
older-generationproductsandmovesontohigher-
marginproducts.In
theory,itispossibleforcompetitorstoultimatelycatchupwithIntel,
butitappearstomethat,inpractice,itismoredifficultthanitappearstoanunconnectedparty.Howcananothercompanyeasilycompetewith
amarketleaderand
innovatorlikeIntel,whichishighlyprofitableand
hasdeeppockets?Thecompetitionmustalsothinkofthepossibilityof
losingbillionsofdollars,notbeingabletocompete,andpossiblyeven
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goingbankrupt.Overall,high-profit–margincompaniesusuallyfallin
thegrowthcategory.
WhatIstheCompany’s
Achilles’Heel?
Withmanypotentialvariablestoexamine,Idonotrecommendthat
youusealonglistofvariablestoevaluateacompany’sgrowthprospects.
Howaboutlookingatacompanyfromanotherperspective?Whereis
theAchilles’heel?Thiswillhelpyoutonotfallinlovewiththestock.
Ifthesituationdeteriorateswithrespecttotheimportantvariables,youwillbeabletosellthestockbeforeitistoolate.Ifyoufallinlove,yousometimesmissthecuestosell.
Once,onaYahoo!chatboard,IaskedwhatBerkshire
Hathaway’s
Achilles’heelcouldbe.ThemostfrequentanswerwasBuffett’sage(77
in2007whenIaskedthequestion).Thequestionisclearlyanimportant
one.WithoutWarrenBuffett,willthestockpricetumble?Inmostcases,
whentheCEOofagreatcompanyretiresorresigns,thereisavacuum
atleastforawhile.AfterSamWaltondied,Wal-Mart’sstockpricewas
stagnantforatime.However,thecompanyremainedstrong;andfinally,
aftertwoorthreeyears,thecompanyresumedapathof
growth.
OneExampleofaNon-TechnologyGrowthStock
Thereareinnumerableexamplesofnon-high–techgrowthstocks,and
dependingonyourskills,background,andcommitmenttoacquire
knowledge,youshouldbe
abletofindsomeoftheminthefuture.Recent
examplesareWal-Mart,HomeDepot,Starbucks,Chipotle,Danaher,
andEatonVance.However,inthissection,wearegoingtodiscussone
specificexampleofanon-technologygrowthstock:McDonald’s.
In1980,McDonald’sstockpricewasabout$1pershare(split-
adjusted)comparedwithitspriceofabout$45persharein2000.On
average,thestockpricerosebymorethan20percentperyearorabout
twiceasfastastheoverallmarket.Evenifyouboughtit
in1990atabout$7pershare,youwouldhaveenjoyedatleastasixfoldincreaseinthe
stockpriceby2000.
ThequestionbecomeswhetheryoushouldhaveboughtMcDonald’s
commonstockin1990afterthecompanyhadexperiencedphenomenal
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growth.Overthepriorfiveyears,theearningspersharegrewatasteadyrateofabout14percentperyear,from
$0.28in1985to$0.55in1990.
McDonald’swasexpandingoverseassuccessfully.So,apersonwitha
goodknowledgeofthefast-foodindustryandMcDonald’swouldhave,
Ibelieve,surmisedthatearningswouldcontinuetogrowsteadily.The
earningspersharegrewfrom$0.55in1990to$1.40in1999.
WhenyouidentifyacompanysuchasMcDonald’sthathasgrown
steadily,youneedtofollowupbyaskingwhetherthecurrentpriceisreasonable.Inmydiscussion,IamnotincludingIPOs,tinycompanies,or
othercompaniesthataredifficulttovalue.TheP/EratiosofstockslikeMcDonald’saregenerallyhighinrelationtotheirhistoricallevelsorthemarket,andtheyremainhighforlongperiods.Youshouldnotimmediatelyconcludethatthestockisexpensiveandthatyouhavemissedthe
boat.Itisuncommonforagrowthstocktotradeatalow
P/Eratio.
Thestockisstillworthbuyingaslongasthepriceisnotastronomical,
sayabove25or30timesearnings,andyouareconfidentaboutfuture
growth.OnlyinrarecasesdostockstradingaboveaP/Eof30generate
highreturnsoveralongperiod.
By2000,McDonald’sP/Ewas32.AP/Eof32washighincontrast
toitsmedianP/Eofabout18intheprior10yearsorthelong-run
S&P500P/Eofabout16.Thisiswhenknowledgeofthefirmbecomes
important.Itwasstillagoodcompanyandwasexpectedtogrow,albeit
ataslowerrate.Itwasjustnotagoodtimetobuy.
Fromaninvestingpointofview,onethingyoucandoistowait
foropportunitiesingoodgrowthstocksonceyouidentifythem.With
McDonald’s,youwouldhavedonewellifyouhadinvestedin2003
whenthestockhitalowofabout$13pershare,primarilybecauseof
anoutbreakofmadcowdiseaseintheUnitedKingdomandisolated
placeselsewhere.TherumorsofthedemiseofMcDonald’s
provedtobe
wrong.Whatabargaingrowthstockitwas!In2009,itsstockpricewas
around$53pershare.
Conclusions
Tofindapromisinggrowthstock,Irecommendthatyoustartbyexamin-
ingearningsforseveralyearsbecausecompaniesthathavegrownstrongly
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forseveralyears,onaverage,aresoundcandidatestogenerategoodearn-
ingsinthefuture.Youalsoneedtoexaminequalitativevariables,such
asthequalityofmanagementandcompanyculture,astheyarethetrue
underpinningsoffuturegrowth.Beforeyoubuya
growthstock,you
shouldconsiderthepossibilitythatthepricemayalreadybereflecting
ahighgrowthpotential.YoumaydosobyevaluatingitsP/Eratioor,
preferably,computingitsintrinsicvalueasIdiscussinthenextchap-
ter.Overall,successingrowthinvestingrequiresyoutohaveavery
goodknowledgeofthecompany’sbusinessandanabilitytoforecastits
earningswell.
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Chapter5
IntrinsicValue
Ingeneralterms,it[intrinsicvalue]isunderstoodtobethat
valuewhichisjustifiedbythefacts,e.g.,theassets,earnings,
dividends,definiteprospects,asdistinct,letussay,frommarket
quotationsestablishedbyartificialmanipulationsordistortedby
psychologicalexcesses.1
—BenjaminGrahamandDavidDodd
Beforeyouriskyourhard-
earnedmoneyonastock,youprobably
wanttoknowthevalueyoucanexpecttogetinreturn.The
valueyouassigntoastock,orthatstock’sintrinsicvalue,isthemaximumamountthatyouarewillingtopaynowforfuturebenefits,
whichcouldcomefrom
dividendsorthepotentialsaleofthestock
atarealisticfutureprice.Itmakesnosensetobuyastockwhenits
intrinsicvalueissmallerthanthecurrentprice.Buffettcautions:“The
calculationofintrinsicvalue,though,isnotsosimple...intrinsicvalueisanestimate
ratherthanaprecisefigure.”2Inthischapter,IcomputetheintrinsicvalueofWescoFinancial,Coca-Cola,andBerkshireHathaway
tomorethoroughlyexplainthisconcept.
ComputingIntrinsicValue
Individualsdifferfromoneanotherinassessing
companies’future
prospects.Theyalsodifferintheirrisktolerance.Hence,itshouldbe
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nogreatleaptoacceptthatthereisnouniqueintrinsicvaluethatcan
beassignedtoacommonstockuponwhicheveryonewillagree.In
computingintrinsicvalue,
youshouldstartbyexaminingacompany’s
balancesheet.Someassets,suchascashandinvestmentsinmarketable
securities,arereportedatmarketvalue.Asafirstapproximation,the
intrinsicvalueofsuchitemscanbetakentobethesameastheirmarket
values.Formostcompanies,however,themajorcomponentofintrinsic
valuecomesfromtheirfutureearnings.
Forvaluationoffutureearnings,youcanstartwithestimatinga
growthratebasedonyourevaluationofthecompany’spastperformance.
Thenyoucanapplytheestimatedgrowthratetocurrentearningsto
approximateexpectedearningsforafutureyear,say,10yearsfromthe
currentyear.Finally,applyaP/Emultipletothefutureearningsper
sharetoestimatethevalueofthoseearningsinthefuture
anddiscount
themtotheirpresentvalue.Inaddition,dividendsshouldbeproperly
accountedfor.
Whileitisasimpleapproach,itrequiresmanyassumptions.For
example,youmayhavetoadjustreportedearningsinan
attemptto
obtainunderlyingorsustainableearnings.Youalsoneedtoassumea
growthrate,aP/Emultiple,andadiscountrate.Withthisapproach,it
isimportanttoknowthecompany’sbusinesswellforyoutocomeup
withreliableestimates.
Let’sexaminethreeexamplesofevaluatingcommonstocks.The
firstone,Wesco,iseasytoevaluatebecausemostofitsassetsarein
marketablesecurities.EarningsplayalimitedroleinWesco’sintrinsic
value.Incontrast,Coca-Cola’svalueisdrivenprimarilybyitsearnings.
Finally,IpresentanapproachtoestimatingBerkshire’sintrinsicvalue.
Wesco:FocusontheBalanceSheet
WescoFinancialCorporationisan80.1percentsubsidiaryofBerkshire
Hathaway.CharlieMunger,vicechairmanofBerkshireHathawayand
chairmanofWesco,hasestimatedtheintrinsicvalueofWescoinselected
prioryears.Thisanalysisfollowshisargumentsusingdatafromthe2008
annualreport.
Table5.1presentstheWescobalancesheetinasummaryform.
Wescohastotalassetsof$3,051million,ofwhich$298million,roughly
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Table5.1
WescoFinancialCorporationBalanceSheet,
December31,2008
Assets
Cashandcashequivalents
$298
Investments
Marketableequitysecurities
1868
Securitieswithfixedmaturities
29
Otherassets
856
Totalassets
$3,051
LiabilitiesandShareholders’Equity
Liabilities
Float(Insurancelossesnotyetpaid)
$215
Incometaxespayable,deferred
231
Otherliabilities
227
Totalliabilities
673
Shareholders’equity
2,378
Totalliabilitiesandshareholders’equity
$3,051
Dollaramountsinmillions.
10percent,areincashandcashequivalents.Themarketablesecurities
of$1,868millionareprimarilyinProcter&Gamble($386million),
Coca-Cola($326million),WellsFargo($373million),andKraftFoods
($269million).Thus,mostofWesco’sassets(cashandcashequivalents,
securitieswithfixedmaturities,andinvestments
of$298million,$29
million,and$1,868million,respectively),amountingto$2,195million,
arereportedatmarketvaluesandmaybeconsideredliquidassets.
Weshouldsubtractliabilitiesfromtheseassetstotheextentthey
arerelatedtotheassets.Ontheliabilitiesside,totalreportedliabilitiesare$673million.Thereareonlytwomeaningfulitemsthataredirectly
relatedtoinvestments:thedeferredincometaxespayableof$231million
andthefloatof$215million.Botharenon-interest–bearingliabilities.
ThefirstamountispayabletotheIRSonlywhenthesecurities(suchas
Procter&Gamble)aresold.Thus,itisessentiallyaninterest-freeloanfromtheIRStoWesco.Youneedtoestimatethetruevalueofthis
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liability.Ifyouassumethatthesesecuritieswillnotbesoldforalongtime,thetaxeswillalsonotbepaidforalongtime.Then,mostofthis
liabilitymaybeignoredfor
valuingWesco.Thus,thetruevalueof
theliabilityissomewherebetweenzeroand$231million.Iassumethe
trueliabilitytobe$115million,halfwaybetweenzeroand$231million.
Thesecondliability,float,isthetermformoneythecompanyholds,andaslong
asinsuranceunderwritingresultsarebreak-even,itcoststhecompanynothing.Iassumethatthecompanywillnothavetopaythis
floatforanyforeseeablefutureandmayevengeneratesomeincomefrom
thefloat.Thus,Iwillassumethatthefloatfromtheinsurancebusiness
isessentiallyfree.Subtractingtheliabilityof$115millionfrom$2,195
millionequals$2,080millionasanestimatedvalueofliquidassets.
IfWescodidnothaveanyoperatingsubsidiaries,wecouldstophere.
Wesco’stotalnetincomefor2008was$82million.Outof
this,$64mil-
lioncamefrominvestments,andtheremaining$18millioncamefrom
operatingbusinesses.Havingalreadyassignedavaluetotheinvestments,
weshouldconsideronlytheremaining$18million.Anexamination
oftheearningsoverthepastfewyearssuggeststhattheseearningsare
sustainable,asearningshavebeensimilarinrecentyears.BecauseWesco
hasnodebtandearningsarelikelytoremainatleastatthisleveland
possiblygrow,Iuseasimpleapproachtovaluethese
earnings.Iassign
aP/Emultipleof15thatresultsinavaluationof$270millionforthe
operatingbusinesses.So,myestimateofintrinsicvalueofWesco’scom-
monstockis$2,080million+$270million,or$2,350million.Based
onthenumberofsharesoutstanding(7.12million),thistranslatesinto
anestimatedintrinsicvalueof$330pershare.Incomparison,themarket
priceattheendof2008was$288pershare.Notethatwemadesev-
eralassumptions,andourestimateofintrinsicvalue
wouldchangeifwe
usedadifferentvaluationforthefloatfromtheinsurancebusiness,the
estimatedP/Eratio,orthevaluationofdeferredtaxes.Ourestimateof
intrinsicvalueisclosetothebookvaluepershareof$334reportedby
thecompanyattheendof2008.3
YouhavesurelynotedthatWesco’sintrinsicvaluedependsaloton
thevaluationofitsinvestments—thatis,themarketpricesofProcter&Gamble,Coca-Cola,WellsFargo,andKraftFoods.Asafirstapproximation,wehaveusedmarketvaluesofthese
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considercomputingintrinsicvaluesoftheseholdings.Rememberthat
theintrinsicvalueisanestimate—evenmoreimportant,itisjustone
person’sestimate,whichcanvarywidelyacrossindividuals.Inthiscase,myestimateof$330wasnotvastlydifferentfromthemarketpriceof
$288pershareattheendof2008.So,Wescowasnotabuy.
Coca-Cola:FocusonEarnings
UnlikeWesco,Coca-Coladerivesitsvaluefromitsearnings.Inthe
caseofWesco,wedidnotemphasizegrowthinearnings.Coca-Colais
different,anditpresentsagoodexampletodiscussgrowthinearnings.
Iwilluse1998asthebaseyearforthispurposebecauseitgivesusan
opportunitytolookatdevelopmentssincethen.
Attheendof1998,Coca-Cola’stotalassetsof$19.14billionwere
mostlyrepresentedbytangibleassets.Thecompany’sliquidassetsinthe
formofcashandmarketablesecuritieswereonly$1.81billion.An11-
yearhistorydetailedintheannualreportshowedthatCoca-Cola’scash
andmarketablesecuritiesin
1998,atabout10percentofrevenues,were
inlinewithhistoricallevels.Also,theywerelessthan1percentofthemarketvalueofthecompany’sshareholders’equity.Therefore,weneed
nottreatthemseparatelyaswedidforWesco.Iassumethatthismuch
cashandmarketablesecuritiesareneededtorunthecompany.
Thenextstepistothinkmoreclearlyaboutgrowthprospects.In
the10yearsbefore1998,Coca-Cola’srevenuesgrewattherateof8.8
percentperyear,anditsearningspersharegrewat
14.5percentperyear.
However,intheimmediatelyprecedingfiveyears,thegrowthinrevenues
hadslowedto6.0percent,andearningspershareto11.2percent.
Thecompany’searningsfor1998were$1.42pershare,which
seemedsustainablebecauseearningspershareforthepriorthreeyears
weresimilar:$1.67,$1.40,and$1.18,respectively.Itseemedreasonable
toestimatethefuturegrowthinearningstobe10percentperyearfor
thenext10years,whichwasclosertothepreviousfive
years’growth
inearnings.Underthisassumption,in10years,expectedearningsfor
2008(basedondatain1998)wouldbe$3.68pershare.Next,weneedto
estimateareasonableP/Emultipleforearningspersharefor2008.For
alow-debt,well-managedcompany,aP/Emultipleof15to20appears
reasonable.However,forthepurposeofthiscomputation,let’susea15
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P/Emultiplethatgivestheexpectedvalueofearningsattheendof2008
as15×3.68,or$55.20pershare.
Thepresentvalueof$55.20dependsonthediscountrate
assumed.
IthinkofthediscountrateastheminimumrateatwhichIwouldbe
comfortableowningapartofthecompany’sbusiness.Thediscounted
valueof$55.20in1998atthediscountrateof7percent(alowrate,
butanassumptionbasedonthemortgagerateIwaspayingatthetime)
is$28.06pershare.IfCoca-Colawasnotpayinganydividends,that
wouldbeoneestimateoftheintrinsicvalueofCoca-Colaattheend
of2008(orinearly1999when1998year-end
accountingdatabecame
available).
Weshouldaddthevalueofdividendsatleastfortheamounts
expectedtobereceivedduringthefollowing10years.Thecashdiv-
idendin1998was$0.60pershare.Assuminga10percent
growthrate
individends(similartothegrowthrateinearnings),aninvestorwould
havereceived$0.66in1999,andsoon.Usingadiscountrateof7per-
cent,thediscountedvalueofthenext10years’dividendsis$9.83per
share.Therefore,myestimateofCoca-Cola’sintrinsicvaluein1999was
$28.06+$9.83=$37.89.
Inthefallof1999,whenImadethesecalculationsinaclassIwas
teaching,thestockpricewasabout$70pershare.Basedonthesecalcula-
tions,Coca-Colastockseemedovervaluedbyalmost100percent.Note
thatweestimatedthatinearly2009,theCoca-Colastockpricewould
bearound$55.20pershare.Inearly2009,theCoca-Colastockprice
was$45pershare;andtheP/Emultiple,basedon
trailing12months’
earnings,was18.
Youcanaddmanyotherchangesandcomplications.Forexample,
youcouldarguethatweshouldvaluedividendsdifferentlyfromearnings
becausedividendsarebeingpaidoutwhileearningsare
not.Youcould
havesimplyusedthedividenddiscountmodelgenerallyattributedto
MyronGordon.4Overall,dependingonassumptions,youcouldhave
producedsubstantiallydifferentestimatesofCoca-Cola’sintrinsicvalue
inearly1999.
Afewadditionalcommentsontheanalysisareworthmaking.Coca-
Colaisastablecompany,soitisrelativelyeasytoestimatefutureearnings.
Thepossibilityofyougoingverywrongislow.Giventhattherearefar
toomanyuncertaintiesforhigh-techcompanies,youshouldthinkmore
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carefullyabouttheirfutureearningsbeforeyoucomputeintrinsicvalue
inasimilarmanner.
EvenCoca-Cola’sstockpricefluctuatedbyafactoroftwobetween
1998and2009.Ithasseenalowoflessthan$40pershareandahighof
morethan$85pershare.Soifyoudonothavealong-termviewanddo
nothavesufficientliquidity,youmaynotachieveyourgoalofreasonablereturnswithanycompany’sstock.Forexample,ifyousuddenlyneed
fundsandarerequiredtosellwhenthepriceislow,youmightlosea
substantialamountofyouroriginalinvestmentevenifyouinvestinCoca-
Cola,letaloneinstocksofcompanieswithlesspredictableearnings.
Thereisanotheradvantagetocomputingintrinsicvalue.Itkeepsyou
groundedsothatyoudonotbecomenervouswhenthe
stockpricegoes
down.Asamatteroffact,IconsideredbuyingCoca-Colastockwhen
thesharepricewasaround$40,downfrom$85.ButIdidnotbecause
intrinsicvalueestimatesstilldidnotjustifybuying.
Acheck:WhileIwas
assigninga15to20P/EmultipletoCoca-
Cola’sstock,IwonderedwhytheP/Emultipleinearly1999was
$70/1.42,orabout49.Itcouldhavebeen25oreven30,butwhy
didthestockcommandahighP/Eof49?Aroundthen,themarket
wasassigninghighvaluationsnotonlytoCoca-Colabutalsotoahost
ofotherstocks,especiallyInternetstocks.Thesestockswereboatsthat
werebeingliftedinarisingtide.Whatcanwelearnfromthis?Youcouldsay,“Themarketwaswrong,”butforme,unfortunately,thatisnevera
satisfactoryanswer.Iwouldask,“Whywasthemarketwrong?”Isimply
donothaveasatisfactoryanswertothequestion,“WhywasCoca-Cola’s
stockpricesohigh?”Nevertheless,whenitdoeshappen,itisbestnot
tobuy.
BerkshireHathaway:IntrinsicValue
Let’scomputeBerkshire’sintrinsicvalue.BuffetthasneverfurnishedhisestimateofBerkshire’sintrinsicvalue,norhashesuggestedawell-definedapproach.However,hehasfrequentlydiscussedvariousinputsthatmay
beconsideredbyinvestors.
MyapproachisbasedonBuffett’srecent
hintsonhowtocomputeBerkshire’sintrinsicvalue.Asmentionedin
thepreface,myobjectivehereistolearnasmuchaswecanfromBuffett’swritings.
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Table5.2
BerkshireHathawayDataforItsValuation
Per-share
Pretaxearningspershare
Year
investments
(noninsurancebusinesses)
2000
$50,648
$
848
2001
47,460
1,379
2002
52,705
2,215
2003
62,273
1,971
2004
66,967
2,148
2005
74,129
2,441
2006
80,636
3,625
2007
90,343
4,093
2008
77,793
3,921
2000–2008compounded
growthrate
5.50%
23.10%
Onewaytocomputeintrinsic
valueistostartbyestimatingexpected
futurecashflowsthatcanbetakenoutofabusiness.Ifcashflowsare
nottakenoutofthebusiness(asinthecaseofBerkshire),theyresultinadditionalgrowth.Wecanthenextrapolatepastgrowthintothefuture
withanyadjustmentsthatwedeemappropriate.InthecaseofBerkshire,
cashflowsultimatelyendupinoneoftwoplaces.
1.Investments,suchasstocks,bonds,andcashequivalents.These
includeequityinvestmentsAmericanExpress,WellsFargo,etc.
2.Purchaseofmajority-ownedorfullyownedsubsidiariessuchas
DairyQueen,NetJets,etc.
Byvaluingthesetwoitems,wecanvalueBerkshire.Tovaluethe
investments(item1),wewillusetheirmarketvalues.Tovaluesub-
sidiaries(item2),wewillusetheirearnings.Buffetthasperiodically
givennumbersforboththeseitemsinBerkshire’sannualreports.Let’s
examinethehistoricalperformancefromTable5.2.
1.Berkshire’sinvestmentspersharegrewfrom$50,648in2000to
$77,793in2008,acompoundedgrowthrateof5.5percentper
year.Fortheperiod1995to2006,Buffettreportsthegrowthtobe
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12.6percent.Thelowerrecentgrowthprobablyreflectsadditional
investmentsinfullyownedsubsidiaries,theincreasingsizeofthe
company,andespeciallythemarketcrashof2008.
2.Thepretaxearningsofnoninsurancebusinesseshavegoneupfrom$848persharein2000to$3,921persharein2008.5Thisgrowth
rateinearningsamountsto21percentperyear.Fortheentireperiod
from1965to2008,thecompoundedannualgrowthratewasabout
17percent.Therecenthighgrowthinearningsisprimarilydueto
acquisitions,asBerkshire’sfocusshiftedtowardusingmorefreecash
flowsforthispurpose.Undertheassumptionthattherecentpattern
ofusingcashflowswillcontinue,wewillapplythe
growthrateof
21percenttoestimatefutureearnings.
Let’sconsiderwhatthecompanywilllooklike10yearsfromnow.
RecallthatwedidnotusesuchprojectionsincomputingWesco’sintrin-
sicvalue,asitdidnotseem
importantanditwasnoteasytodoso.InthecaseofBerkshireHathaway,thereareatleastthreequestionstoconsider.
rIsthegrowthrategoingtobesmallerorhigherthanthepercentages
wejustcomputed,orthesame?
rHowlongisthegrowthrate
goingtolast?
rFinally,whatdiscountrateshouldweuse?
Ididn’tseeanythinginthevariousannualreportsthatsuggeststhat
weshouldnotusethecompany’srecentgrowthrates,solet’suse5.5
percentforinvestmentsper
shareand21percentforearningsofnonin-
surancebusinesses.The5.5percentgrowthrateforinvestmentsappears
lowandthe21percentgrowthratefornoninsuranceearningsappears
high,butyoucanalwaysusedifferentratesandgetdifferentintrinsic
valueestimates.Alsonotethatiftherearenonewacquisitionsforgrowth,Berkshire’scashflowswillbeusedtowardahighergrowthininvestments.
Asbefore,Iwillusethediscountrateof7percentfordiscountingfuturevaluestocomputethecurrentintrinsicvalueestimate.6
Basedontheseassumptions,
10yearsfromnow—thatis,attheend
of2018—thevaluesareexpectedtobeasfollows:
Investmentspershare:
$132,882
Pretaxearningspershare:
$26,379
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Let’svalueinvestmentspershareattheirreportedvalueof$132,882
becausetheyareessentiallyatmarketvalue.Forearnings,IuseaP/E
multipleof10onpretaxearnings(whichisequaltoamultipleofabout
15onafter-taxearnings).Ifwedothat,wegetaper-sharevaluationof
Berkshire’scommonstock,classA.Theestimatedvalue
10yearsfrom
nowis$132,882+10(26,379)=$396,672.Thepresentvalueofthis
dependsonthediscountrateyouuse.Witha7percentdiscountrate,
thatgivesapresentvalueof396,672÷1.97,or$201,356.
Wearealmostthere.Similar
toourapproachtoWesco,ifweassume
thatthecostoffloatiszeroandusehalfthedeferredtaxliabilityamount,weendupsubtractingabout$3,300persharefrom$201,356.Rounding
itoff,myestimateofBerkshire’scurrentintrinsicvalueis$198,000pershare.
Wow!ItseemsthatBerkshirewasundervaluedatthetimeofthis
analysisinearly2009asthemarketpriceofthestockwasaround$90,000
perclassAshare.So,Berkshirestockwasabuyandremainssoin
November2009,withthestockpricearound$100,000.
ThiscomputationdoesnotimplythatBerkshire’sstockpriceislikely
tojumpintheshortrun.Itisdifficulttoknowhowandwhenpriceswillreflectvalueevenifmyestimatesarecorrect.Idon’tknowhowother
marketparticipantsarethinkingandvaluingBerkshire.Thisisjustmy
estimate.Asearningsgodownin2009becauseofrecession,itwillnot
surprisemeifBerkshire’sstockpricegoesdownorremainsaboutthe
sameintheshortterm.However,let’sexaminewhatthefuturevalues
implyintermsofexpectedreturns.Ifyoupurchasea
BerkshireclassA
shareat$90,000,theimpliedrateofreturnis16percentperyearifthestockpricedoesreach$396,672.
Acheck:Let’susethedatafrom2006and2007toexaminethevalid-
ityofthisapproach.For2006,theinvestmentspersharewere$80,636,
andthepretaxearningspersharewere$3,625.Ignoringadditional
minorestimates,thisgivesusaper-sharevalueof$80,636+10(3,625)
=$116,886.Inearly2007,whenthe2006annualreportbecameavail-
able,thestockpricewasabout$110,000.Somaybe
ourmetricisslightly
generousinvaluingBerkshirecommonstock.Butitisnotdramatically
differentfromthepriceinthemarket.Usingthesamemetricfor2007
data,anestimatedintrinsicvalueinearly2008is$90,343+10(4,093),or$131,273.Thestockpricein
early2008was$140,000.Berkshire’sstock
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pricesmoveconsiderably
withthemarketbecauseofitslargeinvestments
incommonstocks.
WhentoBuyAnyStock:
ConsiderMarginofSafety
Wecomputedintrinsicvaluesofthreecompanies,andweknowthata
stockshouldbepurchased
onlyifthemarketpriceisbelowthestock’s
intrinsicvalue.Aquestionthatyoumustaskis:“Howmuchlowershouldthepriceberelativetotheintrinsicvalue?”Ithinkofmarginofsafetyforanystockasthedifferencebetweenastock’sintrinsicvalueanditsmarketprice.Ifyoubuyastockatitsintrinsicvalue,youwillhavenomargin
ofsafety.Ifeverythinggoesasyouassumeinyourcalculations,youwillearnanannualrateofreturnequivalenttothediscountrateassumed.
Forexample,ifyouassumeadiscountrateof7percentaswedidinthe
examplesandpurchasethestockatintrinsicvalue,yourannualrateof
returnwillbe7percent.Ifthesamestockispurchasedat25percent
belowtheintrinsicvalue,thecalculationsshowthattherateofreturn
willbeabout10percentperyear.Andifthestockisathalftheintrinsicvalue,therateofreturnwillbeabout15percent.Soitseemslogicalthatyoushouldbuya
stockwithalargemarginofsafety.Analternatewayof
thinkingaboutlookingforalargemarginofsafetyistorequirealarge
discountrate.
Afewpointsyoushouldbefullyawareof:First,incomputations
ofBerkshire’sintrinsic
value,investmentspersharearebasedonmarket
prices.Asthemarketgoesupordown,thevalueofinvestmentsper
sharewillchangeaccordingly.Iftheunderlyingstocksareoverpricedor
underpriced,theintrinsicvaluewillalsobebiased
upwardordownward.
Second,wereliedonoperatingearningsofnoninsurancesubsidiariesto
growattherateof21percent.WiththeNovember2009announcement
oftheBurlingtonNorthernSantaFeacquisition,thegrowthratein
earningsisnowmorelikelytobeaccomplished.
Giventhattherearemanyassumptionsinvolvedinthisprocess,you
shouldcomputedifferentnumbersbasedonthoseassumptions.The
proportionyouinvestinanindividualstockshoulddependonitsmargin
ofsafetyandyourconfidenceinyourcomputationofitsintrinsicvalue.
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Finally,youshouldlearnaboutthemanagement.IfyouhaveaBuffettor
Mungertypeonyourside,asmallermarginofsafetyshouldbeadequate.
Conclusions
Thischapterisdevotedtoexplainingthemethodologybehindestimating
theintrinsicvalueofacommonstocktoprovideyouwithaguidelinefor
abuyorselldecision.Itisimportanttolearnalotaboutthecompanysothatyoumayconsideranappropriatemethodforcomputingitsintrinsic
value.Youshouldinvestonlywhenthemarginofsafetyishigh.
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Chapter6
BuffettInvesting=
Value+Growth
[M]ostanalystsfeeltheymustchoosebetweentwo
approaches
customarilythoughttobeinopposition:“value”and“growth.”
...Inouropinion,thetwoapproachesarejoinedatthe
hip:Growthisalwaysacomponentinthecalculationof
value.1
—WarrenBuffett
MostpeoplecharacterizeBuffettasavalueinvestor.Thecom-
monusageofthetermvalueinvestorconnotessomeonewho
investsinstocksthathavesuchcharacteristicsaslowprice-
to-earnings(P/E)ormarket-to-book(M/B)ratios.Italso
referstothose
peoplewhobuystocksafterthemarketpriceshavefallensubstantially.
Presumably,suchinvestorshaveasufficientunderstandingoftheunderly-
ingbusinessesandexpectthepricestorecover.AsBuffett’swordsclearlystate,asmartinvestorshould
considerbothvalueandgrowthinvesting
simultaneously.Contrarytopopularbelief,Buffettisnotapurevalue
investor.Inthischapter,IillustratethewayBuffettcombinesvalueandgrowthinvestingstrategiestoearnhighreturns.
69
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BerkshireHathawayIsaGrowthStock
Foreachofthepastfourdecades,BerkshirehasoutperformedtheS&P
500index.Table6.1presentstheannualizedratesofgrowthinBerk-
shire’sbookvaluepershare,Berkshire’sstockreturns,andcorrespondingreturnsontheS&P500index.Fortheentire40-yearperiodendingin
2008,Berkshire’sannualizedgrowthinper-sharebookvalueis20.7per-
centanditsannualizedstockreturnis21.8percent.Ifyouhadinvested
$10,000inBerkshirecommonstockatthebeginningof1969,your
investmentwouldhavegrownto$26.7million.On
theotherhand,
theannualizedreturnontheS&P500indexhasbeenonly8.9per-
cent,whichwouldhavegrownyourinvestmentfrom$10,000toonly
$302,000.Clearly,Berkshirehasbeenalong-termgrowthstock.
Berkshire’srateofgrowthseemstohaveslowedinrecentyears,maybe
becauseofitslargesizeandmaybebecauseofeventsincludingtheter-
roristattackontheUnitedStatesin2001andthemarketcrashin2008.
Since1965,Berkshirehassufferedadeclineinbook
valuepershareonly
in2001and2008.Still,eveninthemostrecentdecade,Berkshirehas
generated4.7percentabovethecorrespondingreturnsontheS&P500
index.
Berkshire’sresultsinTable6.1includethosefromits
majority-owned
orwhollyownedsubsidiariesanditsminorityholdingsthroughcommon
Table6.1
Berkshire’sPerformanceversustheS&P500
AnnualChange
Inper-share
InS&P500
Berkshire’sstock
10-yearperiods
bookvalueof
InBerkshire
(dividends
performance
andthe40-year
Berkshire
stockprice
included)
relativetoS&P500
period
(1)
(2)
(3)
(2)–(3)
1969–1978
20.5%
15.9%
3.1%
12.8%
1979–1988
28.2
40.4
16.2
24.2
1989–1998
29.0
31.0
19.2
11.8
1999–2008
6.4
3.3
−1.4
4.7
1969–2008
20.7
21.8
8.9
12.9
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stocks.DetaileddataonpurchasingandsellingdatesandpricesonBerk-
shire’sminorityinvestmentsincommonstocksarehardertocollect.
However,GeraldMartin
fromAmericanUniversity,WashingtonDC,
andJohnPuthenpurackalfromUniversityofNevada,LasVegas,col-
lectedthedetaileddataonBerkshire’sinvestmentsincommonstocks
andanalyzedthemcarefully.2For1976–2008,theBerkshirecommon
stockportfoliogeneratedanaveragereturnof18.2percent,handilybeat-
ingthe10.6percentthattheinvestmentswouldhavegeneratedifthe
investmentshadbeenmadeintheS&P500index.
ItseemsalmostimpossibletoduplicateBuffett’strackrecord.How-
ever,thegoodnewsisthatovertheyears,hehasprovidedanextensive
bodyofwrittenandspokenmaterialonhisideasandprinciples.Evenif
wecannotduplicateBuffett’sresults,weshouldatleastbeabletolearnfromhisownmethodstoimproveourresults.IbeginwithabriefdiscussionofwhyBuffett
mayhaveinitiallyinvestedinGEICOin1976,
andlateralludetosomeotheracquisitionsanddrawsomeinferenceson
salientfeaturesofhisinvestingstyle.
ValuePlusGrowth
GEICO’sstockpricesoaredfrom$5inthelate1950sto
morethan$60
in1972.Then,theCinderellastoryended.Onthebrinkofbankruptcy,
thestocktradednear$2persharein1976.By1977,Berkshirehad
purchased1.29millionsharesfor$4.1million,averaging$2.55pershare.
Inaddition,Berkshireinvested$19millioninaGEICOconvertible
preferredstockissuanceof$75million.By1980,Berkshire’sinvestment
inGEICOwas$47million,whichamountedtoabouta33percent
equityinterestinGEICO.AsGEICOrepurchaseditsown
sharesover
thenext15years,Berkshire’sownershipofGEICOincreasedto50
percent.
Invalueinvesting,thepurposeofusingtheP/Eratiooranother
metricisnottobenefitfromsomespecialqualityofthe
metricperse.
Theunderlyingpurposeofusingsuchmetricsistowarntheinvestor
toinvestonlywhenthedownsideriskislow.Atthetimeoftheinitial
GEICOpurchase,thecompanywasincurringlosses,andhence,the
P/Eratiowasmeaningless.Becausethecompanywasabouttodeclare
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bankruptcy,itsbookvaluealsodidnotmeanmuch.However,after
raisingadditionalequityfromBerkshireandothers,thecompanywas
savedfromfilingforbankruptcy.Consequently,Buffett’sinvestmentdid
nothaveahighprobabilityoflosingmoney.ThisattentiontodownsideriskisthemainingredientthatBuffettborrowsfromthevalueinvestingstrategy.
IfBuffettwerejustaplainvanillavalueinvestor,hewouldprobably
havesoldtheGEICOsharesafterthepricehadgoneupbymorethan
100percentinlessthanayearofhisinitialpurchaseorwithinafewyearsthereafter.HeunderstoodGEICOwell,ashehadfollowedthecompany
since1951.Overall,heinvestedinGEICOforitspotentiallong-term
growth,justasagrowthinvestorwould.Berkshire’s$47millioninvest-
mentinGEICOgrewbyabout50times,to$2.3billion,by1995when
hepurchasedtheremainderofthefirm.GEICOisagoodexampleof
howBuffett’ssuccessliesinidentifyingcompaniesthatarenotjustvalueinvestmentsbutalsohavegoodgrowthpotential.Buffett-styleinvesting
orBuffettinvestingisnotjustpurevalueinvesting;itisvalueplusgrowthinvesting.
Thevalueinvestingapproachissometimesknownasthequantitative
approachbecauseofitsfocusonmathematicalvariablessuchastheP/E
ratio,whilethegrowthinvestingapproachisoften
referredtoasthequalitativeapproachbecauseofitsfocusonharder-to-calculatevariablesbasedonfutureestimates.Obviously,Iamnotclaimingtohavediscoveredthe
approachofcombiningvalueandgrowthasasuperiorapproachtovalue
investing;Buffettgetsfullcreditfordevelopingit.
Buffetthasdescribedhisinvestingapproachinbitsandpiecesinmanydifferentplaces.The
followingstatementstakenfromhis1967lettertohispartnersprobably
givethebestcluestohisphilosophicaldevelopmentinthisregard.He
writes:
AlthoughIconsidermyselftobeprimarilyinthequantitativeschool,
thereallysensationalideasIhavehadovertheyearshavebeenheavily
weightedtowardthequalitativesidewhereIhavehada“high-
probabilityinsight.”Thisiswhatcausesthecashregister
tosing.
However,itisaninfrequentoccurrence,asinsightsusuallyare,and,
ofcourse,noinsightisrequiredonthequantitativeside—thefigures
shouldhityouovertheheadwithabaseballbat.So,thereallybig
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moneytendstobemadebyinvestorswhoarerightonqualitative
decisions,but,atleastinmyopinion,themoresuremoneytendsto
bemadeontheobviousquantitativedecisions.3
Clearly,Buffettbelievesthataconsiderableemphasisongrowth
investingisnecessaryifonewantstoearnlargereturns.
ImplementingValuePlusGrowth
ToimplementBuffett-styleinvestingforcommonstocks,youmay
employatwo-stepprocess.First,decidewhetherthedownsiderisk,
ortheriskoflosingyourinvestment,islow.Often,lowP/EorM/B
metricssuggestalowdownsiderisk.Second,afterhavingjudgedthat
thedownsideriskislow,youshouldanalyzethestock’sgrowthpotential
andcomputeitsintrinsicvalueandmarginofsafety.Youshouldbuya
stockifthemarginofsafetyishigh,evenifitsP/Eis
abovethemarketP/Eorabovethecompany’shistoricalaverageP/E.Notallyourinvestmentswillturnouttobewonderfulgrowthstocks.However,sinceyou
protectedyourselfbytakingalowdownsiderisk,youwillnotloseoften
and,whenyoudounavoidablylose,youwillnotlosemuch.AsIexplain
next,yourgainscanstillbeveryhighifonlyafewofyourinvestments
turnouttobetrulysuccessfulgrowthstocks.
Thesubstantialbenefitofinvestingingrowthstockscanbeillustrated
byahypotheticalexample.Itshowsthatevenifonlyoneoutofevery
fiveofyourstockinvestmentsdoeswell,youroverallreturncanbe
high.Assumethattheaveragemarketreturnis10percent.Youinvest
$1,000ineachoffivestocksforatotalinvestmentof$5,000witha
three-yearhorizon.Ifyouearn10percentperyearas
expected,your
$5,000investmentwouldbecome$6,655attheendofthreeyears.But
ifjustoneofyourfivestocksturnsouttobeagrowthstockwitha
200percentreturnoverthethree-yearperiod,yourportfoliowouldbe
worth$8,324—asubstantiallyhighersumthanthe$6,655.Theannual
compoundedratewithonesuccessfulgrowthstockturnsouttobe18.5
percentperyear.
Thevalueplusgrowthconceptcanbefurtherillustratedusingsome
ofBerkshire’sinvestments.From1987to1991,Berkshireinvesteda
totalofabout$2billioninfiveconvertiblepreferredstocks:Champion
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International,FirstEmpireState,Gillette,SalomonInc.,andU.S.Air.
Alltheseinvestmentscouldbecharacterizedasvalueinvestmentsbecause
thedownsideriskwaslow.
Largecompanypreferredstocks,onaverage,
aresafeinvestmentsbecausetheyarenotexpectedtodefaultontheirdividendpaymentsortheprincipalamounts.Outofthesefive,onlyGillette
turnedouttobeagoodgrowthstock.In1990,Berkshireinvested$600
millioninGillette,whichwastakenoverin2005byProcterandGam-
ble,withBerkshirereceivingabout$5billioninProcterandGamble
stockinexchange.Overthe15-yearperiod,Berkshireearnedabout16
percentperyear,whichwastwicetherateontheS&P
500indexforthesameperiod.Theotherfourinvestmentsessentiallygeneratednormal
returns.In2008,Berkshireinvestedinthreepreferredstocksorconvert-
ibleinstrumentsthataresimilartopreferredstock.Theyareissuedby
GoldmanSachs($5billion),
GeneralElectric($3billion),andWrigley
($6.5billion).Evenifoneofthemturnsouttobeagrowthstock,returnstoBerkshirewillbehigh.Ifnot,Berkshirewillearndecentintereston
theseinvestments.
Itisimportanttorealizethatlowdownsideriskisveryimportant.
Inthepreviousexampleofpickingfivestocks,ifyouweretopickthem
fromafast-growinghigh-techindustry,youwouldhaveprobablylost
allyourinvestmentinoneortwostocks.Assumingthatyoumake200
percentononestockaspointedoutearlier,earnthe
marketreturnon
theremainingtwo,andloseallyourinvestmentintwostocks,your
finalsumwillbe$5,662,givingyouanannualrateofonly4.2percent
onyourinitial$5,000investment.Thisissubstantiallylessthanthe10
percentthatyouwouldhaveearnedhadyousimplyinvestedinthe
market.
AtleasttwoofBuffett’swell-knownpracticescanbedirectlylinked
tothetwo-stepprocessI’veoutlined.First,considerhispracticeofinvestingonlyinhiscircleofcompetence.In
thetwo-stepprocess,youneedtocomputeastock’sintrinsicvalue,whichrequiresreliableearningsforecastsforseveralyearsinthefuture.Youcanforecastwellonlywhenyouknowthecompanywellorwhenitisinyourcircleofcompetence.Second,Buffettrarelyinvestsinhigh-techorfast-growingindustries.One
possiblereasonmaybethat
theyarenotinhiscircleofcompetence.But
evenifBuffettknewalotaboutsomefast-growingcompanies,hemight
avoidthembecauseitishardtofindstockswithahighmarginofsafety
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intheseindustries.Often,investorshavehighexpectationsfromsuch
stocksandbidtheirpricesveryhigh.Onaverage,theyareovervalued;
thatis,thereisnomarginofsafety.InBuffett-styleinvestingor,inotherwords,ifyouarelookingforstocksthatBuffettwouldwanttobuy,you
arebetterofflookingintraditionalindustries.
WhereDoesGrowthComeFrom?
AsIsaidbefore,Buffettdoes
notinvestinhigh-techorfast-growing
industries.Then,howhasheaccomplishedahighrateofgrowth(over
20percent)foranextendedperiod?Thekeyseemstobehisempha-
sisonqualityofmanagement.Hisphilosophyisthesamewhetherhe
acquirescompaniesorinvestsincommonstocks.Thereareseveralchar-
acteristicsinhismanagementphilosophythat,combined,providethis
outcome.
WhenacompanyisacquiredbyBerkshire,managersdonotface
financialanalystsorworryaboutthestockprice.Berkshireanditssub-
sidiariesdonotforecastearningsanddonotconductconferencecalls
withanalysts.Themanagersdonothavetomeetorbeatthenextquar-
ter’sornextyear’searnings.Thisfreesuptheirtimeand
allowsthem
toconcentrateonthecompany’slong-runoperatingperformance.The
compensationplansarealsodesignedtoaccomplishwhatacademicscall
“maximizationofshareholdervalue.”Valueisfurthercreatedwithreduc-
tionsincostsonceafirmcomesundertheBerkshireumbrella.Berkshire
doesnotleveruptheacquiredcompany.Thishastwoadvantages.First,
inkeepingwithBuffett’sphilosophy,thedownsideriskismaintainedat
alowlevel,andsecond,employeesarehappieras
theyaremoresecure
oftheiremployment.Similarly,otherinputcostssuchasrawmaterials
andrentarealsolowerbecausesuppliersfeelmoreassuredofprompt
payment.Themainlessonfromthisisthatafteracquisitions,Buffett
helpsenhancemanagementqualityeventhoughheemphasizesthatgood
qualitymanagementshouldalreadybeinplacebeforehepurchasesa
company.
OneofBuffett’sacquisitioncriteriaisdeceptivelysimplebutvery
insightful.Heacquiresacompanyonlyifthecurrentmanagementcomes
withtheacquisition.Thisisratheruniquebecausemostacquirersreplacetheincumbentmanagementwithanewteamoftheirown.Whydoes
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buffettinvesting=value+growth
Buffettgoagainstthenorminthebusinessworld?Tostartwith,itis
obviousthatiftheacquiredbusinesswassuccessfulundertheexisting
managers,theyshouldnotbereplaced.However,mostotheracquirers
replacethemanyway.Maybe,thereishubrislurkinginthebackground.
Myguessisthatmostacquirersprefertomanagebiggercompanies.This
helpstheircompensationpackage,theirego,andtheir
influenceinthe
businessworld.
Buffett’sapproachhasadditionaladvantages.Iftheacquiredcompany
wasaprivatecompany,asisfrequentlythecase,theCEOwasprobably
alsotheowner.UnderBerkshire,heisstilltheCEO
ofhisunitbutisnowamanagerunderBuffett.Althoughheisnowamanagerratherthanan
owner,heislikelytobehaveasanownerbecausehewasanownerbefore
hesoldhiscompanytoBerkshire.Ineconomicparlance,thisreduces
theprincipal-agent,or
conflictofinterests,problem.Ifthemanager
behavesasanowner,thereisnoconflict.Inmostcases,thesellersare
independentlywealthyandmoreinterestedinsuccessfulgrowthoftheir
companiesthantheirowncompensation.Additionally,sincetheseller
getstokeepthecompanyunderhiscontrol,hemaybewillingtotake
alowerprice.Finally,ifsomecompanymanagementhadmanipulated
earningsinthepasttogetagoodpricefromsellingthecompany,the
sellerprobablywouldnotsellittoBuffett.Thisisbecause
Buffettwouldaskhimtostayonandmanagethecompany.Mosthiddenproblems(for
example,earningsmanagementoroff-balance-sheetdebt)arelikelyto
surfacewithinafewyears.Noonewouldwanttomanageacompany
knowingthatithassuchatickingtimebomb.This
reducesthelikelihood
ofBuffettendingupwithdishonestmanagersandsolvesthe“letthe
buyerbeware”problem.
BuffettalsopromisesthosewhoselltheirfirmstoBerkshirethathe
willholdthepurchasedcompaniesforeverevenif
profitabilitydeclines.
IdonotknowofanymajoracquisitionthatBerkshirelatersold.Why
isthisimportant?Itbuildstrustandsecurityintheseller’smindaboutthefutureofthecompany,especiallyifthesellerwantstobesurehis
businesswillprosper.AsBuffettwrites,“Wehavea
decidedadvantage,
therefore,whenweencountersellerswhotrulycareaboutthefutureof
theirbusinesses.”4Overall,Buffett’sacquisitionprinciplesaredesignedtoproducehighearningsforalongtime.Inessence,growthisaccomplished
throughgoodmanagement.
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77
ExamplesfromBerkshireInvestments
Overthepast44years,Berkshirehasacquiredalargenumberofcom-
paniesandhasinvestedincommonstocksofcompaniesasaminority
shareholder.Buffetthasmentionedthattheprinciplesappliedforthese
twotypesofinvestmentsarethesame.Whilethereisa
commontheme
acrosshisinvestments,notwoinvestmentsareidentical.Toenrichour
understandingofBuffettinvesting,Ibreakdownafewofhisinvestment
decisions.
Railroad:BurlingtonNorthernSantaFe
During2006to2008,Berkshireacquired70.1millionshares,or20.1
percent,ofBurlingtonNorthernSantaFe(BNSF),whichoperatesoneof
thelargestNorthAmericanrailnetworks,withabout32,000routemiles
across28statesandtwoCanadianprovinces.
Berkshirepaidabout$78
pershareforatotalinvestmentof$5.5billion,makingitthethird-largestBerkshirecommonstockholdingbehindCoca-ColaandWellsFargo.
BNSFis,nexttoUnionPacific,oneofthetoptwoU.S.railroads,each
bringinginabout$18billion
inrevenues.Itwasformedfromamerger
betweenBurlingtonNorthernandSantaFePacificin1995.BNSF’s
financialstatementsprovideinsightsintoitsvaluationandthereasonsforthislargeBuffettinvestment.Thedatafrom1996to2008(selectedyears
forbrevity)arepresentedinTable6.2.
First,followingthevalueinvestingprinciples,thedownsideriskis
low.Thelong-termdebtisonly25percentoftotalassetswhichisreasonableforacompanywithlargeholdingsinproperty,plant,andequipment.
Thecompanygeneratessteadycashflowsastheserviceitprovidescannot
beeasilyreplacedbyanothervendor.Fromreadingtheannualreportsof
BNSFandotherrailroads,Igatherthatthecompanyhasalargemarket
shareinseveralregions.Furthermore,returnonequity
(ROE)hasbeen
stableataround13.5percent.Overall,theeconomicsofthebusinessseemgood.Also,therailroadbusinessisaneasyoneforinvestorstounderstand,aprinciplethatBuffettemphasizes.Buffettdidnotpayahighpriceinrelationtoearnings.Hispurchaseprice-to-earnings(P/E)ratiobased
ontheaverageearningspersharein2005and2006is15.3.Thisisonly
slightlyhigherthatBNSF’s13-yearaverageP/Eof14.9andiscloseto
E1C06
Date:Jan29,2010
Time:1:14pm
e
erag
404
v
2.36
1.19
6.69
8.65
3.04
0.66
1.85
0.99
8.6%
0.25
14.9
1.5%
s.
A
11.11
26.95
13.5%
year
of
8.19
1.75
0.89
4.71
5.99
456
1.91
0.40
2.23
0.76
0.24
15.1
1996
19.69
8.9%
1.4%
14.8%
28.79
umbern
8.49
1.77
0.89
5.29
6.82
464
1.88
0.40
2.18
0.77
0.25
16.5
1997
21.27
8.3%
1.3%
13.0%
30.98
selected
for
9.21
2.11
0.98
6.85
7.48
415
2.38
0.48
1.40
0.90
0.28
11.9
2000
24.38
8.7%
1.7%
only
13.1%
28.31
ear
377
data
2004
1.71
0.81
6.52
9.44
2.14
0.64
1.53
1.01
0.22
22.1
10.95
29.02
5.9%
8.5%
47.31
1.4%
ted
repor
2.92
1.53
7.15
9.64
382
4.02
0.74
1.75
1.11
0.24
17.6
,
2005
12.99
30.43
9.6%
1.0%
15.9%
70.82
evitybr
or
3.52
1.89
7.39
370
5.11
0.90
2.01
1.18
0.23
14.4
F
2006
14.99
31.80
10.53
1.2%
11.1%
17.9%
73.81
s.
Highlights
umber
3.49
1.83
8.15
359
5.10
1.14
2.25
1.29
0.24
16.3
n
2007
15.80
33.58
11.14
1.4%
10.4%
16.4%
83.23
e
FinancialeF
348
per-shar
0.26
12.5
2008
$3.91
$2.12
$9.56
$6.08
$1.44
$2.18
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$18.02
$36.40
$11.13
10.7%
19.0%
$75.71
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(Net
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assets
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billions,
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(millions)
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debt
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Operating
Retur
Long-ter
Stock
Pr
Di
Note:
78
E1C06
Date:Jan29,2010
Time:1:14pm
BuffettInvesting=Value+Growth
79
thelong-runS&P500P/Eratioof16.Whilenotcheap
intermsofthe
P/Ethatapurevalueinvestormayprefer,BNSF’svaluationfitsBuffett’sapproachofpayingareasonablepricewhentheeconomicsandgrowth
prospectsofthebusinessaregood.Inhiswords,“It’sfarbettertobuy
awonderfulcompanyata
fairpricethanafaircompanyatawonderful
price.”5
Second,thegrowthprospectsareaboveaverage.Aseriesofdata
spanningalongperiodallowsustoestimatefuturegrowthwitharea-
sonabledegreeofconfidence.
Thegrowthrateinearningsoverthepast
fiveyearswas23percentperyear,butthegrowthoverthepast12years
wasonly10percentayear.Itappearstomethattherecentgrowth
rateisonthehighsideastheeconomywasdoingwellwithdemand
forcoalandagriculturetransportationincreasingatafaster-than-normalrate,probablybecauseofhighoilprices.BNSF’sincreasedgrowthrate
hasdrivenitsROEtoanunusuallyhighrateof19.0percent.Willthe
growthcontinue,andatwhatrate?Thatisprobablythemostdifficult
questionaBuffett-styleinvestorfaces.
BNSFhastheusualsourcesofgrowth,suchasrevenues,acquisitions,
andproductivity.Ithasalsoincreasedearningspersharethroughshare
repurchases,whichthefirmislikelytocontinuebecauseofitssignificantfreecash
flows.Sharerepurchaseshaveslowlyreducedthenumberof
sharesoutstandingfrom456millionin1996to348millionin2008
(areductionof24percentover12years).Thus,a2percentgrowthrate
canbeexpectedbasedonsharerepurchasesalone.For
futureprojection,
Istartwiththe12-yearhistoricalgrowthrateof10percentandreduce
itby1percentto9percenttobeconservative.
Witha9percentgrowthrate,BNSF’sexpectedearningsin10years
willbe$14.39pershare.
ApplyingaP/Eof15,theexpectedpriceat
theendof2018is$216pershare.Thepresentvalueof$216usinga
discountrateof7percentis$110pershare.Inaddition,aninvestorwillgetdividends,whichIassumewillalsogrowattherateof9percentper
yearfromthecurrentlevelof$1.44pershare.Thepresentvalueofthe
dividendsisabout$14,givingusanintrinsicvalueforBNSFofabout
$124($110+$14)pershare.Inearly2009,theBNSFstockpricewas
$68.Itwasagoodinvestmentatthisprice.
OnNovember3,2009,Berkshireannouncedaplantoacquire,at
$100pershare,theremaining77.4percentofBNSF’soutstandingshares
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buffettinvesting=value+growth
notcurrentlyownedbyBerkshire.Baseduponthenumberofshares
remainingforBerkshiretoacquire,thevalueoftheaggregateconsid-
erationtocompletethe
acquisitionisapproximately$26.4billion.This
willbethelargestBerkshireacquisitionever.Overall,thedownsideriskislow,thepriceisnothigh,andgrowthpotentialsaregood.Itisa
quintessentialBuffettinvestment.
Training:FlightSafetyInternational
In1996,BerkshireHathawayacquiredFlightSafetyInternational(FSI),
alargecompanyprovidingpilot,flightattendant,andmechanictraining
servicesintheUnitedStates,Canada,andEurope.Intermsofthevalue
investingprincipleoflowdownsiderisk,themost
relevantfactwasthat
thethenCEO,A.L.Ueltschi,owned31.8percentofthecompanyand
electedtoreceiveBerkshiresharesinexchangeforhisFlightSafetystock.
Thus,hewasnotsellingthecompanybecausehedidnotbelieveinits
future.HeremainedtheCEOuntil2003andisstillthechairmanofthe
board.BruceWhitman,anemployeesince1961,becametheCEOin
2003.A.L.Ueltschifoundedthecompanyin1951anditssharesstarted
tradingpubliclyin1968.PraisingUeltschi,Buffett
wrote,“Almaybe
79,buthelooksandactsabout55.Hewillrunoperationsjustashehas
inthepast.Weneverfoolwithsuccess.”6
Inthefive-yearperiodpriortotheacquisitionbyBerkshirein1995,
FSI’srevenuesgrewfrom
$267millionto$326million,anannualized
growthrateof5.1percent,similartowhatisexpectedinthetraditionalindustries.FSI’snetincomegrewalittlefasterattherateof6.5percent,butnoonewouldhaveclassifiedFSIasagrowthstock.Thepriceof
$1.5billionpaidbyBerkshirewasabout2.5
timesthebookvalueand
18timesearningsin1995.Thus,Buffettdidnotpayahighpricefor
thecompany,butitwasnotcheapeither.AsIdiscussedearlier,good
companiesarerarelyavailablecheap,andinthatsenseBuffettisnota
purevalueinvestor.
Howaboutgrowth?FlightSafetygrewquicklyafteritwasacquired.
BuffettwroteinBerkshire’s1998annualreport,“FlightSafety’soperatingprofitsincreasedsignificantlyover1997asaresultofcontinuedgrowthinallareasofitstrainingbusiness.”7Thecapital
expendituresatFlightSafetyduring1997,1998,and1999wereabout20percentoftheidentifiable
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81
assetsatyear-end.Thiswasatleasttwicetherateofcapitalexpendituresbeforeitwasacquired.BuffettmadeitpossibleforFSItogrowbykeepingsuccessfulmanagementinplace.Company-specificdataarenotavailable
since1996,butthecompanyremainsoneofthelargest
companiesinits
industry.
Aviation:NetJets
NetJets,formerlyknownasExecutiveJetAviation(EJA),wasacquired
byBerkshirein1998for$725million.NetJetssellsfractionalsharesof
jetsandoperatesthefleetforitsmanyowners.NetJetsdoesnotownmostoftheseairplanes;theyareownedbycustomers.WarrenBuffettwasa
satisfiedcustomerforthreeyearsbeforehemadethisacquisition.NetJets,aprivatecompany,grewfastunderitsCEOandmajorityshareholder,
RichardSantulli,whopioneeredthefractionaljetownershipconceptin
1986.HestayedwithhiscompanyjustasmostotherCEOsofBerkshire
acquisitionsstaywiththeircompanies.Idiscussedearlierthatmanagers
arethepurveyorsofgrowth.However,whenalong-term,
successful
CEOstayswiththecompany,itisalsoanindicationthatthedownside
riskintheacquisitionislow.WhenRichardSantulliresignedin2009,
DavidSokol,CEOofBerkshire’ssubsidiaryMidAmerican,tookoveras
thenewNetJetsCEO.
Whatistheusualsourceofahighgrowthrateintheoldeconomy
orinawell-establishedindustry?Insomecases(recallWal-Martand
GEICO),growthcomesfromtakingmarketshareawayfromotherfirms.
Inthiscase,NetJetsgrewbyluringbusinessandfirst-classtravelersintraditionalairlinesandcorporatejetowners.
SinceBerkshireboughtNetJets,growthinrevenueshasbeenwell
abovethenormalgrowthofabout5percentto7percentinso-called
traditionalindustries,whichincludeaviation.AsBuffettwroteinMarch
2000,“Currently,ourcustomersownplanesworthover$2billion,and
inadditionwehave$4.2billionofplanesonorder.Indeed,thelim-
itingfactorinourbusinessrightnowistheavailability
ofplanes.”8In2007,Buffettexplainedhowgrowthmayhavebeenaccomplished:“The
NetJetsbrand—withitspromiseofsafety,serviceandsecurity—grows
strongereveryyear.Behindthisisthepassionofoneman,RichardSan-
tulli.Ifyouweretopick
someonetojoinyouinafoxhole,youcouldn’t
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buffettinvesting=value+growth
dobetterthanRich.Nomatterwhattheobstacles,hejustdoesn’tstop.”9
Onceagain,itappearsthatmanagementqualityisthewaytogrowth.
Itshouldnotbeassumedthatgrowthisasurethingevenifanaccom-
plishedCEOisatthehelm.InthecaseofNetJet’s
Europeanexpansion,
thecompanyincurredacumulativelossof$212millionoveritsfirst10
yearsinoperationstartingin1996.However,Buffettreportedin2007
thattheEuropeansegmentwasnowdoingwell.Buffettgivescreditto
RichardSantulli,whoappointedanewpersontoleadtheEuropean
segment.Thissequenceofeventssuggeststhatexperiencedmanagers
arehelpfulinmaintainingalowdownsideriskintimesoftrouble.
BerkshirecombinesfinancialnumbersonNetJetsandFSI
underone
segmentcalledFlightServices,andeventhen,dataareavailableonlyforcertainyears.Forthetwocompaniesdiscussedhere,Buffettproudly
states,“[A]commoncharacteristicofthecompaniesisthattheyare
stillmanagedbytheir
foundingentrepreneurs....Thesemenarebothremarkablemanagerswhohavenofinancialneedtoworkbutthriveon
helpingtheircompaniesgrowandexcel.”10
For1999,thefirstyearbothsubsidiariesoperatedforafullyearunder
Berkshire,revenueswere
$1.86billionwithidentifiableassetsof$1.79
billion.For2005,thelatestyearforwhichdataareavailable,revenues
were$3.66billion,andidentifiableassetswere$3.17billion.Insixyears,revenuesgrewatarateof12percentperyearandassetsatarateof
10percentperyear.Becauseofcontinuingexpansion,profitabilityhas
beenerratic.11Operatingprofitsin2005wereonly3.8percentofyear-
endidentifiableassets.Thediscussioninthe2006annualreportsuggeststhattheresultshaveimprovedsubstantially.Berkshiredidnotpresentthedetails,butI
estimatethatoperatingprofitswereabout11percentof
theidentifiableassetsemployed.From1999to2007(thelastyearfor
whichearningsdataareavailable),pretaxearningsintheFlightServicessegmenthavegoneupfrom$225millionto$547million,anannualized
growthrateofabout12percent.
NetJetsalsoshowshowagrowthcompany’sprofitabilityisgenerally
tiedstronglytotheeconomy.Theglobalrecessionof2008–2009hada
significantimpactonNetJets.Thecompanyproducedpretaxlossesof
$531millionforthefirstninemonthsin2009.Overall,NetJetsisstill
anevolvingstory,butBuffett’semphasisonpatienceandhigh-quality
managementcomesthrough.
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83
High-Tech:BYD
OnSeptember29,2008,Berkshireannouncedplanstoinvest$230mil-
lionfora10percentstakein
BYD(initialsfortheChinesename),a
fast-growingChinesecompanylistedinHongKong.Theinitialsare
nowusedfor“BuildYourDreams.”With2008revenuesof$3.9bil-
lionandtotalassetsof$4.8billion,BYDisoneoftheworld’slargest
manufacturersofrechargeablebatteriesandhandsetcomponents.Itis
alsoasuccessfulcarmanufacturer.Since2002,itsrevenueshavegrown
abouteighttimesfrom$500milliontothecurrentlevelof$3.9billion,
mostofthegrowthcominginternally.Itisa
quintessentialrags-to-richesHoratioAlgerstoryforBYDCEOWangChuan-fu.
Basedon2008reportedearningspershare,BYD’sP/Eratioatthe
timeofBerkshire’spurchasewasabout14,inlinewithotherBerkshire
acquisitions.Furthermore,asTable6.3shows,BYD’s
earningspershare
havebeensteady,ifnotgrowingconsistentlywithrevenues.Thedebt-
to-total-assetsratioof0.28appearstobefairlyconservative.Overall,thedownsideriskfromthisinvestmentisnothigh.SoonaftertheBerkshire
investment,inOctober2008,
theBYDstockpricedoubledandthen
movedsteadilyupwardanddoubledagainoverthenextseveralmonths.If
Buffettwereapurevalueinvestor,hewouldhavesoldhisstakewhenthe
pricequadrupled.However,duringtheBerkshireannualshareholders
meetingonMay2,2009,CharlieMungermadeitclearthattheBYD
investmentisforthelongterm.
YoumaywonderwhyBerkshiremadeacommitmenttoalong-term
investmentinafast-growinghigh-techcompany.Theanswer:BYDis
agloballeaderintwoofitsthreebusinesses(rechargeablebatteriesandhandsetcomponents),Berkshiredidnotpayahighpriceforit,and
Berkshire’ssubsidiaryMidAmericanhasincentivestohelpBYDsucceed
inproducinginexpensiverechargeablebatteries.MidAmerican’sCEO
DavidSokolisnowanonexecutivedirectorontheBYDboard.Asone
ofthelargestwindpowergeneratorsintheUnitedStates,MidAmeri-
cancanbecomeamajoruserofrechargeablebatteriestostoreenergy
fromwindpowergeneration.Atalowprice,theworldwide
demandfor
rechargeablebatteriesisimmense.
Combiningitsknowledgeofrechargeablebatteriesandautomobiles,
BYDintroducedahybridelectriccarinDecember2008.Ifsuccessful,
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buffettinvesting=value+growth
Table6.3
BYD’sSelectedFinancialData
2008
2007
2006
2005
Revenues
26.79
21.21
12.94
6.5
Totalassets
32.89
29.29
16.39
11.21
Debt(interestbearing)
9.16
8.12
5.73
4.03
Shareholders’equity
11.28
10.71
5.29
4.18
Netincome
1.02
1.61
1.12
0.5
Earningspershare
0.5
0.79
0.55
0.25
Debt/Totalassets
0.28
0.28
0.35
0.36
Returnonequity(percent)
9.0
15.0
21.2
12.0
Numbersareinbillionsof
ChineseYuan(RMB),exceptearningspershareandratios.
itcanbeaworldleaderinelectriccarproduction.Thatmaybethereal
growthstorythathasgeneratedsomuchexcitementforthefirm.12At
theBerkshireannualmeetinginMay2009,largecrowdsgatheredtosee
theprototypes,whichareexpectedtobeintroducedintheUnitedStates
inthenearfuture.
Fromaninvestingpointofview,evenifthecarprojectisnotabighit,thecompanyisalreadygeneratingsatisfactoryprofitsfortheshareholders.
Currentlevelsofprofitsmust
havegivencomforttoBuffetttoinvestin
thisventureevenifhedidnotcompletelyunderstandthetechnology.
Afterall,hedidnothavetofullyunderstandthetechnology;DavidSokolisBuffett’seyesandearsinthiscase.ItalsomakessenseforMidAmericantohelpBYDinlaunchinganelectriccarin
theUnitedStatesasitwill
increasedemandforelectricity,replacingacorrespondingdemandfor
importedoil.Finally,again,forsuccessfulinvesting,Buffetthasalwaysemphasizedtheimportanceofmanagementquality.CharlieMungerand
BuffetthavepraisedtheBYD
CEOhighlyonseveraloccasionsforhis
accomplishments.So,itappearsthatBYDisnotaspeculativeinvestment
eventhoughitisinthehigh-techfield.
Overall,Buffett’sinvestmentsaregenerallynotdrivenbythecon-
ceptofvalueinvestingalone.Asavalueinvestor,hekeepsthedownside
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85
risklowbutiswillingtopayareasonablepriceforexpectedgrowth.
TheBNSFinvestmentinatraditionalcompanyisaquintessentialBuf-
fettinvestment.TheBYDinvestment,eventhoughitisinahigh-tech
company,isagoodexampleofBuffett-styleinvestingin
thatitrepresentsthewayheblendsvalueandgrowthinvestingprinciplestogether,andin
thewaygrowthisaccomplishedthroughhigh-qualitymanagers.
Conclusions
Themainmessagefromvalueinvestingstrategiesistoinvestwithlow
downsiderisk.Ifastocksatisfiesthiscriterion,youshouldthenconsideritsgrowthinearningstoimplementavalue-plus-growthstrategythat
IcallBuffett-styleinvestingorsimplyBuffettinvesting.13Thefocusinvalueinvestingisonthepast,thefocusingrowthinvestingisonthe
future,andthefocusinBuffettinvestingisonboththepastandthe
future.Youshouldalsopayspecialattentiontomanagementquality,
becausehigh-qualitymanagementisthesourceofgrowthinBuffett-style
investing.Toimplementthisstrategy,youshouldcompute
thestock’s
intrinsicvalueandcompareitwiththestock’sprice.Asaruleofthumb,ifthepriceisabouthalftheintrinsicvalue,itisworthinvestinginthatstock.
ThereismoretoBuffettthansimplyvalueandgrowthinvesting.
Buffettengagesinarbitrage
investing,investinginsilverfutures,bettingonoil,forwardtradinginforeigncurrencies,managingalargenumberofwhollyownedsubsidiaries,andwritingderivativecontracts.He
frequentlynarratesinvestment-relevantstoriesfromotherfieldssuchas
psychology,sports,countrymusic,andlifeingeneral.
Givenhisbroad
knowledgeandhisdeepunderstandingofinvestment-relatedtopics,I
prefertocallhimarenaissanceinvestorratherthanattemptingtopin
himdownundermorelimitingmonikers.Therestofthisbookillustrates
Buffett’smethodofextractingrelevantinvestmentinformationfromso
manyseeminglyunrelatedfields.
E1C06
Date:Jan29,2010
Time:1:14pm
E1PART03
Date:Dec10,2009
Time:4:17pm
PartThree
OTHERPEOPLE’S
MONEY
Mostcompaniessellproductsorservicesfirstandcollectcash
later.Buffettdoesthereverse
throughBerkshire’sinsur-
ancecompanies.Insurancecompaniescollectpremiumsin
advance.Buffettthenusesthiscash,whichisreallyotherpeople’smoney,forinvesting.InChapters7and8,IfocusonBerkshire’sinsurancebusinesses,whicharethemainstayofhissuccess.InChapter9,I
discusstaxdeferment,whichisanothersourceofotherpeople’smoney.
87
E1PART03
Date:Dec10,2009
Time:4:17pm
E1C07
Date:Jan20,2010
Time:11:15am
Chapter7
Insurance:Other
People’sMoney
Ourmainbusiness—thoughwehaveothersofgreatimpor-
tance—isinsurance.TounderstandBerkshire,therefore,itis
necessarythatyouunderstandhowtoevaluateaninsurancecom-
pany.Thekeydeterminantsare:(1)theamountoffloatthatthe
businessgenerates;(2)itscost;and(3)mostcriticalof
all,the
long-termoutlookforbothofthesefactors.1
—WarrenBuffett
Berkshire’smainbusinessisinsurance,andWarrenBuffettcan
hardlyhidehisenthusiasmwhenhetalksaboutGEICO,a
Berkshire-ownedinsurerthat
primarilyprovidesautoinsurance.
ThereisprobablynobetterplacetolearnfromBuffettaboutbusinessandinvestingthanfromhislongandsuccessfulinvolvementwithGEICO.
Buffett’sprofessorandmentorBenjaminGrahamatColumbiaUniver-
sitywaschairmanofGEICO.AcarefulexaminationofBuffett’swritings
tellsuswhyheboughtGEICOsharesinitiallyandwhyGEICOhasbeen
successful.BuffettnarratesthestoryofhisdesiretolearndeeplyaboutGEICO:
[O]naSaturdayinJanuary1951,Itookthetrainto
Washington
andheadedforGEICO’sdowntownheadquarters.Tomydismay,the
89
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otherpeople’smoney
buildingwasclosed,butIpoundedonthedooruntilacustodian
appeared.Iaskedthispuzzledfellowiftherewasanyoneintheoffice
Icouldtalkto,andhesaid
he’dseenonemanworkingonthesixth
floor....AndthusImetLorimerDavidson,AssistanttothePresident,whowaslatertobecometheCEO.2
BuffettreflectshisenthusiasminGEICOashecontinues,“WhenI
finishedatColumbiasomemonthslaterandreturnedto
Omahatosell
securities,InaturallyfocusedalmostexclusivelyonGEICO.”Andwhen
BuffettwasrunningBerkshire,hesaid,“Berkshirepurchasedalarge
interestinthecompanyduringthesecondhalfof1976,andalsomade
smallerpurchaseslater....Then,in1995,weagreedtopay$2.3billionforthehalfofthecompanywedidn’town.”Thus,GEICObecamea
whollyownedsubsidiaryofBerkshireHathaway,44yearsafterBuffett
firstsetfootinitsofficeinWashington.
InsuranceCompaniesasOtherPeople’sMoney
TheGEICOcommercialsbeckonpotentialcustomersbyclaiming,“A
fifteen-minutecallcouldsaveyou15percentormore.”Thisresembles
Wal-Mart’sslogan,visibleineveryWal-Martstore:“Wesellforless.”
GEICOhasthepotentialtobecometheWal-Martoftheinsurance
industry.GEICOhasbeentheengineofgrowthforBuffett’sinsurance
businessandhasgeneratedcapitalforBerkshiretoinvestinotheroppor-
tunities.Unlikemostotherbusinesses,aninsurance
companymakes
moneyintwodistinctways:(a)underwritingprofits,oroperatingprofits,and(b)float.
GEICO’sRevenuesandOperatingProfits
Whenyoubuyanautoinsurancepolicy,youpayapremium.Sub-
sequently,ifyousubmitaclaim,theinsurancecompanypaysyou.
Theunderwritingprofits,oroperatingprofits,arethedifference
betweenthepremiumsearnedandtheclaimsmadeinanygiven
period.
GEICO’soperatingprofitsandrevenuessince1996arepresented
inTable7.1.Ihavetwomainobservations.First,GEICO’srevenues
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Table7.1
GEICO’sRevenues,OperatingProfits,andOperatingProfits
Operating
Operating
profitsasa
profits
percentage
Year
Revenues
Float
beforetaxes
ofrevenues
1996
$3,122
$171
5.5%
1997
3,482
$2,917
281
8.1
1998
4,033
3,125
269
6.7
1999
4,757
3,444
24
0.5
2000
5,610
3,943
−224
−4.0
2001
6,060
4,251
221
3.6
2002
6,670
4,678
416
6.2
2003
7,784
5,287
452
5.8
2004
8,915
5,960
970
10.9
2005
10,101
6,692
1,221
12.1
2006
11,055
7,171
1,314
11.9
2007
11,806
7,768
1,113
9.4
2008
12,479
8,454
916
7.3
Total
$95,874
$7,144
7.5
Dollaramountsinmillions.
andoperatingprofitshaveincreasedsubstantiallyovertime—butwhat
isevenmoreimpressiveisthatpercentageprofitability,orprofitsasa
percentageofrevenues,hasalsoincreased.Inmostcases,
especiallyinamatureindustrysuchasinsurance,profitsperdollarofrevenuesdecline
asthecompanygrowsbytakingmarketsharefromothers.Acompany
hastobeverywellmanagedtoincreaserevenuesandsimultaneously
increaseprofitability.
Mysecondobservationisthatoperatingprofitscanchangedramat-
icallyfromyeartoyear.Competitionintheinsurancemarketin1999
and2000drovedownpremiumrates,whichwasthemainreasonthat
GEICOwasclosetobreak-evenprofitsin1999and
incurredlossesin
2000.Sinceoperatingprofitsarevolatile,itisimportantformanagementtofocusonthelongrun—whichmanycompaniessimplycannotdo.As
aninvestor,youshouldexamineearningsforseveralyears,especially
whenanalyzinganinsurance
company.GEICO’soperatingprofitsasa
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shareofrevenuesaveraged6.4percentfrom1996to2008butarehigher,
at10.1percent,overthemostrecentfiveyears.
Insuranceisnotafast-growingindustry,butGEICOhasgrownfast.
ProgressiveInsurancecompeteswithGEICOandisofaboutthesame
size,with$13billionin2008revenues.Itsoperatingprofitabilityof10.1
percentoverthepastfouryearsisalsosimilartothatofGEICO.From
2004to2008,whilerevenuesatProgressivehaveremainedstagnant,
GEICO’srevenueshaveincreasedby40percent.
Buffettshareshisinsight
intoGEICO’sgrowth:“AtGEICO,ToneyNicely—nowinhis48thyear
atthecompanyafterjoiningitwhenhewas18—continuestogobbleup
marketsharewhilemaintainingdisciplinedunderwriting.WhenTony
becameCEOin1993,GEICOhad2.0percentoftheautoinsurance
market,alevelatwhichthecompanyhadlongbeenstuck.Nowwe
havea7.7percentshare.”3Inotherwords,Buffettsuggeststhatlong-
termprofitablegrowthinamatureindustryemanates
fromtheworkof
excellentmanagement.
Float:OtherPeople’sMoney
Unlikemostotherbusinesses,aninsurancecompanyreceivesmoney
fromitscustomers,intheformofpremiums,beforespendingmoneyon
theproduct.Thecompanypaysoutonlyafterclaimsarefiled.Mean-
while,thecompanykeepsthemoneyandcanearnareturnonthis
moneybyinvestingitinbondsandstocks.Thismoneyiscalledfloatininsuranceindustryparlance.
Overthepast10years,from
1998to2008,GEICO’srevenueshave
increasedfrom$4.0billionto$12.5billion,anincreaseof212percent,
whilefloathasincreasedfrom$3.1billionto$8.5billion,anincrease
of174percent.Therearetwodistinctadvantageousaspectsoffloatin
relationtootherliabilitiesordebt.First,eventhoughitisaliability,thecompanyisnotrequiredtopayanyinterestonit.Ifthecompanyfaces
financialhardshipforsomereason,thehardshipwillnotbeaccentuated
becauseofdebtholders.Inothercompanies,saymanufacturingcom-
panies,thedebtholdersmaybringadditionalhardshiptothecompany
indifficulttimesbyaskingfortheirmoneybackorbynotrenewing
theirloans.Second,growthininsurancecompaniesrequiresverylit-
tleadditionalcapitalexpenditure.Ifacompanyis
wellmanagedand
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grows,theleveloffloat
growsasthecompanygrows.Ontheother
hand,inmanufacturingcompanies,growthusuallyrequiressubstantial
additionalcapitalexpenditures,whichmaynecessitateissuanceofnew
debtorequity.So,thebenefitsfromgrowthinmanufacturingbusinesses
arenotashighasthosefromgrowthininsurancebusinesses.
HowhasGEICObeensosuccessful?Themainreasonisitsfocuson
thelongrunwhichmustbeattributedtoitshigh-qualitymanagement.
Forexample,considerearningsvolatility.While
mostcompaniesregard
earningsvolatilitytobeanuisance,ahigh-qualitymanagementteam
canactuallybenefitfromearningsvolatility.Whencompaniesencounterdecliningearnings,suchasinthesevererecessionof2008,mostpubliclytradedcompaniesreducemarketingeffortstotrimcosts.
However,
GEICOviewstimesofeconomicdownturnasopportunitiestoincrease
marketingeffortstocapturemarketsharefromothercompanies.This
mayreduceearningsintheshortterm,butitisagoodlong-runstrategy
thatGEICOcanengageinbutothercompaniesthatareworriedabout
short-termearningscannot.Buffett’sphilosophyoffocusingonthelong
runandignoringperiodicvolatilityisadvantageoustoGEICO.
InBerkshire’s1998annualreport,Buffettexplainsthis
approach.
“[C]ompaniesthatareconcernedaboutquarterlyorannualearnings
wouldshyfromsimilar[marketing]investments,nomatterhowintelli-
gentthesemightbeintermsofbuildinglong-termvalue.Ourcalculus
isdifferent:Wesimplymeasurewhetherwearecreatingmorethana
dollarofvalueperdollarspent—andifthatcalculationisfavorable,themoredollarswespendthehappierIam.”4In1995,GEICOspent$33
milliononmarketing,in1999,itspent$190million,andin2009,it
spentapproximately$800million.InthecaseofGEICO,Buffettsees
thelong-termbenefitsfromcapturingmarketshareanddoesnotworry
abouttheshort-termlossesfromincreasedmarketingexpenses.
GEICO’smanagementhasalsobeenabletomaintainor
evenincrease
itsoperatingprofitabilityasmentionedearlier.Operatinglosses,ifany,maybeviewedasthecostofgeneratingfloat.Onaverage,GEICOhas
beengeneratingoperatingprofits,notlosses.Thus,thereisnocostof
float.Inotherwords,GEICO’sfloatorother
people’smoneyisfree.
Foraninsurancecompany,boththeamountandthecostofthefloat
areimportant.ForGEICO’svaluation,discussednext,weusethesetwo
variables.
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otherpeople’smoney
GEICO’sValuationandReturnstoBerkshire
Since1996,GEICOhasbeenawhollyownedBerkshire
subsidiary.
Berkshirepaid$2.3billionforabouthalfthecompany,whichsuggests
GEICO’smarketvaluetobe$4.6billion.Therearetwosourcesofintrin-
sicvalueforGEICO.First,GEICO’soperatingprofits,accordingtomy
estimatesfromreadingthefinancialstatements,wereabout$100million
in1995.Usingamultipleof10tovaluethispretaxincomeamount
(whichisaboutaP/Eof15),Iestimatedthevalueofoperatingprof-
itstobe$1.0billion.Second,usingGEICO’sfinancial
statements,I
estimatedthecompany’sfloattobeabout$3.1billion.Sincethisfloat
isaninterest-freeloanfrompolicyholders,itsvaluetoGEICOcanbe
assumedtobe$3.1billion.ThisgivesusanestimateofGEICO’sintrin-
sicvaluetobe$4.1billion.Therewerealsosomeinvestmentsinexcess
offloat.Hence,myestimateofGEICO’sintrinsicvalueisconservative.
Overall,Berkshire’sacquisitionpricewasinlineoralittleoverGEICO’sintrinsicvalue.The1995purchaseofhalfofGEICOwasnotcheapasa
purevalueinvestorwouldlike.However,consistentwiththeargument
onBuffett-styleinvestinginthepreviouschapter,itwasacquiredforitsfuturegrowthpotential.
HowmuchwasGEICOworthin2009,basedonend-of-the-year
datain2007or2008?AsI
didbefore,Iuse10timestheunderwrit-
ingprofitsandaddfloattoit.Thisimpliesavalueof$18.8billion,
givenby(10×1.1)+7.8for2007data.Basedon2008data,whichareinfluencedbythedramaticeconomicslowdown,GEICO’svaluation
isstill$17.6(10×0.9+8.5)billion.Ipreferusing2007databecause2008isanunusualyear,althoughthedifferenceisnotsignificant.UnderBerkshire,GEICO’svaluehasincreasedfrom$4.6billionto$18.8billionin11years.Inaddition,Iestimatethatinthemeantime,GEICO
generatedabout$4billionoffreecashflows.Thesemay
havebeen
paidtoBerkshireindividendsorheldbyGEICOasinvestments.Thus,
GEICO’svalueof$4.6billionatacquisitionattheendof1995hasnow
goneupto$22.8billion,whichworksouttobeareturnofalittleover
13percentperyearsince1995.Incomparison,theannualizedreturn
ontheS&P500indexforthesameperiodwasonly4.8percent.Ido
notknowwhattoattributeGEICO’sgrowthtootherthanhigh-quality
management.
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PriorBerkshireInsuranceBusinessesandBlueChipStamps
Berkshire’sinsurancebusinessandBuffett’suseoffloatdidnotstartwithGEICO.Buffettusedotherpeople’smoneyfromseveralpriorbusinesses.
In1967,whenMalcolmG.Chacewasthechairman,andBuffettwas
aboardmember,Buffett’sinfluenceonBerkshirewasclearlyevidentas
Chacewrote,“Wearehighlypleasedwiththeresultsofourinsurance
subsidiariessincetheiracquisitionsinMarch1967....Ourinvestmentintheinsurancecompaniesreflectsafirstmajorstepinoureffortsto
achieveamorediversifiedbaseofearningpower.”5Itwasthebeginning
ofBuffett’slong-termplantotransformBerkshirefromamanufacturing
companyintoaninsurancegiant.ItisdifficulttoimaginethatBuffett
couldhaveachievedwhathehaswithoutalong-termplan.
Afterlearningabouttheinsurancebusinesswhilehewasastudentat
ColumbiaUniversity,heprobablythoughtitwasbettertoacquire100
percentofsmallinsurancecompaniesthantoacquiresharesinalarge
insurancecompanysuchasGEICO.Byacquiringentireinsurancecom-
panies,Buffettcouldinfluencethequalityof
insuranceunderwritingand
theuseofitsfloat.Afteritsinitialentryintotheinsurancebusinessin1967,Berkshireacquiredseveralsmallerinsurancecompaniesandstarted
newinsurancebusinesses.By1975,Berkshire’sinsurancesegmentcon-
stitutedabout64percentof
the$255millionofBerkshire’sidentifiable
totalassets.BythetimeanopportunityarosetoinvestinGEICOin
1976,Buffettwassavvyenoughtohandlealargecompanyandacquired
asignificantstake.
Insuranceisnottheonly
businessthatgeneratesfloat.Asfarbackas
1972,Berkshireowned17percentofBlueChipStamps,whichengaged
infurnishingatradingstampserviceinCalifornia,Nevada,andOregon.
In1973,BlueChipheld$93.4millionofwhatcanbetermedother
people’smoney—themoneyitcollectedthatwouldbegivenbackslowly
tocustomersastheyredeemedtheirstamps.Thesizeofthisfloatwas
almosttwicetheamountofitsshareholders’equityof$53.1million.In
1973,Berkshireincreaseditsholdingto19percentofthe
outstanding
sharesand,by1980,ownedabout60percent.In1984,BlueChipStamps
wasmergedintoBerkshire.
Withtime,tradingstampservicerevenuesdeclined.Manybusinesses
gotintotroubleastheirrevenuesdeclined,resulting
inasuddenloss
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otherpeople’smoney
ofshareholdervalue.
However,inwell-managedfloat-generatingbusi-
nesses,thetransitionisnotasseverebecausetheoutputisalmostneversoldataloss.Asthedemandforaproduct(tradingstampsinthiscase)
declines,thecompanymayreduceitssizeslowlywithoutmuchpainand
suffering.Theamountof
floatdoesnotdropasfastasrevenuesdecline.
Withrespecttofloatanddecliningbusiness,CharlieMunger,chairman
oftheBlueChipboard,wrotein1981,“Inourtradingstampbusiness,
our‘float’—islargeinrelationtocurrentissuances.(Tradingstamprev-
enuespeakedat$124millioninfiscal1970,andour1981revenuesof
$15.6millionthereforerepresentadeclineof87%frompeakvolume.)”6
BlueChip’sfloathasbeenagoodsourceforBerkshire’sgrowth.Using
thisfloat,Berkshireacquiredseveralcompaniesincluding
See’sCandies,
MutualSavings,BuffaloEveningNews,andPrecisionSteel.Whydid
Berkshireacquirethesebusinessesthatdonotseemtohaveanythingin
common?WegetagoodinsightintoBuffettandMunger’sprinciplesof
investingandrunningbusinessesfromwhatCharlieMungerwrote7:
Ourfiveconstituentbusinesseshavemoreincommonthanmightbe
notedbyacasualobserver:
1.Theyareallhigh-gradeoperationssuffusedtoaconsiderableextentwithbusinessideasofBenjamin
Franklin,mannedbyhigh-grade
peopleoperatingwithinalongtraditionemphasizingreliableand
effectiveservice.
2.Whenfunctioningproperly,eachbusinesswillusuallygenerate
substantialamountsofcash
notclaimedbycompulsoryreinvest-
mentinthesamebusiness.
BuffettandMungerhaveemphasizedtheimportanceofcashflows
beyondthecompulsoryreinvestmentinthesamebusinessbecausethese
cashflowscanhelpgrowth
ofBerkshireasawhole.
Conclusions
Inyourinvestments,youshouldfollowBuffett’sleadandstaywithin
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in-depthunderstandingofinsurancebusinesshasservedBerkshirewell.
ItsinsurancebusinessGEICOhasdonewell,inpart,becauseBuffett
doesnotpayattentiontoshort-termearningsvolatility.Also,instead
ofborrowingintheopenmarket,Buffettuseslow-costfloat,orother
people’smoney,fromtheinsurancebusinesstoinvestinoracquireother
companies.
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Chapter8
Reinsurance:Moreof
OtherPeople’sMoney
[W]eareaFortKnoxofcapital,andthatmeansvolatileearnings
can’timpairourpremiercreditratings.Thuswehavetheperfect
structureforwriting—andretaining—reinsuranceinvirtually
anyamount.Infact,we’veusedthisstrengthoverthepastdecade
tobuildapowerfulsuper-catbusiness.1
—WarrenBuffett
IfahurricanehitsMiami,aninsurancecompanywithalargenumber
ofpoliciesintheareawillbeinundatedwithclaimsandcouldgo
bankrupt.Othernaturalorman-madedisasterssuchastornadoes,
floods,fires,oilspills,andearthquakescanalsoresultinhugeinsur-
anceclaimsinshortorder.Toavoidafinancialdisaster,manyinsurance
companiestransfertheirriskstootherinsurance
companies,calledreinsurancecompanies.GeneralReCorporationisoneofthelargestreinsurancecompaniesintheworld,anditisownedbyBerkshireHathaway.
SizeMatters:Berkshire’sAcquisitionofGeneralRe
Asmallinsurancecompany—forthatmatter,anysmallcompany—
cannottakelargerisksevenwhentherewardsseemattractive.Forthis
99
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otherpeople’smoney
reason,largerinsurancecompaniesarelikelytobemoreprofitablethan
smallerones.ForBerkshireasawhole,sizeisadvantageousbecause
moreoftheinsuranceandreinsurancepremiumsandfloatcanbekept
in-house.Furthermore,Berkshiremayacceptmorereinsurancebusiness
fromotherinsurancecompanies.
In1998,BerkshireHathawayacquiredGeneralReCorporationfor
$22billion.ThisremainedBerkshire’slargestacquisitionuntilNovember
2009whenBerkshireannouncedplanstoacquireBurlingtonNorthern
SantaFefor$34billion.Berkshire’spremergershareholderequityof$31
billionincreasedby70percentinonefellswoop.Whenthemergerwas
announced,GeneralRewasthelargestprofessional
propertyandcasu-
altyreinsurancegroupdomiciledintheUnitedStates,anditconducted
businessinalmost150countries.Itwasoneofonlyfivenongovernmen-
talU.S.-basedfinancialinstitutionswithanAAAseniordebtratingfrom
Standard&Poor’s.
Was$22billionagoodpricetopay?Atthetimeoftheacquisition,
GeneralRe’sunderwriting(operating)profitswereaboutzeroanditwas
notexpectedtoearnanysuchprofits.Theseresultshadbeensimilarin
recentyears.Butthefirmwasgrowingfast,havingexpandeditsinsurancepremiumsatanannualrateof10.7percentinthe10-yearperiodending
in1997.SinceGeneralRe’sunderwritingprofitswereaboutzero,the
valueofunderwritingprofitspersecanbeassumedtobezero.However,
float,ortheamountofpremiumscollectedinadvancebutclaimsnotyetpaid,was$14.9billion.Asdiscussedinpreviouschapters,floatcanbe
valueddollarfordollarorevenhigherowingtopotentialgrowth.Buffetthasmadesimilararguments:“[T]houghourfloatisrecordedonour
balancesheetasaliability,ithashadmoreeconomicvaluetousthananequalamountofnetworthwouldhavehad.Aslongaswecancontinue
toachieveanunderwritingprofit,floatwillcontinuetooutranknet
worthinvalue.”2Iffloatcanbevaluedatabout$14.9billion,General
Re’stotalvaluewouldbeatleast$14.9billion.Sowhypay$22billion?
Theremayhavebeenintangibleassetssuchasreputationandsynergy
withotherBerkshireunitsthatIamunabletoassessbutthatBuffett
couldhave.Overall,itdoesnotappeartobeacheap
acquisitionthata
purevalueinvestorwouldendorse.InlinewithourdiscussioninChapter
6onBuffett-styleinvesting,Buffettprobablysawgrowthpotentialand
waswillingtopayapremiumforthatreason.
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101
Table8.1
GeneralRe’sRevenues,Float,andOperatingProfits
Operating
Operatingprofits
profits
asapercentageof
Year
Revenues
Float
beforetaxes
revenues
1998
$14,909
1999
$6,905
15,166
−$1,184
−17.1%
2000
8,696
15,525
−1,224
−14.1
2001
8,353
19,310
−3,671
−43.9
2002
8,500
22,207
−1,393
−16.4
2003
8,245
23,654
145
1.8
2004
7,245
23,120
3
0.0
2005
6,435
22,920
−334
−5.2
2006
6,075
22,827
526
8.7
2007
6,076
23,009
555
9.1
2008
6,014
21,074
342
5.7
Total
$72,544
−$6,235
−8.6
Dollaramountsinmillions.
GeneralRe:1998–2008
Table8.1showsthatafterthe
acquisition,GeneralRe’sfloatincreased
from$14.9billionin1998to$21.1billionin2008,whichrepresentsan
annualgrowthrateofabout3.5percentoverthe10-yearperiod.Rev-
enues(premiums)grewfrom1998until2002buthavesincedeclined.
Overthepast10years,thegrowthinpremiumrevenuesisclosetozero.
Theoperatingprofitshavebeenvolatile,andtherehavebeensomelarge
losses.Wecanlearnseveralthingsfromthis.
Thehugelossof$3,671millionin2001reflectstheeffectofthe
9/11terroristattacks.Underwritinglossesfrom1999to2002werealso
large,muchgreaterthanintheyearsbeforebeingacquiredbyBerk-
shire.Whydidthishappen?In2002,Buffettmentionedthattheculture
atGeneralRewassuchthatpremiumswerenotbeing
writtenwith
asmuchdisciplineastheyshouldhavebeen.OnceBuffettrealizedthis
culturalproblem,GeneralRereducedtheamountofinsurancebeing
written.In2008,revenueswereonly71percentofwhattheywere
in2002.Sincethefloat-to-revenuesratioisabout4to1,floatisnot
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otherpeople’smoney
expectedtodeclineatthesamerate.In2008,floatwas95percentof
whatithadbeenin2002.Operatingprofitswerepositiveduring2006
to2008,whichisagoodsign.Basedonthefirstninemonthsofresults,
2009waslikelytobeevenastrongeryear.However,to
reallyevaluate
thequalityofunderwriting,itwilltakeusanother10yearsormore
becauselossesfromnewpoliciesdonotsurfaceimmediately.Whenesti-
matinganinsurancecompany’scostoffloat,youshouldtakealong-term
view.
HowhastheGeneralReacquisitionturnedoutsofar?From1999
to2008,floatincreasedby$6.2billion,anincreasefrom$14.9billion
to$21.1billion.However,thecompanyincurredlargeoperatinglosses
duringthisperiod,alsoamountingto$6.2billion.Valuingfloatdol-
larfordollar,theincreaseinthevalueoffloatisnullifiedbyoperatinglosses.Therearesomeunderwritingprofitsnow,buttheyarenotsignificant.IapproximatethatBerkshirehasearnedjustaboutnothingfrom
itsinvestmentinGeneralRe
overthepast10years.Thegoodnewsis
thatthecumulative10-yearreturnontheS&P500indexfromyear-end
1998to2008wasabout–13percent.Thus,ifBerkshirehadinvested
thesameamountintheS&P500index,theresultswouldhavebeen
evenworse.Buffettisoptimisticaboutthefuture:“GeneralRe,our
largeinternationalreinsurer,alsohadanoutstandingyearin2008....
TodayGeneralRehasregaineditsluster....CharlieandIare...certainthat,withTad[Montross,CEO],GeneralRe’sfutureisinthebestof
hands.”3
WasbuyingGeneralReamistakeonBuffett’spart,oristheresome-
thingsystemicthatwecanlearn?Thisepisodeisagoodreminderthat
reportedprofitabilitymaynotreflectreality.Beforetheacquisition,GeneralRehadastellarrecord.Istudiedthe
preacquisition1997GeneralReannualreportcarefully.Theresultslookedverygood,andeveninhindsightIcouldnotseeanyprevailingcultureatGeneralRethatwouldleadtosubparunderwriting.GeneralRe’sgrowthinrevenueswasslowing,
butithadrecentlyacquiredotherinsurancecompanies.Itsprofitshad
increasedsteadily.Ingeneral,whenapubliccompanyisacquired,thereissomeprobabilityofhiddenproblems.ManyofBuffett’sacquisitionshave
beenfamily-controlledcompanies.MyguessisthatifGeneralRewere
afamily-controlledfirm,theculturalproblemmightnothaveoccurred
orwouldhavebeendiscoveredintimetopreventtheacquisition.
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GEICOversusGeneralReStrategiesonCapturingMarketShare
WhydoesGeneralRenotfocusonmarketsharethewayGEICOdoes?
ItseemsthatthetwoinsurancecompaniesunderthesameBerkshire
umbrellafollowdifferentifnotoppositestrategies.
GeneralRe’srevenueshavedeclinedforseveralyears,startingin2003.Itspolicyisnottowriteunprofitablepolicies.Ontheotherhand,GEICOmakesaseriouseffort
toincreaseitsmarketshareandspendslargesumsonadvertising.Thus,
unlikeGeneralRe,GEICOprobablyincursalossin
acquiringnew
customers.Thisdifference,onceagain,showsthatnotwocompanies
arealikeandtheyneednotfollowthesamestrategies.Thereasonsfor
thetwodifferentapproachesarethenatureofthecustomersandthe
amountofthepremiums.
InthecaseofGEICO,onceacustomerbuysautomobileinsurance,
heislikelytoremainacustomerforalongtimebecauseofinertiaandlowabsolutepremiumamounts.So,itmakessensetoworkhardtoattracta
customereveniftheinitial
costofdoingsoishigh.However,GeneralRewritesreinsurancepoliciestootherinsurancecompanies.Sincereinsurancepremiumamountsarelarge,itislikelythatGeneralRe’scustomers
donotsufferfrominertiaandshoparoundwhenareinsurancepolicyis
upforrenewal.Hence,repeatbusinesswillnotmaterialize
asitdoesin
thecaseofGEICO.Overall,itisnothighlybeneficialforGeneralReto
writeunprofitablepoliciestograbmarketshare.Berkshirehasanother
largereinsuranceunitthatisworthdiscussingbecauseitsprofitabilityissubstantiallydifferentfromthatof
GeneralRe.
BerkshireHathawayReinsuranceGroup
Berkshire’sthirdmajorandprobablythemostprofitableinsurancegroup,
BerkshireHathawayReinsuranceGroup,ismanagedbyAjitJainwith
astaffofonly31employees.
BuffetthaspraisedAjitJainlavishlyalmosteveryyearintheannuallettertotheshareholders.Inthemostrecent
annualreport,hewrites,“This[B.H.ReinsuranceGroup]maybeone
ofthemostremarkablebusinessesintheworld,hardtocharacterize
buteasytoadmire....Itfeaturesverylargetransactions,incrediblespeedofexecutionandawillingnesstoquoteonpoliciesthatleave
othersscratchingtheirheads.”4Onceagain,notwobusinessesarealike,
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otherpeople’smoney
Table8.2
BerkshireHathawayReinsuranceGroup’sRevenues,Float,and
OperatingProfits
Operating
Operatingprofits
profits
asapercentageof
Year
Revenues
Float
beforetaxes
revenues
1998
$4,305
1999
$2,382
6,286
−$256
−10.7%
2000
4,712
7,805
−162
−3.4
2001
2,991
11,262
−647
−21.6
2002
3,300
13,396
534
16.2
2003
4,330
13,948
1,047
24.2
2004
3,714
15,278
417
11.2
2005
3,968
16,233
−1,069
−26.9
2006
4,976
16,860
1,658
33.3
2007
11,902
23,692
1,427
12.0
2008
5,082
24,221
1,324
26.1
Total
$47,357
$4,273
9.0
Dollaramountsinmillions.
eveniftheyareinthesameindustry.Thisisoneofthe
manyreasons
whyasimplecomparisonoffinancialratiosaloneisnotenoughtofind
goodstocks.Youneedtothinkaboutthecompany-specificbusiness,
acquirethemostknowledgethatyoucanaboutthebusinessandits
high-levelmanagers,thencomputeitsintrinsicvaluetomakebuyorsell
decisions.
Table8.2highlightsthefinancialperformanceofBerkshireHathaway
ReinsuranceGroupfrom1998to2008andcanbejuxtaposedagainst
theGeneralRedataintheprevioustable.B.H.ReinsuranceGroup’s
earningsarealsovolatilewithlossesin4outof10years.However,overthepast10years,B.H.ReinsuranceGrouphasproducedpretaxprofitsof
$4,273million(9.0percentofrevenues)incontrasttoGeneralRe’slossesof$6,235
million(–8.6percentofrevenues).GEICO’scorresponding
profitabilitynumberis7.5percent.
Tofurtherillustratetheargumentthatnotwobusinesseseveninthe
insuranceindustryarealike,Icomputefloat-to-revenuesforeachofthe
threemajorBerkshireinsurancebusinesses.GEICO’sfloatisonlyabout
E1C08
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105
70percentoftherevenues,orthefloatisabouteightmonthsofrevenues.
ThisreflectsthefactthatmostofGEICOinsurancepoliciesarerelated
toautomobilesandarerenewedeverysixmonthsorthereabouts.Onthe
otherhand,asimilaranalysisofTables8.1and8.2shows
thatGeneral
Re’sandB.H.ReinsuranceGroup’sfloatsareequivalentto3and3.4
yearsofpremiums,respectively.Thisexampleillustratesthepointthat
financialratiosoftencharacterizethenatureoftheunderlyingbusinesses.
Aswepreviouslydid,assumingthatthevalueoffloatisbasically
dollarfordollar,B.H.ReinsuranceGroup’sfloathasincreasedinvalue
from$4.3billionattheendof1998to$24.2billionattheendof2008.
Inaddition,thecompanyhasgeneratedoperatingprofitsof
$4.3billion
whoseafter-taxvaluewithoutdiscountingisabout$2.8billion.Adding
$2.8tothecurrentvalueoffloatof$24.2producesavalueof$27.0
billion,whichisaconservativeapproximationtostudythegrowthrate
fromthevalueof$4.3billionin1998.In10years,B.H.Reinsurance
Group’svaluehasincreasedattheannualrateofabout20percent.Thisisremarkableforalargecompanyinalow-growthindustry.WhileBerkshire’sinsuranceandreinsurancebusinessesasawholehavedonevery
well,youshouldnot
generalizethistootherfirmsintheindustryunlessyouviewtheirCEOstobeoutstanding.Withthatinmind,Ipresent
twointerestingexamplesoflargereinsurancecompaniesonthevergeof
goingbankrupt.
FailureofRelianceInsuranceCompany
Areinsurancebusinessisnotnecessarilysaferthananinsurancebusiness.
Youmustlookatthekindsofreinsurancerisksacompanymaybetaking.
Hereisanexampleworthkeepinginmindifyouareplanningtoinvestin
areinsurancecompanystock.RelianceGroupHoldings
Inc.,a183-year-
oldinsurer,sufferedsuchhugelossesinitsreinsurancebusinessthatitsstockpricedroppedfrom$19persharein1998to$0.25in2000—aloss
of$2billioninmarketvalue.Inthiscase,workers’compensationliabilitywaspassedfromtheprimaryinsurerstoseveralreinsurers,
including
Reliance.Thereinsurersgotstuckwithlowpremiumsandpotentially
largeclaims.Asimplelessonfromthisisthatasinglelargemistakecanleadanestablishedreinsurancecompanyintobankruptcy.
E1C08
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otherpeople’smoney
BerkshireHathaway,operatingthroughitssubsidiaryCologneRe,
alsowrotesomeofthe
reinsurancecontractsandtooka$275million
pretaxchargein1999.Fortunately,Berkshire’sshareofthisreinsurance
poolwasnotlarge.Whereas$275millionisalargesuminabsoluteterms,itwasonlyaboutone-fourthof1percentofBerkshire’smarketvalue.If
youplantoinvestinreinsurancecompanies,youshouldtrytofindout
ifthecompanyismakingconsciouseffortstoavoidlargelosses.Buffett
hasclarifiedthatgiventhediversifiedportfolioofinsurancepoliciesandthenatureofriskstaken,Berkshireisunlikelytofacealargeone-time
claimfromanyofitspolicies.AndBerkshirecaneasilyabsorbaclaim
worthseveralbilliondollarsasitdidfollowingthe9/11terroristattacks.
BuffettaptlycapturesBerkshire’sadvantages:
[W]esellpoliciesthatinsuranceandreinsurancecompaniespurchase
inordertolimittheirlosseswhenmega-catastrophesstrike....Whatyoumustunderstand,however,isthatatrulyterribleyearinthesuper-catbusinessisnotapossibility—it’sacertainty.Theonlyquestionis
whenitwillcome.5
Berkshire’sadvantagesincludeitssizeandconservativefinancing
policy.Lettheseattributesalwaysbeyourguidesforinvestingingeneral.
The2008–2009MarketCrashandAIG
AmericanInternationalGroup(AIG)wroteabout$84billionofinsur-
ancepremiumsin2008,comparedwith$26billionwrittenbyBerkshire.
Withastockpriceofabout$100persharein2000,itsmarketvaluewas
$260billion,muchlargerthanBerkshire.Butinearly2009,AIGwas
almostbankrupt,itssharepricearound$1.Whathappenedtosucha
greatcompany?Canthathappentoanycompany?
First,considerhowithappened.Therearemanypartstothis
puzzle,butoneaspectstandsout.AIGgotintoaninsurancebusi-
nessthatitthoughtitknewwell.AIGthoughtitwasinitscircleof
competence—insurance.Theinsuranceitprovided,called
creditdefaultswaps,wasagainstcorporationsdefaulting(usuallyasagroup)ontheirdebt.Whilecreditdefaultswapsareessentiallyinsurancepolicies,they
requirepostingofimmediatecollateralwhenlossesoccur.AIGfailed
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107
toconsidertheeffectofarecessiononmanycompaniessimultaneously
andthemaximumamountof
lossitcanface.Astheeconomyslowed
significantlyin2008,policyholders(calledcounterpartiesincreditdefaultswaps)demandedmanybillionsofadditionalcollateralthatAIGdidnot
have.Thefederalgovernmenthadtostepinwithanemergencyloan
toAIGasitbecameclearthatAIGmayhavetodeclarebankruptcy.By
May2009,AIGhadreceived$180billionfromthegovernmentinone
formoranother,aboutthevalueofallthegoldheldinFortKnox.It
appearsthatAIGdidnotknowwhatitwasdoingor
thattheemployees
responsibleknewbutgambledwithotherpeople’smoneyanyway.
Disasterscanstrikeanyinsurancecompany,ofcourse,because
unforeseencircumstancesoccur.Forexample,theSeptember11,2001,
attackontheWorldTradeCentercouldhavebeenfataltoGeneralRe.
Buffettwrites,“[H]adGenReremainedindependent,theWorldTrade
Centerattackalonewouldhavethreatenedthecompany’sexistence.”6
Eveniflargeinsurancecompaniesarebailedoutby
thegovernment,
theirbusinesscandryupandshareholderscansufferhugelosses.In
2009,largebondinsurersMBIAandAmback,amongmanyothers,fell
intothiscategory.
GrahamandBuffettadvocateconservativefinancing
becausewhen
companieshavetheabilitytoborrowalot,theysometimesdo.In
badtimes,highlyleveredcompaniessufferandcanevengobankrupt.
Similarly,wheninsurancecompaniesbecomeaggressive,theywriteeco-
nomicallyunsoundinsurancepolicies(becausetheycollectfloat,whichissimilartoborrowing),andinbadtimes,theysufferandcangobankrupt.
Howdoyouknowifacompanyisbecomingaggressive?Itisdifficult
toknowforsure.Buthereisahint.Risk-takingbehaviorofindividuals
islikelytobereflectedintherisk-takingbehaviorofthecompanies.Ininvestingininsuranceandothercompanieswherecomputationofearningsrequiressignificantestimates,youwillbebetteroffwithmanagers
whoarefinanciallyconservativeintheirpersonallives.
Conclusions
Attheendof2008,outofBerkshire’stotalinsurancefloatof$58.5
billion,GeneralReandBerkshireHathawayReinsurancecontributed
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otherpeople’smoney
$21.1billionand$24.2billion,respectively.Theselargesumsarevirtuallycostfree,buttheytrulybelongtotheinsuranceholdersorareother
people’smoney.Whenusingotherpeople’smoney,acompanyhasthe
addedresponsibilityofusingthatmoneyeffectively.Insituationswhen
otherpeople’s(your)moneyisbeingmanaged,oneshouldlookfor
extraordinarymanagerswiththehighestlevelofintegrity.
Itiseasyto
straywhenmoneyischeapanditisnotyourown,butitcanbevery
destructivetothecompany.
E1C09
Date:Jan18,2010
Time:8:21pm
Chapter9
TaxDeferment:
Interest-FreeLoansfrom
theGovernment
SolongasWesco[aBerkshiresubsidiary]doesnotliquidate,
anddoesnotsellanyappreciatedsecurities,ithas,
ineffect,an
interest-free“loan”fromthegovernmentequaltoitsdeferred
incomestaxesontheunrealizedgains,subtractedindetermining
itsnetworth.1
—CharlieMunger
Youmayfinditdifficulttobelievethatattheendof2008,
BerkshireHathawayhada$10billioninterest-freeloanfrom
theU.S.InternalRevenueServiceandothertaxauthorities.
Accordingtomosttaxrules,neitheryounoranyoneelse
hastopaytaxes
onpapergainsonstocksuntilthosepapergainsareconvertedintoreal
gains.Forexample,Berkshire’sCoca-Colainvestment,purchasedabout
20yearsago,hasincreasedfromtheinitial$1.3billionto$9.1billion,butBerkshirehasnotyetpaidanytaxeson
thepapergainsof$7.8billion.
Thenonpaymentoftaxesisindirectlyaninterest-freeloanthatBerkshireenjoys.Thelongeryouwaittocaptureyourpapergains,thelongeryou
don’thavetopaytaxes.
109
E1C09
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otherpeople’smoney
ValueofBerkshire’s$10BillionInterest-FreeLoan
fromtheGovernment
WhatisthevaluetoBerkshireoftheinterest-freeloan?Wecanunder-
standthisusingasimpleexample.Assumethatyourmothergivesyou
$100interestfreeandsaysthatyoucankeepitforever.Sinceyouneed
notpayanyinterestandneednoteverpaythemoneyback,itisessen-
tiallyagift.Ifaninterest-freeloanisheldforever,itsvalueisthesameastheamountoftheloan.So,ifBerkshirecankeepthesecuritiesforever,
thevalueofthetaxdefermentis$10billion.Iftheholdingperiodis
morethan10years,thevaluewillbecloseto$10billion,say,$8billion.
AnotherwaytothinkaboutthisisthatifBerkshireearnsa10percent
annualreturnonthisinterest-freeloan,Berkshiremakesabout$1billionayearthatitwouldotherwisenotmake.
Aninterestingandsomewhat
dramaticdiscussionappearsinBerk-
shire’s1989annualreport.Buffettwrites2:
ImaginethatBerkshirehadonly$1,whichweputinasecuritythat
doubledbyyear-endandwasthensold.Imaginefurtherthatweused
theafter-taxproceedstorepeatthisprocessineachofthenext19
years,scoringadoubleeachtime.Attheendof20years,the34%
capitalgainstaxthatwewouldhavepaidontheprofitsfromeach
salewouldhavedeliveredabout$13,000tothe
governmentandwe
wouldbeleftwithabout$25,250.Notbad.If,however,wemadea
singlefantasticinvestmentthatitselfdoubled20timesduringthe20
years,ourdollarwouldgrowto$1,048,576.Werewethentocashout,
wewouldpaya34%taxofroughly$356,500andbeleftwithabout
$692,000.
Unlikemostmutualfundsthatbuyandsellfrequently,Buffettdoes
notengageinfrequenttrading.Buffett’sexampleshowsthatmutual
fundsthattradeoftencauseinvestorstopaymoreintaxesthaninvestorswhotradelessoften.Mostdiscussionsinthepopularpressonmutual
fundinvestingdonotmentiontheadvantagesfromtaxdeferment.Iftax
defermentwerediscussed,mostmutualfundswouldbeunattractiveto
tax-payingindividuals.
E1C09
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TaxDeferment:Interest-FreeLoansfromtheGovernment
111
Returnsona$10,000
Investmentin25Yearswith
andwithoutTaxDeferment
Let’sassumethatyouinvest$10,000inamutualfundthatisexpected
toearnthesamereturnastheS&P500index.Alsoassumethatallyourtaxescanbedeferreduntilyousellyourinvestment.Ifyouhadinvested
onJanuary1,1984,andheldthisinvestmentfor25yearsuntiltheend
of2008,yourinvestmentwouldhaveincreasedtoabout$103,500.This
equalsarateofreturnofabout9.8percentperyear.Youhavetopay
taxeswhenyoutakethemoneyoutattheendofthe
25-yearperiod.
Assumingthelong-termtaxrateof20percent,youwillpay$18,700in
taxesandyourinitialinvestmentwouldgrowto$84,800netoftaxes.
Figure9.1showsthisamount,$84,800,andcomparesitwithasec-
ondamountthatyourinvestmentwouldgrowuptoifyoupaidtaxeson
yourincomeeveryyear.Forcomparison,assumethatyourmarginaltax
rateis35percentincludingstateandlocaltaxes.Then,youwouldhave
earnedonly6.37percent(0.65×9.8percent)peryear,
andyourfinal
amountwouldhavebeenabout$46,800.Inthefirstcase,yourmoney
wouldhavegrownabout8.48times($10,000to$84,800)andinthe
secondcase4.68times($10,000to$46,800).Itseemstobeaverylarge
differencetome,andIdidnotevenconsiderthefactthatmutualfunds
alsochargeamanagementfee.Itisreasonabletoassumethatin25years,youwouldearnonlyhalfofwhatyouwouldotherwiseearnifyoucan
saveonfrequenttaxesandmoneymanagementfees.
Whydopeopletradesooftenorhavesomuchmoneyinvestedin
mutualfundsthattradeoften?Manypeoplewhoinvestinmutualfunds
dosobecausetheydonotfeelconfidentenoughintheirstock-picking
abilitiestomaketheirowninvestmentsandgiveinto
advicefrommutual
fundsalespeople.Theydonotthinkintermsofcompoundingand
100,000
$84,800
$46,800
50,000
Dollars
0
Amoutwithtaxdeferment
Amountwithouttaxdeferment
Figure9.1
FinalAmountwithandwithoutTaxDefermentfromInitial$10,000
InvestmentinS&P500from1984to2008
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otherpeople’smoney
long-termreturnsoftenenoughandaretooquicktoselltotrytomake
aquickbuck(greed)oravoidlosses(fear).Also,thefactthatputting
yourmoneyintoamutualfundthattradesfrequentlyresultsinamuch
highertaxrateisnotthefirstpointmutualfund
salespeopleemphasize
intheirpitch.
Thelessonhereisthatyoushouldsearchforstocksthataregood
long-terminvestments.Ifyoudonothavetimetosearchforstocksor
ifyoudonotbelieveininvestinginindividual
stocks,investinindex
funds,notinactivelytradedmutualfunds.
Conclusions
Thelessonontaxdefermentandcompoundingteachestwothings.First,
itimplicitlysuggeststhatyoushouldstartinvestingearly.Ifyouaregoingtobe
leavingyourmoneyaloneforlongperiods,youwillwanttomake
yourinitialinvestmentasearlyaspossibletoallowforthemaximum
growthbeforeyouneedtopullyourmoneybackout.Second,donot
buyandsellyourinvestmentsfrequently.This
willcauseasubstantial
percentageofyourtaxestobedeferredandyourreturnstobehigher.
BuffettpracticestaxdefermentforBerkshireshareholders.Insteadof
constantlymakingtrades,buygoodstocksandgotothebeach.Ifyou
donotknowwhattobuy,buytheVanguard500IndexFundandhold
itforaslongasyoucan.
E1PART04
Date:Dec10,2009
Time:4:19pm
PartFour
SUCCESSINRETAILING,
MANUFACTURING,
ANDUTILITIES
BerkshireHathawayownsseveralcompaniesintheretailing,man-
ufacturing,andutilitysectors.Chapters10to13explorewhy
Buffettpurchasedthesecompaniesandwhathedoes
tocreate
theirsubsequentprofitablegrowth.
113
E1PART04
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Time:4:19pm
E1C10
Date:Feb4,2010
Time:2:35pm
Chapter10
IfYouDon’t
KnowJewelry,
KnowYourJeweler
[T]herewasneveranyquestioninmymindthat,
first,Helzberg’s
wasthekindofbusinessthatwewantedtoownand,second,Jeff
wasourkindofmanager.1
—WarrenBuffett
In1989,BerkshirepurchasedBorsheim’s,ajewelrystoreinOmaha.
WhenIreadabouttheannouncementinthe
newspaper,Iwas
puzzled.Whyisthewell-knownvalueinvestorbuyingadazzling
business?Whereisthevalue?Later,Buffettexplainedthecostadvantage
ofBorsheim’s:“Weattractbusinessnationwidebecausewehaveseveral
advantagesthatcompetitorscan’tmatch.Themostimportantitemin
theequationisouroperatingcosts....JustasWal-Martsellsatpricesthathigh-costcompetitorscan’ttouchandtherebyconstantlyincreases
itsmarketshare,sodoesBorsheim’s.Whatworkswithdiapersworks
withdiamonds.”2
115
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116
retailing,manufacturing,andutilities
ComparisonwithWal-Mart:CostAdvantage
Buffett’sanalogyisworthrepeatingbecauseitisnotconventionalwis-
dom:“Whatworkswithdiapersworkswithdiamonds.”Hispointisthat
inalmostanyindustry,costadvantageisimportant.
Costadvantageinthejewelrybusinessmaycomefromvarious
sources.First,thereisanadvantageinlocation:OmahaisalessexpensiveplacetooperateabusinessthanNewYork,andthiscanbeespecially
relevantduringeconomicdownturns.Overheadsaresmaller,period.
Keepingthisphilosophyinmind,mostWal-Martstoresarelocatedin
thesuburbs,notinexpensivecitycenters.Consequently,Wal-Marthas
slowlybuiltareputationofreliablylowprices.Second,onceacompany
orastorehasbuiltagoodreputation,itscostsgodown
evenmore.
Thishappensforavarietyofreasons.Forexample,itdoesnothave
toadvertisemuch.Spendinglessonadvertisinghelpsbringdownthe
costperunitofsales.Untilrecently,Wal-Martdidnotadvertisemuch
innewspapersandontelevision.Beyondeasilyidentifiablecostadvan-
tagessuchasadvertising,additionalcostadvantagescomefromsuperior
managerswhobuiltthereputationinthefirstplace.AsBuffettpoints
out,helikedJeffComment,themanager,whowas
runningHelzberg
Diamondsatthetime.BuffettdidnotjustmeanthathelikedJeffas
agolfbuddy.HelikedJeffforhisabilitiesasamanager.Goodman-
agersknowwhatqualityitemstobuyandinwhatquantitiestoorder.
Thisgivesthemacostadvantagethroughpurchasingandlowcustomer
returns.
Forbig-ticketitemssuchasjewelry,thereputationofthestoreand
itsmanagersalsohelpsgeneratehigherrevenuesand,hence,higherprof-
itability.Averageconsumersoftenfinditdifficulttodeterminethetruevalueofdiamondsandjewelry.Hence,trustplaysamajorroleinbuying
decisions.Theaveragecustomerwouldratherpay10percentmoreto
ensurethatthediamondsandpreciousmetalareofthehighestquality.Inthis
regard,Berkshire’snamehasprobablyalsohelpedincreaserevenuesatBorsheim’s.RegardingBorsheim’sCEO,Buffettwrites:“Inthesixyears
priortothemove,saleshaddoubled.IkeFriedman,Borsheim’smanag-
inggenius—andImeanthat—hasonlyonespeed:fastforward.”3When
youseeabusinessmanagedbypeoplelikeSamWaltonorIkeFriedman,
thebestactiontotakeistotrytopartnerwiththem.Buffettbelieved
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117
inFriedman’sintegritysomuchthatheboughtthebusinesswithoutan
audit.“Ifyoudon’tknowjewelry,knowyourjeweler”makessensefor
anybusinessorstockyou
plantobuy.Thejewelersinthismaximare
thepeoplemanagingthebusiness.
Regardlessofhowmuchyouresearchacompany,youcannotlearn
enoughaboutitsfutureproducts,researchanddevelopment(R&D)
plans,newmarkets,alliances,corporategovernancepractices,andso
on.However,ifthecompany’smanagersare“goodjewelers,”youreally
donotneedtoinvestahugeamountoftimeininvestigatingthebusi-
ness.Tounderstandthemanagement,youhaveto
makeafewphone
callstolearnaboutcustomerservice;yourfamilyandfriendsmaytell
youabouttheirexperiences,andyoumaytrythecompany’sproducts.
Theimportanceofmanagementqualityisunderscoredinthefollowing
Berkshireacquisitions.
HelzbergDiamonds,BenBridgeJeweler,
andOthers
BerkshirepurchasedHelzbergDiamondsin1995.Theinspiringstory
ofthecompany’sgrowthrevealswhatBuffettlikestoseeinapotential
acquisition.Thisisnotonlyaboutthesuccessofthebusinessbutalso,
onceagain,aboutthepeople.Hereisthestoryofthepeoplebehind
HelzbergDiamonds.
MorrisHelzbergopenedthefirstHelzbergjewelrystorein1915.
HisyoungsonBarnettoftenworkedintheshoponSaturdays.When
hisfatherbecameill,Barnettbecameresponsiblefortheentireoper-
ationattheageof14.BythetimehisolderbrotherGilbertreturned
fromWorldWarItojointhebusiness,Barnetthadbecome
anexuber-
antbusinessman.Anaggressivepromoter,heranlargenewspaperads
toutingtheslogans“MeettheHelzbergBoys”and“WearDiamonds.”
Healsoofferedfreeairplanerideswithapurchase.By1925,Helzberg
hadexpandedsignificantlyandquicklybecameknownasaprominent
jewelerintheMidwest.
WhenBerkshirepurchasedHelzberg,ithad134storesscatteredall
overtheUnitedStates.Bythebeginningof2009,thenumberhadrisen
to270stores.BuffettexplainswhatledhimtoacquireHelzberg4:
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118
retailing,manufacturing,andutilities
InMay1994,aweekorsoaftertheAnnualMeeting,Iwascrossingthe
streetat58thandFifthAvenueinNewYork,whenawomancalledout
myname.Ilistenedasshetoldmeshe’dbeento,andhadenjoyed,the
AnnualMeeting.Afewsecondslater,amanwho’d
heardthewoman
stopmedidsoaswell.HeturnedouttobeBarnettHelzberg,Jr.,who
ownedfoursharesofBerkshireandhadalsobeenatourmeeting.
Inourfewminutesofconversation,Barnettsaidhehadabusiness
wemightbeinterestedin.Whenpeoplesaythat,itusuallyturnsout
theyhavealemonadestand—withpotential,ofcourse,toquickly
growintothenextMicrosoft.SoIsimplyaskedBarnetttosendme
particulars.That,Ithoughttomyself,willbetheendof
that.
Berkshirewasmadetoorderforhim.Ittookusawhiletoget
togetheronprice,buttherewasneveranyquestioninmymindthat,
first,Helzbergwasthekindofbusinessthatwewantedtoownand,
second,Jeffwasourkindofmanager.Infact,wewouldnothavebought
thebusinessifJeffhadnotbeentheretorunit.BuyingaretailerwithoutgoodmanagementislikebuyingtheEiffelTowerwithoutanelevator.
YoumaynoticethateventhoughBuffettlikedthebusinessandthe
management,hedidnotwanttooverpayforit.Ashesaid,ittook
themawhiletogettogetheronprice.However,asBarnettHelzberg
said,“Buffettdidn’tchangeahairintheleadershipofHelzberg.”5This
statementbyHelzbergisahallmarkofBuffett’s
managementstyle.After
Buffettinvestsinacompanyoracquiresacompany,hedoesnottryto
influencethemanagement.Helooksforacompanythathasanexcel-
lentlong-standingreputationandsuperiormanagementalreadyinplace.
Helzberg’sthinkingaboutdevelopingasuccessfulbusinessissimilarto
Buffett’s:“BusinessisPeople.”6Thissoundssimple,butitisnotnecessarilyeasyforeverymanagertoimplement.Ifyoufindacompanywith
aSamWalton,don’tworryaboutwhetherhesellsdiapersordiamonds.
Youhavefoundagoodjeweler,andyoushouldthinkofbecominghis
partner.
Berkshire’sjewelrybusinesshasgrownsteadily,addingmorebusi-
nesseswithexcellentreputations.In2000,BerkshireacquiredBen
BridgeJeweler,achainof65stores.Thenumberofstoreshadrisen
to77byearly2009.EdBridgeandJonBridgewerethefourth-
generationowner-managersofahighlyreputedjewelrybusinessthat
hadgrownsteadilyundertheirleadership.EdBridge
calledBuffetton
E1C10
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IfYouDon’tKnowJewelry,KnowYourJeweler
119
arecommendationfrom
BarnettHelzberg.Hewasespeciallyimpressed
byBuffett’spreferencetoletthecurrentmanagementofhisacquisitions
operatewithlittleinterference.In2007,Berkshireacquiredtwogold
jewelrymanufacturers:Bel-OroInternationalandAurafinLLC.One
additionalpointtodrawfromBerkshire’sinitialpurchaseofBorsheim’s
andsubsequentexpansionsisthatthevariouscompaniesarekeptinde-
pendentofoneanotherintermsofmanagement.Hemadenoeffortto
mergehisjewelrycompaniesintoasingleentity.Overall,
Buffettseemstoemphasizethelong-termreputationofthebusinessanditsmanagement
quality.
Profitability:Berkshire’sJewelryBusinesses
versusTiffany&Co.
Inanybusiness,whatultimatelymattersis
profitability.UnderBerkshire,acquiredcompaniesareabletodoevenbetterthanwhattheywouldhave
doneindependentlybecauserisksarereducedandexpansionplanscan
beimplemented,possiblythroughBerkshire’sfinancialsupport.InTable
10.1,IpresentananalysisofBerkshire’sjewelrybusinessesfor1996to
1999.(Morerecentdataarenotavailable.)SalesrevenuesofBerkshire’s
jewelrybusinessesgrewfrom$392millionto$486million,a24percent
increase.Thistranslatesintoagrowthrateofabout7
percentperyear,agoodgrowthrateformaturebusinesses.However,operatingprofitswent
upsubstantiallymore,from$28millionto$51million,whichtranslates
into82percent,orabout22percentperyear.Similarly,profitability
oftheassetsemployed—that
is,thereturnonassets—increasedfrom
10percentto20percent.Theincreaseinreturnonassetsshowsthat
Berkshire’sjewelrybusinessesdidnotneedthesamelevelofinventories
andotherassetsperunitofsalesin1999thattheydidin1996.Given
thatBuffettemphasizesprofitability,IthinkthatBuffettinfluencedtheirfocusontheefficiencyoftheassetsemployed.
IuseTiffany&Co.asayardstickforcomparisonbecauseitisthe
premierjewelrybusinessintheUnitedStates.Ithasbeenoperatingsince1837andcommandsthegreatest
respectinthejewelryindustry.Itisalsohighlyprofitableandsuccessfulinmaintainingitsleadershipposition.IfwecomparetheprofitabilityofBerkshire’sjewelrybusinesseswiththat
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retailing,manufacturing,andutilities
Table10.1
ProfitabilityofBerkshire’sJewelryBusinessesComparedwith
Tiffany&Co.’s
Berkshire’sJewelry
Business
1999
1998
1997
1996
Revenues
$486
$420
$398
$392
Identifiableassetsatyear
end
$258
$234
$219
$267
Operatingprofitsbefore
taxes
$51
$39
$32
$28
Operatingprofitsasa
percentageofrevenues
11%
9%
11%
7%
Operatingprofitsasa
percentageof
identifiableassets
20%
17%
15%
10%
Tiffany&Co.
1999
1998
1997
1996
Revenues
$1,461
$1,169
$1,018
$922
Totalassets
$1,343
$1,057
$827
$739
Operatingprofits
$257
$161
$133
$109
Operatingprofitsasa
percentageofrevenues
18%
14%
13%
12%
Operatingprofitsasa
percentageof
identifiableassets
19%
15%
16%
15%
Dollaramountsinmillions.
ofTiffany’s,wewillbeputtingBerkshire’sjewelrybusinessesupagainstthebestintheindustry.Table10.1showsthetwosetsofdata.
Tiffany’srevenuesareaboutthreetimesthoseofBerkshire’sjew-
elrybusinesses.Inthefour
yearsfrom1996to1999,Tiffany’salso
increaseditsrevenuessubstantially,from$922millionto$1.46billion,
a58percentrise.Ultimately,itisnotthedollaramountofrevenues
orthedollaramountofoperatingprofitsthatmattersthemost.What
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IfYouDon’tKnowJewelry,KnowYourJeweler
121
mattersisprofitability.Weshouldalwaysask:“Whatisthereturnonassets
employed?”ThelastrowofdatainthetableisthemostusefulforcomparingBerkshire’sjewelrybusinesseswithTiffany’s.In1996,Berkshire’sjewelrybusinesseslaggedbehindTiffany’sintermsofoperatingprofitasapercentageoftotalassets:10percentversus15percentforTiffany’s.
However,by1999,
Berkshire’sjewelrybusinesseshadachievedparity:
20percentversusTiffany’s19percent.Themainreasonforthissuc-
cessseemstobethatBuffettpickshigh-qualitymanagerstorunreputed
businessesandthenallowsthosemanagerstorunthose
businessesasif
theyownedthem.
Conclusions
Whiletheyareallretailjewelrystores,Borsheim’s,HelzbergDiamonds,
andBenBridgeJewelerarerunasseparatebusinessesundertheBerkshire
umbrella.Theprincipalreasonismanagerswhomadethosebusinessessuccessfulinthefirstplacebykeepingcostslowandcustomerssatisfied.
Hence,theirsuccessesarelikelytocontinueundertheexistingmanage-
ment.Remember,“Whatworksfordiapersworksfordiamondsandfor
otherbusinesses.”WhenBerkshireacquiresabusiness,itmaintainsthe
business’soriginalorganizationalstructuretosuitthemanagement,ratherthanrequiringthemanagementtoconformtoacommonorganization
structure.
E1C10
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Time:2:35pm
E1C11
Date:Jan20,2010
Time:11:19am
Chapter11
CompeteLikeMrs.B
There’snooperationinthe
furnitureretailingbusinessremotely
liketheoneassembledbyBerkshire.It’sfunformeandprofitable
foryou.1
—WarrenBuffett
Ihaveoftenaskedmyfriendsandcolleaguesabouttheirthoughts
oninvestinginfurniture
retailers.Notsurprisingly,mostofthem
considerthebusinessmundaneandhaveneverthoughtofinvesting
inone.In1983,Berkshireacquireda90percentinterestinNebraska
FurnitureMart,whichwasrunbyitsthen-ownerRoseBlumkin,
popularlyknownasMrs.B.WhydidBuffettpurchasethisbusiness?
Theanswerswegetfurtherstrengthenourconclusionsintheprevious
chapter.
KnowWhenNottoCompete:
NebraskaFurnitureMart
RegardingtheNebraskaFurnitureMartacquisition,Buffettwrote:
OnequestionIalwaysaskmyselfinappraisingabusinessishowIwould
like,assumingIhadamplecapitalandskilledpersonnel,tocompete
withit.I’dwrestlegrizzliesratherthancompetewith
Mrs.Bandher
123
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retailing,manufacturing,andutilities
progeny.Theybuybrilliantly,theyoperateatexpenseratioscompeti-
torsdon’tevendreamabout,andtheythenpassontotheircustomers
muchofthesavings.It’stheidealbusiness—onebuiltuponexcep-
tionalvaluetothecustomerthatinturntranslatesinto
exceptional
economicsforitsowners.2
Clearly,themainreasonforthesuccessofNebraskaFurnitureMart
isthatitisrunbyincrediblemanagerswhoremainfocusedoncustomers
andcost.TheirphilosophyisnotverydifferentfromWal-
Mart’sphilos-
ophyof“Wesellforless.”Mrs.Bsummarizedherphilosophyas“Sell
cheapandtellthetruth.”3
NebraskaFurnitureMartcontinuedtodowellafteritsacquisitionby
Berkshireandisstilldoingwellunderthemanagement
ofMrs.B’schil-
drenandgrandchildren.Revenuesincreasedsteadilyfrom$100million
in1983tomorethan$300millionin1999.Sincethen,thecompany’s
salesdatahavenotbeenpubliclyavailable.NebraskaFurnitureMart
nowhasstoresinDesMoines,Iowa,andKansasCity,Kansas.Nebraska
FurnitureMartwasnotacquiredbecauseithadwonderfulproducts.It
wasacquiredbecauseithadwonderfulmanagers.In1996,Buffettwrote
ofMrs.B:“She’s103nowandsometimesoperateswith
anoxygen
maskthatisattachedtoatankonhercart.Butifyoutrytokeeppace
withher,itwillbeyouwhoneedsoxygen.”4OneBerkshirepractice
thatmayplayaroleinthecontinuityofexcellentmanagementisto
offerdesirableincentivestomanagers.InthecaseofNebraskaFurni-
tureMart,10percentofthestore’sownershipwaskeptintheBlumkin
family.
Inawalkaroundyourtown,youwillnodoubtseesomeincred-
iblebusinessesthathavebeenoperatingthereformanyyears.Besides
furniturestores,youmayfindafewrestaurants,grocerystores,bars,
bakeries,cafes,dry-cleaningstores,andpizzaparlors.Someofthem
maybelargeenoughtobepubliclytraded.Mostpeople
ignoresmall
businesses—theyaretooboringtobediscussedintheWallStreetJournaloronCNBC.PeterLynchdiscussestheimportanceofbuyingboringbut
well-runcompanies:“Ifacompanywithterrificearningsandastrong
balancesheetalsodoesdull
things,itgivesyoualotoftimetopurchasethestockatadiscount.”5Youshouldnothesitatetopartnerwithsuch
businesses.
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CompeteLikeMrs.B
125
R.C.WilleyHomeFurnishings
TheacquisitionofNebraskaFurnitureMartledBuffetttoanother
successfulfurnitureacquisition.Berkshireacquiredthefive-storeR.C.
WilleyHomeFurnishingsin
1995.Thenumberofstoreshassincegrown
steadilyandreached15by2008.NebraskaFurnitureMart’sIrvBlumkin
wasthemainpersonbehindthisacquisition.Buffettwrites,“Itwas
NebraskaFurnitureMart’sIrvBlumkinwhodidthewalkingaround
inthecaseofR.C.Willey,longtheleadinghomefurnishingsbusiness
inUtah.Overtheyears,Irvhadtoldmeaboutthestrengthsofthat
company.AndhehadalsotoldBillChild,CEOofR.C.Willey,how
pleasedtheBlumkinfamilyhadbeenwithitsBerkshire
relationship.”6
R.C.Willey’shistoryalsotellsussomethingaboutitslikelyfuturesuc-
cess.Fromasmallbusinesswithsalesof$250,000in1954,CEOBill
Childbuiltitintoa$257millionrevenueestablishment.
AsIdiscussedinthepreviouschapter,Buffettrespectsindependence.
InthecaseofNebraskaFurnitureMartandR.C.Willey,hesaidthat,liketheCEOsofotherbusinesses,themanagersofthesetwobusinesseswould
operateautonomously.Thephilosophybehindthis—worthrepeating
manytimesover—isthatitiseasiertohandlealargenumberofcom-
petentmanagersiftheyaregivenindependence.Ifcompetentmanagers
arenotgivenindependence,theyarelikelytoleave.Buffettwrites,“IfIhaveonepersonreportingtomeandheisalemon,that’sonetoomany,
andifIhavemanagerslikethosewenowhave,thenumbercanbealmost
unlimited.”7
StarFurnitureandJordan’sFurniture
TheNebraskaFurnitureMartandR.C.Willeystoriescontinuedto
unfoldasBerkshire
HathawayacquiredStarFurniturein1997.When
BuffettaskedR.C.Willey’sCEOaboutfurnitureindustrystandouts,
oneofthenameshegavewasStarFurniture,afive-storeretailer.Severalyearslater,StarFurniturebecameavailable,andBuffettappearedhappy
toacquireit.“AswasthecasewithBlumkinsandBillChild,Ihadno
needtocheckleases,workoutemploymentcontracts,etc.IknewIwas
dealingwithamanofintegrityandthat’swhatcounted.”8Ofcourse,in
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retailing,manufacturing,andutilities
additiontoexcellentmanagement,Buffettsawopportunityforgrowth.
Andthecompanyhasgrown
steadilyeversince.In2009,therewere10
StarFurniturestores.
Excellentmanagerscontributenotonlythroughthesuperiorprof-
itabilityoftheirbusinessesbutalsothroughtheirideas.Theybecome
extravoiceswhocanadvise
youonhowtodobusinesswithintheir
field.AndBuffettlistenstothem.TheideatopurchaseJordan’sFurni-
turealsocamefromthemanagersofotherfurniturestoresthatBerkshire
alreadyowned.BuffettexplainshowhecameacrossJordan’sFurni-
ture:“IhavepersistentlyaskedtheBlumkins,BillChild,andMelvyn
Wolffwhetherthereareanymoreouttherelikeyou.Theirinvariable
answerwastheTatelmanbrothersofNewEnglandandtheirremarkable
furniturebusiness,Jordan’s.”9
InthecaseofJordan’s,thecompanynotonlysellsfurniture;italso
presentscustomerswithadazzlingentertainmentexperiencecalledshoppertainment.ParentscangotoJordan’sandsimultaneouslyfindanewottomanandtaketheirkidsoutforanafternoonoffun.Arewelikelyto
seeinnovationsfromoneunit,say,Jordan’s,transferredtotheotherunits?
Asweknow,Buffettdoesnotinterfereintheday-to-daymanagement
ofthevarioussubsidiaries,buthedoesprovideallpossibleopportu-
nitiesforinteraction.Aslongasmanagershaveincentives
toimprove
profitability,theywilladopttheinnovationsthataresuitabletothem
butavoidtheonesthatarenot.Thisismoreefficientthanrequiringallthefurniturestorestoadoptpracticesthathavebeensuccessfulforone
ofthem.
CORTBusinessServices
HereisanothertwisttoBerkshire’sfurniturebusiness.CORTisnota
furniturestoreinthesamemannerasNebraskaFurnitureMart.CORT
isaleadingnationalproviderofrentalfurniture,accessories,andrelatedservices.CORTwasacquired
in2000byBerkshire’ssubsidiaryWescofor
$385million.InJanuary2008,CORTagreedtoacquireRoomservice
Group,asimilarsmallerfirmintheUnitedKingdom.InNovember
2008,itacquiredabusinessdivisionofAaronRentsandexpandedto
severalnewmarkets.CORThasgrownminimallyinthepasteightyears
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127
(revenuesof$395millionin2001to$410millionin2008),probably
becauseofmarketconditions.
However,CORThaspromise,asCharlieMungerwrites:
CORThascontinuedtomakeseveralselectiveacquisitionssinceit
waspurchasedbyWesco,anditisbelievedthatCORTisnowbetter
positionedtobenefitfromjobgrowthandanycorrespondingeco-
nomicexpansion....CORTiswellpositioned...duenotonlytoits
nationalpresenceandliquidity,butalsobecause
thebusinessreputation
ofBerkshireHathawaygivesitentréetotheofficesofmanyprospective
customers,andthusacompetitiveadvantage.10
ThestoryofCORTtellsusthatnotallofBerkshire’sacquisitions
growfast.However,theyare
allmanagedwithalong-termpointofview.
Thisapproachtoslowandsteadygrowthresemblestheonewesawfor
GEICO.CORTisbuildingitsreputationnowandwillprobablybecome
aggressiveincapturingmarketshareandacquiringweakercompetitors
whentheeconomyisdownbecauseitdoesnothavetoworryabout
quarter-over-quarterprofits.Lowcost,reputation,andfinancialstrengtharekeystolong-termsuccessinfurnitureandsimilarbusinesses.
Conclusions
Youmightthinkthatother
thanafewbusinesseslikejewelrythatwe
discussedinthepreviouschapter,consumersdonotcaremuchabout
thereputationofabusiness.Thatisnotso.Thereisatleastoneimportantreasontocareaboutthereputationofafurniturestore.Howoftendo
youseeadsforfurniture
stores’going-out-of-businesssales?Theyseem
omnipresent.Whenafurniturestoregoesoutofbusiness,customers
oftenlosetheirdeposits,warranties,andreturnprivileges.Itisdifficulttorebuildareputationonceitisdestroyedbysuchevents.LevitzFurniture,forexample,hasfiledfor
Chapter11bankruptcythreetimes:1997,2005,
and2007.Businessesrunbyreputablefirmsormanagersrarely,ifever,
gooutofbusiness.Insteadtheycontinuetogrow.Wheneverpossible,
investwithreputablemanagersrunningreputablebusinesses.
E1C11
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E1C12
Date:Jan20,2010
Time:11:36am
Chapter12
WhyInvestin
UtilityCompanies?
Thoughtherearemanyregulatoryconstraintsintheutility
industry,it’spossiblethatwewillmakeadditionalcommitments
inthefield.Ifwedo,theamountsinvolvedcouldbelarge.1
—WarrenBuffett
In2000,BerkshireHathawayinvested$1.7billiontoacquire
MidAmericanEnergy(MEC)withWalterScottasitspartner.MEC
isanelectricutilitybasedinIowawithoperationsintheUnited
StatesandtheUnitedKingdom.Withthisacquisition,Berkshirecame
toownamajorutilitycompanyandenteredintoanewindustry.Invest-
mentsintheutilitysectoraregenerallyregardedaslowrisk,whichis
somethingBuffettalwayslooksforinapotential
acquisition.Butwhat
elsecouldhavepromptedBuffetttobreakintotheutilityindustry?
SimilaritybetweentheMECand
OtherAcquisitions
TheMECacquisitionhasseveralfeaturesincommonwithBuffett’s
prioracquisitionsinthefurnitureandjewelryretailingbusinesses.First,129
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retailing,manufact
uring,andutilities
customersbuymostoftheirfurnitureandjewelrylocally,justasthey
doelectricity.Second,theseindustriesarealllikelytocontinuetogrowbecauseofincreasesinpopulationandstandardsofliving.Third,Buffettonceagainemphasizestheimportanceofmanagementinthis
acquisition.
TalkingaboutWalterScott,MEC’sthenlargestshareholder,andDavid
Sokol,theCEO,Buffettwrites:“IfIonlyhadtwodraftpicksoutof
Americanbusiness,WalterScottandDavidSokolaretheonesIwould
chooseforthisindustry.”2
WhydoesBuffettfocusonmanagement?GoingbacktoBerk-
shire’sinvestmentinNebraskaFurnitureMart,notmanypeoplewould
havepredictedthatBerkshirewouldacquirefurniturebusinessesallover
thecountry.Thesubsequentacquisitionsweremadewiththehelpof
NebraskaFurniture’smanagement.Similarly,severaljewelrybusinesses
wereacquiredaftertheinitialacquisitionofBorsheim’s.Likewise,Berk-
shirehopedtobenefitbyusingtheMECmanagement
selectfollow-up
acquisitions.
Buffettwasnotbuyingacheapcompanyasapurevalueinvestor
wouldliketodo.Berkshirepaid$35.05pershareforMEC,whichitself
atthetimewasgrowingfastthroughacquisitions.Over
theprior10
years,itstotalassetshadgrownfromlessthan$500milliontoabove
$10billion,atwentyfoldincrease.Revenueshadgrownalongthesame
lines.Theaverageearningspersharefortwoyearsbeforetheacquisitionwas$1.74,givingMECan
acquisitionprice-to-earnings(P/E)of20,
comparedwiththelong-runS&P500P/Eaverageofabout16.Other
metricssuchasmarket-to-book(M/B)ratiosimilarlydidnotsuggest
thatthecompanyfittheprofileofatraditionalvalueinvestment.
Moststateregulatorsallowutilitiestoearnareturnonequityof
about10percent.MidAmericanwasearningaboutthesamerateof
returnatthetimeitwasacquiredbyBerkshire.Utilities,regulatedor
otherwise,donotearnahighrateofreturnonequity,but
mostofthem
earnasteadyrateofreturn.Thus,theyareusuallyconsideredtobelow-
riskinvestments,buttheirlong-runstockmarketreturnsareonlyatad
belowthecorrespondingreturnsfromindustrials.Fromdataavailablefor
1993to2008,compoundedannualreturnsontheDowJonesUtilities
indexincludingdividendsare7.8percent(233percentover16years)in
comparisonwith8.6percent(276percentover16years)fortheDow
JonesIndustrialAverage.(PriordataonUtilitiesindex
withdividends
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131
factoredinarenotavailable.)
Overall,itseemstomethatBuffettinvestedintheutilityindustrytoearnareasonablerateofreturn,somewhat
betterthantheratehecouldearnbyinvestinginmedium-orlong-term
bonds.Inthelongrun,theremayalsobeprofitablegrowthopportunities
becauseofoutstanding
managersBerkshirepickedupwiththeMEC
acquisition.Finally,utilitieswouldallowBuffetttoinvestalargesumofmoneyovertime,amuch-neededoutletforBerkshire’sever-growing
insurancefloat.Let’sconsiderBuffett’sacquisitioncriteriainconnectionwithMEC.
FourNonpriceAcquisitionCriteria
“Webuygoodcompanieswithoutstandingmanagementandgood
growthpotentialatafairprice,andwe’rewillingtowaitlongerthan
someinvestorsforthatpotentialtoberealized.This[MEC]investment
isrightinoursweetspot,”writesBuffett.3Notethefourcriteria,in
additiontoprice,mentionedbyBuffett:
1.Outstandingmanagement
2.Goodcompany
3.Goodgrowthpotential
4.Patience
TheMECacquisitionprovidesagoodexampletodiscussthese
criteria.
OutstandingManagement
BuffettrecallshowhestartedthinkingabouttheMECdeal:“Walter
casuallyaskedmewhetherBerkshiremightbeinterested
inmakinga
largeinvestmentinMidAmerican,andfromthestarttheideaofbeing
inpartnershipwithWalterstruckmeasagoodone....Waltercharac-
teristicallybackeduphisconvictionswithrealmoney:Heandhisfamily
willbuymoreMidAmericanstock....Walterwillalsobethecontrollingshareholderofthecompany,andIcan’tthinkofabetterpersontohold
thatpost.”4Giventhesestatements,thekeyelementforthepostacqui-
sitionsuccessofamergeristhequalityofmanagement.Inthecaseof
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retailing,manufacturing,andutilities
MEC’sacquisition,WalterScottparticipatedbyinvesting$300million
ofhisownfundsthatalsosignaledhisconfidenceinthefutureofthe
company.
Itisnoteasytoidentifyoutstandingmanagement.Buffettempha-
sizesalongtrackrecordofsuccess,attimesaverylongtrackrecord.
Hehasmentionedthatthereshouldbenomandatoryretirementagefor
CEOsbecauseexperienceonlymakesthembetter.Mrs.BatNebraska
Furnitureremainedactivewellpasttheageof100.OtherBerkshire
managersolderthan80yearsofageincludeA.L.Ueltschi,
chairman
ofFlightSafety,andCharlieMunger,vicechairmanofBerkshire.AsI
discussedearlier,high-qualitymanagersalsofuelgrowththroughacqui-
sitions,astheyknowwhattobuyintheirindustry.Theirhumancapital
isnotreflectedonthecompanybalancesheet,andhenceBuffettiswill-
ingtopayareasonableprice-to-earnings(P/E)ratiowhenhebuysa
companythatcomeswithexcellentmanagement.
GoodCompany
Buffettdoesnotsay“great
company”;hesays“goodcompany.”The
definitionofagoodcompanyisalsonoteasytopindown.Inmymind,
agoodcompanyisonethathasgivensatisfactoryreturnsoninvestment
andislikelytogivesatisfactoryreturnsfortheforeseeablefuture.This
conditionisclearlymetbyMECasthecompanyformostpartisregulated.Buffetthasalsosaidthatsignificantbarrierstoentryaredesirablecompanycharacteristics,andinthecaseofMEC,thatconditionismet
becauseutilitiesrequirelargesumsofmoneyforpowerplants.Buthis
mainfocusinacquisitionsseemstobetoplaceagoodcompanyinthe
handsofexcellentmanagementwithfullsupportfromBerkshire.That
managementmaytransformagoodcompanyintoagreatcompany.Ifit
doesnotbecomeagreatcompany,thereturnswill
stillbesatisfactory.Ifthecompanyisalreadyrecognizedasagreatcompany,thestockprice
maybetoohighforittobeaBuffettinvestment.Ontheotherhand,the
potentialincreaseinthevaluefromtransferringagoodcompanyintoa
greatcompanyisenormous.5
AsshowninTable12.1,MidAmerican’sreturnonassets(earnings
beforeinterestandtaxes/totalassets[EBIT/TA])in2008and2007is
5.4percentand5.5percent,respectively,oranaverageof5.45percent.
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133
Theoverallconclusionsaresimilarifweusealltheavailabledata.Ifweincludeonlytangibleassets(inotherwords,ifweexclude
accounting
Goodwill),theaveragereturnis6.35percent.Ialsoestimatedreturn
onequity,whichturnsouttobeabout8percent.6Ignoringaccounting
Goodwill,thereturnonequityisabout13percent.Sincedetaileddata
onreplacementcostsofproperty,plant,andequipmentarenotavailable,
myguessisthatthereturnonequityissomewherebetween8percent
and13percent,oranaverageof10.5percent.Thisreturniscloseto
whattheregulatorsoftengranttheutilities.Consistent
goodreturnsareatell-talesignofagoodcompany.
Likemostutilities,MidAmericanhasalargeamountofdebt.At
theendof2008,MidAmerican’sdebtwas$20.1billionagainst$41.6
billionoftotalassets,orabouthalfoftotalassets.DoesitgoagainstBuffett’s
philosophyofmaintainingalowfinancialleverageandmake
MidAmericanabadcompany?Themainreasonforapreferencetoward
lowfinancialleverageingeneralistoavoidfinancialstress.However,
well-managedutilitiesgeneratesteadycashflows
andhavelargeamounts
ofplantassets.Suchcompaniescanavoidfinancialdistressbyremaining
focusedontheirbusiness.Utilitiessometimesgetintotroubleprimarily
becauseofineptmanagementasEnrondidwhenitenteredintohuge
derivativecontracts.Also,debtissuedbyMidAmericanisnotguaranteed
byBerkshire.Overall,ahighlevelofdebtatMECdoesnotseemtobe
aconcern.
GoodGrowthPotentialandPatience
Youmighthavenoticedthat
Buffettdoesnotcite“excellentgrowth
potential.”Onceagain,ifacompanyhasexcellentgrowthpotential,
themarketpriceislikelytoalreadybetoohighfortheinvestmentto
beaBuffettinvestment.Ontheotherhand,whenacompanyhasno
growthpotential,smallchangesintechnologyordemandforitsprod-
uctsmaycreatesignificantdiseconomiesrequiringthecompanytoshut
down.Nordosuchcompaniesattracttalentedemployees.Buffettrefers
toinvestinginacompanywithlittletonogrowth
potentialasa“cigar
butt”approachtoinvesting.Suchinvestmentsdonotofferhighlong-
termgainsjustascigarbuttsdonotoffermuchlong-termsmoke.Thus,
goodgrowthpotentialisahealthyacquisitioncriterion.
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retailing,manufacturing,andutilities
Intheutilitysector,thegrowthpotentialforgoodcompaniesappears
promising,butaninvestor
mayhavetowaitforalongtimetorealizeanyactualgrowth.Specifically,newlawswillultimatelyallowunbundling
ofthegeneration,transmission,anddistributionfunctionstraditionally
performedbyutilitiesinoneunit.ThisunbundlingintheUnitedStates
willbesimilartothatintheUnitedKingdom,andMECshouldbenefit
greatlyfromitsexperienceintheUnitedKingdom.Butitwillnot
happenquicklybecauseitisapoliticalprocess.Intheinterim,Berkshirewillcontinuetoearnareasonablerateofreturn.
Table12.1showsthatMidAmerican’stotalassetshavemorethan
tripledto$41.57billionineightyears.Howdidthisgrowthoccur?It
appearsthatthepresumedlow-riskcharacteristicoftheutilityindustry
appliesonlytotheregulatedsector.Theunregulated
sector,domi-
natedbyfirmssellingelectricityandnaturalgasintheopenmarket,
isnotaslowriskastheregulatedsector,owingtothehighlevelof
financialleverage.Therefore,acquisitionopportunitiesarisewhencom-
paniesgetintotroublebecauseutilitycompaniesarehighlylevered.
OpportunitiesforBerkshiretoinvestintheenergysectorappeared
in2001and2002inthewakeofEnron’sbankruptcyandproblems
atotherenergycompanies.Berkshirepurchased
NorthernNaturalGas
pipelinefromDynegyfor$1.9billionandanothergaspipeline,Kern
River,fromtheWilliamsCompaniesfor$950million.In2006,Berk-
shireinvested$5.2billioninPacifiCorp.MidAmericanisalsogrowing
organically.From2006to2008,MidAmerican’scapitalexpenditurein
excessofdepreciationwas$6.7billion.Overall,therearegoodgrowth
potentials.
Youarenotlikelytoearnhighratesofreturnbyinvestinginautility.
Thebesttimetoinvestinautilityisprobablywhenautility’sbookreturnonitsequitygoesdown,affectingthestockpricesnegatively.Thiscan
occurwheninputpricesofcoal,gas,andthelikegoup,whencustomer
demandgoesdown(perhapsresultingfromeconomicslowdown),or
wheninterestratesgoup.Autilitywouldbeagoodvalueinvestment
then.Ofcourse,youshouldinvestinonlyhealthycompanieslestyou
loseyourinvestmentcompletelywhenacompanyisnotabletosurvive
theslump.Sinceutilitiesgenerateareasonablerateof
returnonequity
overthelongrun,alowreturninoneperiodislikelytobounceback
toahigherreturninsubsequentperiods.
E1C12
Date:Jan20,2010
Time:11:36am
616
5.3%
2000
8,008
3,673
4,013
$
$
$11,681
$
$
8.3%
2001
8,987
3,639
4,973
1,004
$
$
$12,626
$
$
8.1%
2002
4,258
4,968
1,253
$14,177
$
$18,435
$
$
8.5%
2003
4,306
6,145
1,591
$14,862
$
$19,168
$
$
6.8%
2004
4,307
6,727
1,331
$15,597
$
$19,904
$
$
Holdings)
Energy
8.5%
2005
4,156
7,279
1,698
$16,037
$
$20,193
$
$
ican
6.1%
2006
5,548
1,737
$30,942
$
$36,490
$10,644
$
(MidAmer
Sector
5.5%
2007
5,591
2,086
$33,917
$
$39,508
$12,628
$
Energy
5,280
2,203
5.4%
away
2008
$36,290
$
$41,570
$13,971
$
Hathe
est
other
(%)
millions.
inter
in
Berkshir
and
e
(EBIT)
Assets
ues
plant,
es
,
net
befor
otal
12.1
ty
amounts
assets
reven
tax
ble
nings
a
oper
equipment,
assets,
and
otal
otal
T
Pr
Goodwill
T
T
Ear
EBIT/T
Dollar
135
E1C12
Date:Jan20,2010
Time:11:36am
136
retailing,manufacturing,andutilities
Conclusions
Berkshire’sacquisitionshavebeenforthemostpartsuccessful,probably
becauseofBuffett’semphasisonthequalityofmanagementandkeeping
thecurrentmanagementinplaceafterthemerger.Unlessyouarein
apositiontoclearlyforeseethesuccessofthemergedcompany,you
shouldavoidinvestingincompaniesthatareacquiringothercompanies.
Otherthanprice,youshouldaskatleastfourquestions
whenevaluating
anacquisitionsituation:Isthequalityofmanagementexcellent?Isita
goodcompany?Isthegrowthpotentialgood?Anddoestheacquirer
havepatience?
E1C13
Date:Jan20,2010
Time:11:43am
Chapter13
HighProfitsin
Honest-to-Goodness
Manufacturing
Companies
Thecompany’s[Scott
Fetzer’s]successcomesfromthemanage-
rialexpertiseofCEORalphSchey—ThereasonsforRalph’s
successarenotcomplicated.1
—WarrenBuffett
ScottFetzerhasbeenaBerkshireHathawaysubsidiarysince1986
andmanufacturesorsells
suchwide-rangingitemsasutilitytree
vehicles,brushlessDC(directcurrent)anduniversalmotors,
Ginsuknives,WorldBookencyclopedias,Kirbyvacuumcleaners,and
professionalcleaningproducts,amongothersmallindustrialandcon-
sumeritems.
RalphE.Schey’sleadershipinsalesmanshipandmanagementwas
instrumentalinScottFetzer’ssuccessbeforeitwasacquiredbyBerkshire.
WhenScheyjoinedScottFetzerin1974,ScottFetzer’sstockpricewas
$8pershare.Tenyearslater,itsoldfor$62ashare.Atonetime,Ivan
137
E1C13
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138
retailing,manufacturing,andutilities
Boesky,acorporatebuyoutexpert,offeredtobuythecompany;andat
anothertime,thecompany’smanagementtriedtotakeitprivate.Both
thoseattemptsfailed,andBerkshireHathawaypurchasedthecompany
in1986for$61pershare,orabout$315million.Itwasacquiredafter
itssignificantgrowthinprioryearsunderRalphSchey’smanagement.
Untilhisretirementin2000,Scheymanagedthecompanyandproduced
highreturnsforBerkshire.
ScottFetzer’sSuccess
Table13.1showsthatforthefirstnineyearsafterBerkshireacquiredthecompany,ScottFetzerearnedatotalof$555millionandpaiddividends
of$635milliontoBerkshire.Therateofdividendpayments,onaver-
age,was22percentperyear
onBerkshire’sinitialinvestment.Earnings
grewsteadilyduringthisperiod.Whilerevenuesgrewattherateof
Table13.1
ScottFetzer’sEarningsandDividends
ReturntoBerkshireasa
PercentageofInitialInvestment
Year
Earnings
Dividends
Earnings
Dividends
1986
$40.3
$125.0
13%
40%
1987
48.6
41.0
15
13
1988
58.0
35.0
18
11
1989
58.5
71.5
19
23
1990
61.3
33.5
19
11
1991
61.4
75.0
19
24
1992
70.5
80.0
22
25
1993
77.5
98.0
25
31
1994
79.3
76.0
25
24
Total
555.4
635.0
Average
20
22
Dollaramountsinmillions.
E1C13
Date:Jan20,2010
Time:11:43am
HighProfitsinHonest-to-GoodnessManufacturingCompanies139
about4percentperyear,reaching$1billionin1994,earningsgrewat
about8percentperyear—aratethatseemsremarkablegiventhatallthe
companiesintheScottFetzergroupwerefromseeminglyold-fashioned
industries.
Althoughdetaileddataonearningsanddividendsarenotavailable
after1994,dataonoperatingearningsbeforetaxesareavailablefrom
1996until2002.AnanalysisofthosedatashowsthatthegroupofScott
Fetzercompaniescontinuedtodowell,althoughgrowthseemstohave
slowedsince1996.Basedonnumbersfromoperatingearnings,netearn-
ingsseemtobeabout$78millionperyear,which
translatesintoarate
of25percentperyearonBerkshire’sinitialinvestment.Overall,Scott
Fetzerhasbeenaremarkableinvestmentandcontinuestogeneratehigh
returns.
HowdidScottFetzerdosowellwhenmanycompanies
fromtra-
ditionalindustriesdidnotsurvivethecompetitionorfaceddeclining
profitability?YourunderstandingofScottFetzerwillhelpyoufindothercompaniesthatarepubliclytradedandfollowsimilarprinciples.
Companiesintraditionalor
old-fashionedindustriestypicallyface
decliningprofitability—soitisimportantformanagementtoavoidthe
temptationtoplowbackearningsintothecompany.Essentially,managers
needtoremembernottothrowgoodmoneyafterbad.From1986to
1994,totalearningswere$555.4million,butmostwerenotplowedback
intoScottFetzer.Instead,theywerepaidtoBerkshireintheformof
dividends.Intheso-calledold-fashionedindustries,highgrowthisnot
thenorm;growingeitherinternallyorthroughgood
acquisitionsisnot
easy.SocreditgoestoScheyandBuffettfornotexpandingsimplyfor
thesakeofexpanding.Ifyounoticeacompanythathasgoodcashflows
butwhosemanagersexpandthecompanybyacquiringothercompanies
orbyinternalgrowthofassets,youneedtoinvestigateitcarefully.
HowdoesBuffettaccomplishexemplarybehaviorfromhisman-
agers?Beyondpickingtherighttypeofpeople,thekeytosuccessmay
becarefullydesignedCEOcompensationcontracts.The
focusshould
beonprofitabilityandnotontotalprofits,whichdisregardsthecapitalbase.InthecaseofScottFetzer,Scheycouldhaveeasilygeneratedeven
higherlevelsofearningsifcashflowshadbeenplowedbackintothe
company.However,therate
ofreturnoninvestmentwouldhavegone
downandwouldnotbeoptimumforBerkshireasawhole.
E1C13
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140
retailing,manufacturing,andutilities
LestwethinkthatScottFetzer’sgrowthhasbeeninappropriately
deemphasized,weshouldnotforgetthatBuffettcanusethedividends
receivedinanywayhewants.ThecapitalallocationjobforBerkshireas
awholeisinBuffett’shands.Inthatsense,growthfromthedividends
receivedfromScottFetzercanoccurinanothercompany,givinghigher
ratesofreturntoBerkshireshareholders,whoaretheultimateownersof
ScottFetzer.Abriefexaminationofothersimilar
Berkshiresubsidiaries
ispresentednext.
ShawIndustries,Marmon,andMcLane
SeveralotherBerkshiresubsidiariesarealsofromhonest-to-goodness
traditionalindustries.WegetlikeinsightsfromthewayBuffettmanages
thesesubsidiaries.InTable13.2,Ipresenttheprofitabilitynumbersofonesubsidiarybecauseitisarelativelyrecentacquisition,anditsmajornumbersareavailablefromvariousBerkshireannualreports.ShawIndustries
isaleadingmanufactureranddistributorofcarpetsandrugsforresiden-
tialandcommercialuse.Berkshireacquired87.3percentofthecompany
in2001andtheremaining12.7percentin2002.Intotal,Berkshirepaid
$2.4billion.2
Shaw’srevenuesandearningsclimbedsteadilyfrom2001to2006but
declinedin2007and2008asthehousingmarketcollapsed.(Dividend
numbersarenotavailable.)IdentifiableassetsalsoincreasedasthedemandforShaw’sproductsroseduringtheboominghousingmarket.Interms
ofreturnonBerkshire’sinvestmentof$2.4billion,theaveragelevelof
annualreturnfrom2002to2008isabout15percentafteraccountingfor
taxes.Thisiscertainlyaveryhealthyreturnbecausetheinvestmentin
Shawshouldbeconsideredrelativelysafefromalong-termperspective.
Itisdifficulttoimaginethatthemarketforcarpetswillgo
awayand
thatawell-managed,dominantcompanywillnotremainprofitablefor
alongtime.
InthecasesofbothScottFetzerandShaw,theCEOsinchargeatthe
timeoftheacquisitionswerenotreplaced.RalphScheyat
ScottFetzer
continuedastheCEOfor14moreyears,andRobertE.Shawcontinued
astheCEOforsixmoreyears.Neitherofthemleftthecompaniesthey
managedforanotherposition,butretired.
E1C13
Date:Jan20,2010
Time:11:43am
HighProfitsinHonest-to-GoodnessManufacturingCompanies141
Table13.2
ShawIndustries:ProfitabilityandGrowthafterBerkshire’s
AcquisitionofShaw
Earningsbefore
Earnings
taxesasa
Earningsbeforetaxesas
Identifiable
percentageof
before
apercentage
assetsat
identifiableassets
Year
Revenues
taxes
ofrevenues
year-end
atyear-end
2001
$4,090
$298
7.3%
$1,619
18.4%
2002
4,334
424
9.8
1,932
21.9
2003
4,660
436
9.4
1,999
21.8
2004
5,274
466
8.8
2,153
21.6
2005
5,723
485
8.5
2,718
17.8
2006
5,834
594
10.2
2,776
21.4
Average
9.0
20.5
Dollarsamountsinmillions.
In2008,Berkshireacquired60percentofMarmonHoldings,which
consistsof130manufacturingandservicebusinessesthatoperateinde-
pendentlywithin11diversebusinesssectors.Theproductsrangefrom
nutsandbolts,wire,andcabletoshoppingcartsandrailroadtankcars.
Theremaining40percentwillbeacquiredinfutureyearsforconsider-
ationtobebasedonthefutureearningsofMarmon.
Fromlimiteddata
thatareavailable,Isurmisethatprofitabilityishighlysatisfactoryatabout10percentoperatingincomeontangibleassets.
IalsoexaminedsimilarnumbersforMcLaneCompany,whichwas
acquiredbyBerkshireinMay2003.McLaneisoneofthe
nation’slargest
wholesaledistributorsofgroceriesandnonfooditemstoconvenience
anddiscountstores.Theafter-taxreturnontheinitialBerkshireinvest-
mentof$1.5billionhasbeenabout10percentperyear,onaverage.For
2008,earningsbeforetaxeswere$276million,whichisabout18per-
centbeforetaxesorabout11percentaftertaxes.ChancesareitsearningswillgrowwithtimeevenwithoutadditionalBerkshireinvestment.One
reasonforitsgrowthpotentialisthat,whenMcLanewasaWal-Mart
subsidiary,itwasnotviewedasanindependentdistributorbyWal-Mart’s
competitors.Manyofthepotentialcustomerswouldthennotbuyfrom
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142
retailing,manufacturing,andutilities
McLane.However,asaBerkshireunit,itwillnothavethatimpediment
togrowth.Overall,whenacompanyisrunwell,theprofitabilityinbusi-
nessesfromtraditional
industriesdoesnothavetobelow.Asamatteroffact,Buffett’ssuccessmaycomepartlyfromthefactthathismanagers
doanoutstandingjobinmanagingseeminglyold-fashionedcompanies.
Conclusions
Themainingredientbehindthesuccessofcompaniesin
traditional
industriesisthepresenceofcompetentCEOswhomighthavemade
themsuccessfulinthefirstplace.TopraisetheCEOofShawIndustries,
Buffettwrites:“Anymanwhocanstartfromabsolutescratchinatough,
competitiveindustryandbuilda$5billionbusinessissomeoneIwantto
bepartneredwith.”3Asaninvestorlookingtoinvestincompaniesthat
havebeenaroundforawhile,youshouldgiveconsiderableimportance
tothequalityofmanagement.Tojudgethe
qualityofmanagement,
ShawCEORobertShawsays,“Investorscanlookatourtrackrecord
andgetonthetrainorgetoff.It’sthatsimple.”4Soitallboilsdowntotrackrecord;findCEOswhohaveagood—andlong—trackrecord.
E1PART05
Date:Dec10,2009
Time:12:21pm
PartFive
RISK,
DIVERSIFICATION,
ANDWHENTOSELL
WarrenBuffett’sconceptofriskfrominvestingincommon
stocksisdifferentfromwhat
istaughtinbusinessschools.
Hisideasondiversificationandwhentosellarealsovery
insightfulandworthspendingsometimethinkingabout,evenifyou
havestudiedthesetopicsfromotherperspectivesbefore.Chapters14to
17aredevotedtothese
issues.
143
E1PART05
Date:Dec10,2009
Time:12:21pm
E1C14
Date:Jan18,2010
Time:9:14pm
Chapter14
RiskandVolatility:How
toThinkProfitably
aboutThem
[W]edefinerisk,usingdictionaryterms,as“thepossibilityof
lossorinjury.”1
—WarrenBuffett
Whatdoesthewordriskmean?Thinkaboutit.Becauseof
theU.S.governmentguarantees,U.S.Treasurybillsand
bondsareconsideredtobetheleastriskysecuritiesaround
theworld.Inthiscontext,
riskimpliesdefaultriskordownsiderisk.
Followingthislineofthinking,corporatebondsareriskierthanU.S.
bonds,commonstocksareriskierthancorporatebonds,andoptionsare
riskierthancommonstocks.However,whenacademicsmentionthat
commonstocksareriskierthancorporatebonds,theyinvariablyimply
thatcommonstockshaveahigher“beta.”Insimpleterms,betameasureshowstockreturnsarecorrelatedwithmarketreturns:Thehigherthe
correlation,thehigherthebeta,withtheaveragebetaofallstocksbeingnormalized
to1.0.However,inmostresearchstudies,betahasnotbeenfoundtobeausefuldefinitionforpredictingcommonstockreturns,
especiallyforindividualstocks.2So,academicsarestilltryingtodevelop145
E1C14
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Time:9:14pm
146
risk,diversification,andwhentosell
bettermeasuresofrisk.Inthemeantime,asanindividualinvestor,you
arebetteroffignoringbetaforpickingindividualstocks.Youshould
insteadcarefullydifferentiatebetweenthedownsideriskandtheupside
potential.Attheveryleast,youshouldknowwhatyou
meanbythe
wordrisk.
Avagueunderstandingofriskisadangerousthing.Considerthe
well-knowncaseoftheOrangeCountybankruptcy.In1994,Orange
County,California,lostmorethan$1.5billion.Stateand
localgov-
ernmentsaregenerallyconsideredtobesomeofthemostconservative
investors.HowdidOrangeCountylosesuchahugeamount?Inthiscase,
theanswerlayinamisunderstandingoftheriskembeddedinderivative
securities:callandputoptionsandfuturescontracts.Inthemindsofsomeadministrators,thesederivativesecuritiesweresupposedtohavereduced
riskandenhancedreturns.However,theydidjusttheopposite.Aclearer
understandingofriskwouldhavehelpedOrangeCountyavoidthishuge
loss.IfOrangeCounty’sadministratorshadaskedabouttheprobability
andpotentialmagnitudeofloss(downsiderisk),theyprobablywould
havemadebetterdecisions.3Inyourinvesting,youshouldalwaysask
thosequestions.
RiskandReturn:HoldingPeriod
WarrenBuffettsuggeststhatreturnsfromquartertoquarter,oreven
yeartoyear,arenotveryimportantifthereturnsinthelongrunare
predictable.Volatilityofreturnsintheshortrunshouldnotbethemain
criterionforassessingrisk.Whatmattersisthereturnattheendoftheinvestmentperiod.Assumethatyouinvest$1,000ina30-yearTreasury
bondyielding5percent.Ifyourinvestmenthorizonis30years,youwill
earn$50ininterestperyear,plustheprincipalof$1,000attheendof30
years.However,themarketpriceofthe30-yearbondwillchangefrom
monthtomonthdependingonthemarketinterestrate,whichcould
createsignificantshort-termvolatility.Ifyouhavea30-yearinvestmenthorizon,shouldyoudefinethemonthlyvolatilityofbondpricesasrisk?
No.Theinvestmentisrisk-freesofarasthepaymentsareconcerned
innominaldollars.Considerthesame30-yearbondinvestmentfrom
theperspectiveofapersonwithaone-yearinvestmenthorizon.This
E1C14
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RiskandVolatility:HowtoThinkProfitablyaboutThem
147
investorcanloseasignificantamountifinterestratesrisebecausethe
pricesoflong-termbonds
fallasinterestratesrise.Inearly2009,the30-yearTreasurybondsdeclinedinpriceby20percentwhentheinterest
rateswentupbyabout1.5percent.
Let’smoveontostocksandreturnvolatility.Assumethataninsur-
ancecompanyhas
underwrittenalargenumberofhurricaneinsurance
policiesinFlorida.YouareprobablyalreadythinkingofBerkshire’sinsurancebusiness.Theinsurancecompanywillshowhighprofitsintheyears
Floridaisnothitbyamajorhurricane.Sincethestockmarketusually
focusesontheshortterm,youshouldnotbesurprisedifthecompany’s
stockenjoyshighreturnsinthoseyears.Butduringayearinwhicha
majorhurricanehitsthestate,profitswillgodownandthestockprice
couldbebiddownsubstantially.“However,
Berkshire’smanagementis
willingtoacceptvolatilityinreportedresults,providedthereisarea-
sonableprospectoflong-termprofitability,”writesBuffett.4Aninvestorwhorecognizesthataone-timeeventmaynotaffecttheunderlying
long-runriskprofileofthe
companyislikelytoinvestmoreinagood
insurancecompanywhenthestockpricegoesdown.
Themainlessontotakeawayfromthisdiscussionisthatthereis
aninteractionbetweenthelengthoftheholdingperiodandrisk,espe-
ciallyifyouthinkofriskasdownsiderisk.Thisappliestobothbondsandstocks.Ifstockreturnsfromoneperiodtoanotherwerestatisticallyindependent,thelengthofthehorizonwouldnotbeimportant.However,
thereisampleempiricalevidencethatstockvolatilityinthelongrunislowerthanvolatilityintheshortrun.Thus,thelengthofthe
investmenthorizonshouldbeanimportantconsiderationforaninvestor.
VolatilityOffersOpportunities
Aninvestorwhoviewsvolatilityasriskwillbetemptedtoavoidvolatilestocks,whichmaynotbetherightinvestmentapproach.Indeed,Buffett
suggestsjusttheopposite:“Infact,atrueinvestorwelcomesvolatility.”5
Asanexample,considervolatilityandfirmsize.Smallercompaniesare
usuallymorevolatilethanlargercompanies,probablybecauseasmall
numberofbuyandsellorderscandramatically
changethestockprices
ofsmallercompanies.Butsmallcompaniesneednotbefundamentally
E1C14
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148
risk,diversification,andwhentosell
risky,especiallywhenyouknowalotaboutthespecificcompaniesyou
plantoinvestin.Opportunitiesaremorelikelytoariseinsmallercom-
paniesthaninlargercompanies.Buffetthasexpresslysaidthatifhe
hadasmalleramountofmoneytomanage,hewouldbeabletogen-
eratehigherreturns.SincetheBerkshireinvestmentportfolioishuge,
Buffettrestrictshimselftoinvestinginlargecompanies.However,if
youfollowanindustrycloselyenough,youshould
notignoresmaller
companies.
Increasedvolatilitydoesnotimplyincreasedriskbecausethereare
manyfactorsthatcancausevolatilitythathavenothingtodowithrisk.
ProfessorRobertShillerofYaleUniversityhasoften
arguedthatthe
stockmarketistoovolatiletobeeasilyexplainedbyrationalityalone.
Heconcludes,“Priceschangeinsubstantialmeasurebecausetheinvest-
ingpublicenmassecapriciouslychangesitsmind.”6Usually,afteran
earningsannouncement,acompany’sstockpricebecomesmorevolatile.
Thestockpriceisalsomorevolatileafterastocksplitbecausethepricepersharedecreases.Suchariseinvolatilitydoesnotnecessarilymean
thatthestockhasbecomemorerisky.Volatilityalsoincreaseswhen
theFederalReserveannouncesinterestratesorwhenothermacroeco-
nomicdataarereleased.Mostcompanyfundamentalsarenotaffected
bythesenewsitems,andyoushouldbuymoreofyourfavoritestocks
whenever“Mr.Market”iswillingtosellthemtoyouat
alowerprice
becauseofmarketvolatility.InOctober1974,theDowJonesIndustrial
Average(DJIA)wasbelow600afterhavingdeclined40percent,and
whenForbesaskedBuffetthowhecontemplatedthestockmarket,heshotback,“Likeanoversexedguyina
harem.Thisisthetimetostart
investing.”7
OpportunitiesfromtheSharpDeclineof1987
Therearemanypotentialreasonsforsharpdeclinesinstockprices,and
unlessyouarefairlycertainaboutthereasonforthe
decline,youshouldnotincreaseyourinvestmentinstockssimplybecausetheirpriceshave
declined.Acarefulsearchforareasonwillkeepyoufromcatchinga
fallingknife.Thedeclineofabout20percentonOctober19,1987,is
usuallyattributedtotheso-
calledportfolioinsuranceeffect,whichrequiredE1C14
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RiskandVolatility:HowtoThinkProfitablyaboutThem
149
manyinstitutionalinvestorstosellpartoftheirholdings
aspricesfell,whichinturnpushedpricesdownfurther.Wasthisjustified?Adetailed
examinationofthefundamentalsmayprovideasatisfactoryanswer.
Priceshadbeengoingupsteadilysincethemiddleof1982,when
theDJIAsoaredfrombelow800toahighof2,722in
August1987,an
increaseof240percentinfiveyears.Whilepredictingthemarketisnexttoimpossible,manyinvestorswerefeelinguncertainbecauseinterest
ratesonlong-termbondshadincreasedfromaround7.5percentto10
percentinamatterof
months.Atthesametime,themarketP/Eratio
washoveringaround22fromalowofaround10in1982.Generally,the
relationshipbetweeninterestratesandtheP/Eratioisinverse—thetwo
moveinoppositedirections—yetthistimearound,theP/Eratiowas
increasingasinterestratesweregoingup.Untilpricessuddenlycame
crashingdown.
EvenifyoucouldnotpredictthedownfallofOctober1987,you
wereprobablytemptedtostartinvestingaggressivelywhenpricesbecame
reasonableafterthedownfall.Inrecognizingthatthemarketwasready
forreinvesting,wehavethebenefitofhindsight.Buthistoryteaches
usthatwhenpricesrapidlygodown,theprobabilityoffindinggood
businessesorstocksatlowerpricesgoesup.Buffett
investedheavilyin
Coca-Colastockin1988inthewakeofthe1987marketcorrection.
Althoughthestockmarketinthiscaserecoveredinlessthantwoyears,itcouldhaveeasilytakenlonger.Justaswecannotforeseeacomingcrash,
weshouldnotfeel
comfortablepredictingaquickrecovery.
ASlowDeclinein1973–1974and2008–2009
During1973–1974,pricesdeclinedslowly,fromtheDow’shighof1,057
in1973toalowof577in1974—adropofabout45percent.Inpercent-
ageterms,thedeclinein1973–1974wasmoreseverethanthedeclinein
1987.Whydidthisoccur,andwasitpossibletoknowatvariousstagesifanopportunetimetoinvesthadarrived?BuffettnotedinOctober1974
thatitwastimetostartinvesting.Onceagain,withhindsight,wecan
allconcludethatlate1974certainlywasagoodtimetostartinvesting.
However,itseemsthatmostinvestorshadbeguntoinvestearlierthan
that.ThemarketP/Eratioattheendof1973wasalreadyarounda
E1C14
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150
risk,diversification,andwhentosell
reasonable12.Howcouldyouhaveknownthatyoushouldwaitalmost
anotherfullyearfortheP/E
ratiotofalltoalowofaround7?Thereisnowaytotimethemarketperfectly.Itisextremelydifficulttoknowwhen
priceshavebottomedout.Themainlessonthatwecanlearnfromthe
variousbearmarketsisthatitisimpossibletodevelopageneraltheory
aboutthecausesofbearmarketsbecausetherearedifferentcausesfor
everydecline.Themarketin1973–1974declinedprimarilybecauseof
thesimultaneousrecessionandincreaseintheinflationrate.TheArab
oilembargoinlate1973didnothelpmatters.Although
priceshad
declinedsubstantiallyin1973,noendtotherecessionwasinsightfor
awhile.
Whentherestoftheworldwasfearfulofinvestinginthestock
market,Buffettinvested$10.6millioninWashington
Postinthewake
ofthemarketdecline.Atthetime,thisamountedto21percentall
ofBerkshire’scommonstockinvestmentsinunaffiliatedcompanies.He
writes,“Weboughtallofourholdingsinmid-1973atapriceofnotmore
thanone-fourthofthethenper-sharebusinessvalueoftheenterprise.”8
WashingtonPostpricecontinuedtodeclineforanotheryear.Itillustratesthepointthatitisnotpossibletopickthepricebottomperfectly.By
mid-1974,astherecessionwasfinallygivingwaytooptimism,theoil
embargowaslifted,andtheFederalReserveloweredthefederalfunds
ratefrom8percentto7.75percent,andadditionalratecutsfollowed.
Thepricesfinallybouncedback.
In2009,theyearofthiswriting,theDowhasbeenaslowas7,500,
downfromapeakofover14,000just18monthsearlier.TheUnited
States,Europe,andJapanhavebeeninseriousrecessionsandgrowthin
ChinaandIndiahasslowedconsiderably.Themaindifferencebetween
the1973–1974declineandthecurrentrecessionisthat
thereisno
increaseininflationandinterestratesarelow.TheDowreboundedto
about10,000byNovember2009.Isthisagoodbuyingopportunity?
Noonecanbesure.Ipersonallyboughtsomeearlierandamstillbuying
alittlebit,butitisnosurethingthatwewillseeaquickturnaround
to14,000again.However,ifyouhavea10-yearinvestmenthorizon,it
seemslikeagoodtimetobuystocksinyourfavoritecompanies,withthe
Dow10,000.Betweenthethirdquarterof2008andthe
secondquarter
of2009,Berkshireinvestedalargesumofabout$18billioninvarious
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preferredstocksandnotesofGoldmanSachs,GeneralElectric,Wrigley,
DowChemical,andSwissRe.Inaddition,inNovember2009,Berk-
shireannouncedplanstoacquireBurlingtonNorthernSantaFewhich
willconstituteitslargestacquisitionever.Theseinvestmentsseemtohavebeeninfluenced,inpart,bythemarketdecline.
MoreonDownsideRisk
Thebestwaytoavoidfinancialcatastropheistounderstanddownside
riskwell.Ifpossible,youshouldcompletelyavoid
stocksthathavea
largedownsiderisk.Downsideriskisnotjustadefaultriskforbondsorbankruptcyriskforstocks;youshouldalsoincorporatetheriskofalargedeclineinacompany’smarketvalueowingtoadversedevelopments.
Forexample,acompanyinvestinginmortgage-backed
securitiesmay
seealargenegativeeffectonitsstockpricesifhousingpricesfall.Whenhousingpricesaregoingup,stockpricesofsuchcompaniesmayalso
goup.Theymayappeartobegoodbuyingopportunities,butnotethat
downsideriskisalsogoing
upatthesametime.Asanotherexample,
considerbuyingstocksonmargin.Adeclineinthestockmarketmay
resultinamargincallthatmayrequiresellingoffthesecuritiesatatimewhenbuyingismoredesirable.Aninvestorwhohasthoughtaboutthe
downsideriskcarefullyismorelikelytoavoidinvestingonmarginand
avoidruininthelongrun.
Largepubliccorporationsdonotdefaultoften,butsometimesthey
do.Somelargecompanieshavesuddenlygonebankrupt(forexample,
EnronandWorldCom),andtheirstockholdershavelosttheirinvestments
completely.Inearly2007,BearStearns’stockpricewas$150pershare,
butthecompanywassoldtoJ.P.Morganforjust$10pershareayear
later.Asaninvestor,youshouldtakethisintoaccount.
Ingeneral,you
shouldbeespeciallycarefulininvestinginhighlyleveragedcompanies.
Atleastcomparetheirfinancialleveragewiththecorrespondingindustry
leverage,andavoidinvestingalargepercentageofyournetworthinto
highlyleveragedcompanies.
Earlier,wetalkedabouttheriskofinflationthatcanbeseriouseven
incountriesliketheUnitedStates.Theproblemwithinflationisnot
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risk,diversification,andwhentosell
inflationitself.Theproblemsarisefromtheunforeseenhardshipsfor
thosewhoarenotpreparedforasubstantialfallinthepurchasingpower
oftheirsavingsorfortheeconomysheddingjobs.Buffettsays,“Inour
opinion,therealriskaninvestormustassessiswhetherhisaggregate
after-taxreceiptsfromaninvestment(includingthosehereceiveson
sale)will,overhisprospectiveholdingperiod,
givehimatleastasmuchpurchasingpowerashehadtobeginwith,plusamodestrateofinterest
onthatinitialstake.”9
Toavoidinflationrisk,youcaninvestininflation-adjustedTreasury
securitiesortheso-calledTIPs.Afterall,youareprobablynotinvestingin
Treasuriesforhighreturns.Youcanalsoavoidsomeinflationriskby
owningrealassets.Forexample,itmakesalotofsensetoownyourown
house.Ifyouhaveamortgage,afixed-ratemortgageisbetterbecauseit
allowsyoutoavoidthelargesurprisesthatcanresultfrom
avariablerate.
Inmyopinion,youshouldpayoffyourmortgageassoonaspossibleso
thatyouhavethesecurityofowningyourownhome(andyourmonthly
expensesdonotincludeamortgagepayment)intheeventyouloseyour
job.Ifpossible,youshouldtrytoacquiresomeotherrealestate;maybe
somefarmlandsothatyoucanlivethereandgrowyourownfoodifthings
reallygosouth!Finally,youshouldnotignoreshort-terminvestments
inmoneymarketsbecausetheyareliquid,andtherates
usuallyadjustas
inflationrises.Overall,safetyfirstandliquidityaregoodrulesthatpeopleoftenforgetwhenthegoingisgood.Berkshirehasalwaysmaintained
highliquidityandlowfinancialleverage.Shouldn’tyou?
Anotherdownsideriskisthe
declineinthevalueofthedollar.The
valueoftheU.S.dollaragainstothercurrenciesmaydecline,whichmay
affectyourconsumptionifyoutravelabroad.Tosomeextent,youcan
avoidthisriskbyholdingsomeothercurrencies;ChineseandEuro-
peanmoneyarelogicalchoicesinthissituation.Itisworthsummarizing
Buffett’soutlineonhowtothinkaboutrisk.Hewrites10:
Thoughthisrisk[inowningstocks]cannotbecalculatedwithengi-
neeringprecision,itcaninsomecasesbejudgedwithadegreeof
accuracythatisuseful.Theprimaryfactorsbearinguponthisevalua-
tionare:
1.Thecertaintywithwhichthelong-termeconomiccharacteristics
ofthebusinesscanbeevaluated;
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2.Thecertaintywithwhichmanagementcanbeevaluated,both
astoitsabilitytorealizethe
fullpotentialofthebusinessandto
wiselyemployitscashflows;
3.Thecertaintywithwhichmanagementcanbecountedonto
channeltherewardfromthebusinesstotheshareholdersrather
thantoitself;
4.Thepurchasepriceofthebusiness;
5.Theleveloftaxationandinflationthatwillbeexperiencedandthatwilldeterminethedegreebywhichaninvestor’spurchasing-powerreturnisreducedfromhisgrossreturn.
Thesefactorswillprobablystrikemanyanalystsas
unbearablyfuzzy
becausetheycannotbeextractedfromadatabase.Butthedifficulty
ofpreciselyquantifyingthesemattersisnotinsuperableanddoesnot
negatetheirimportance.JustasSupremeCourtJusticePotterStewart
founditimpossibletoformulateatestforobscenitybutnevertheless
asserted,“IknowitwhenIseeit,”investors—inaninexactbutuse-
fulway—can“see”therisksinherentincertaininvestmentswithout
referencetocomplexequationsorpricehistories.
Conclusions
Whenyouthinkthatthereisalargedownsideriskininvestingina
company,youshouldbeespeciallyvigilantevenifexpectedreturnsare
high.Ahighlyleveragedbalancesheetisoneindicatorofhighdownside
riskinacompany.Evencountriesthatborrowlargeamountsofmoney
arenotsafe:Russiadefaultedonitsloansin1998.Ifyouhadinvested
inRussianbonds,youwouldhavelostheavily.Inparticular,LongTerm
CapitalManagement,thelargesthedgefundatthe
time,lostbillions
ofdollarsasaresultoftheRussiandefaultandalmostwentbankrupt.
SinceevenacountrythesizeofRussiacangetintotrouble,clearlyyou
shouldneverthinkofanycompanyas“toolargetofail.”Byeliminating
orseverelylimitingyourinvestmentsincompanieswithlargedownside
risks,youshouldbeabletoavoidthehugelossesemanatingfrommarket
volatility.Ontheotherhand,marketvolatilitymaycausegoodcompa-
nies’stockpricestogodownintheshortrun,givingyou
goodbuying
opportunities.
E1C14
Date:Jan18,2010
Time:9:14pm
E1C15
Date:Jan20,2010
Time:11:52am
Chapter15
WhyHoldCash:
LiquidityBrings
Opportunities
[K]eepinmindthatmostofthevalueofourconvertiblepre-
ferredsisderivedfromtheir
fixed-incomecharacteristics.That
meansthesecuritiescannotbeworthlessthanthevaluethey
wouldpossessasnon-convertiblepreferredsandmaybeworth
morebecauseoftheirconversionoptions.1
—WarrenBuffett
Topreserveprincipalandpossiblyinvestinmoreprofitableoppor-
tunitieslater,BuffettkeepsasignificantportionofBerkshire’s
totalassetsincash,short-termgovernmentsecurities,andpre-
ferredstock.Eveninadversesituations,theseinvestments
generally
safeguardthevalueoftheprincipalamount.Attheendof2008,Berk-
shirehad$24billionincashorcashequivalents,or12percentof
totalassets,initsinsurancebusinesses.Ithadanadditional$27bil-
lioninfixed-maturitysecurities,abouthalfofwhichareingovernment
securities.
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risk,diversification,andwhentosell
LiquidityandOpportunities
Beyondsafety,thereareatleasttworeasonswhyBerkshiremaintainsa
largeamountofcashandshort-termsecurities.First,
Berkshirecaninvestlargesumsofmoneyquicklywheneveragoodinvestmentopportunity
arises.Anopportunityarosein2002whenDynegyneededtosellits
16,600-milepipeline—theNorthernNaturalGasCompany—toBerk-
shirefor$928million,a
steepdiscountonthe$1.5billionthatDynegy
hadpaidonlyafewmonthsearlier.Inmanyothercases,suchasbuying
an80percentstakeinIscarfor$4billionin2006,Berkshiremadethe
dealquicklywithoutgoingtoanybanks.Obviously,ahighlevelofcash
isnotmaintainedbecauseitisagoodinvestmentperse.Itismaintainedandallowedtobuildupbecauseofpaucityofgoodinvestmentopportunities.Youshouldnotfeeltemptedtoinvestyourcashunlessyouhave
goodinvestmentopportunities.
During2008,Berkshire’scashandcashequivalent
decreasedfrom
$37billionto$24billionmainlybecauseBerkshireinvestedinWrigley,
GoldmanSachs,andGeneralElectricpreferredstocks.Berkshirecould
nothavemadetheseinvestmentswithoutliquidassetsthatitcould
accessquickly.Yetanotheropportunityarosein2008whenConstel-
lationEnergywasabouttogobankrupt.Berkshirewasabletoinvest
$1billionimmediatelyandmadeanofferwithinthedaytoacquirethe
entirecompanyfor$4.7billion.Thedealwasstruck
withabreak-up
clause,assuchdealsare.Subsequently,Constellationreceivedahigher
bidandBerkshiredidnotcompetetoacquirethecompany.However,
theoriginalinvestmentandthebreak-upfeeledtoa$1.1billionprofit
toBerkshire.
Thesecondreasonformaintainingliquidityistoattractbetter-
paying—ormoreprofitable—customers.Berkshirecanchargehigher
premiumsthanotherinsurersbecauseitcanfulfilllargeinsuranceclaimsmoreeasily.Intheworldofinsurance,
BuffettcomparesBerkshirewith
FortKnox.Nooneeventhinksaboutthepossibilityofaliquidityprob-
lematBerkshireresultingfromlargeclaims.Berkshirewasabletopay
$1.5billioninclaimsarisingfromthe2001terroristattacksontheWorldTrade
Centerand$3.5billioninclaimsfromHurricaneKatrinaandother
lossesin2005.Indeed,Berkshireprobablybecameapreferredinsurerin
thewakeoftheseincidents.Berkshiremostlikelydidnotloseanything
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157
inthisevent.MorganStanleyestimatedthatinsurancepremiumincreases
alonewouldcoverthelosses
fromtheWorldTradeCenterattack.2This
isthepowerofliquidity.
Thesereasonsforkeepingliquidassetsalsoapplytotheaverage
investor.First,whatshouldyoudoifthestockmarketgoesdownsubstan-
tiallyandyoufindsome
wonderfulinvestingopportunities?Ofcourse,
youshouldbuystocks.However,youwillmissthisopportunityifyou
arefullyinvestedinthestockmarketanddonothavecashorcashequiv-
alentsreadytoinvest.Second,whatshouldyoudoifyouneedsomecash
foranemergency?Onceagain,itisgoodtohavesomecashonhand
sothatyoudonothavetosellyourinvestmentsatunfavorablepricesto
coverunexpectedcosts.
Berkshire’sInvestmentsinConvertibles
Convertiblebondsand
preferredstocksaresimilartorent-to-ownstores,
whereyoucanrentfurnitureorappliancesandthen,ifyouwant,pur-
chasetheitems.Becauseofconvertibilityintocommonstocks,investing
inconvertiblebondsorpreferredstocksmayworkwonderfullywhen
thestockpricegoesup.Ifthestockpricegoesdown,thecapitaland
interestpaymentisgenerallystillsafe.Putsimply,itislikeeatingyourcakeand,sometimes,havinganotheronelater.
Thebestexamplesofconvertiblepreferredstockinvestmentsby
BerkshireHathawayinclude$600millioninGillette,$700millionin
Salomon,$300millioninChampionInternational,and$358million
inU.S.Airways.Clearly,ifBuffetthadbeenabsolutelyconvincedthat
thecommonstockpriceswouldincreasesubstantially,
hewouldhave
investedincommonstocksratherthaninconvertiblepreferredstocks.
TheinvestmentinGillettehasproducedexcellentreturns,buttheothers
havebeensortofamixedbag.
Aconvertiblepreferredstock
paysadividendataprespecifiedrateinamannersimilartothatofabond.Forexample,theGilletteconvertiblepreferredstockpurchasedbyBerkshirein1989carriedadividend
rateof8.75percent.Oneadvantageofreceivingdividendsinsteadof
interestisthatabouthalfofthedividendsreceivedbyone
corporation
fromanothercorporationarenottaxable.So,itmakessensetoinvestin
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risk,diversification,andwhentosell
preferredstocksratherthaninbondswhentheissuerisofsufficientlyhighquality.
SoonafterBerkshireinvested$358millionin1989,U.S.Airways
gotintotroubleand,overthenextfiveyears,incurredsignificantlosses.
Finally,in1994,theairlineannouncedthatitwasdeferringthedividendpayment.Basedonthisandotherinformation,Berkshiredecidedthat
thefairvalueoftheinitialinvestmenthaddeclinedby75percent,and
therefore,the$358millioninvestmentwasworthonly$89.5million.
Fortunately,U.S.Air’soperationsimprovedsignificantly,andBerkshire
recovereditsinvestment.
InthecaseofBerkshire’sinvestmentinSalomon,Berkshirecould
eitherhavetakencashpaymentsof$140millionorreceivedcommon
sharesat$38pershare.In1995,Berkshiredecidedtotakethe$140
millionincashbecausetheSolomonsharepricewasbelow$38per
shareatthetimeofmaturityofpartofthepreferredshareinvestment.
Iftheinitialinvestmenthadbeenmadeincommon
stocks,thedividend
amountwouldhavebeensmaller,andBerkshirewouldhavebeenstuck
withthelower-pricedcommonstock.
BerkshireacquiredpreferredstockinGillettein1989whenBerk-
shirecameinasawhite
knightinresponsetoatakeoverbidbyRonaldO.
Perelman.Suchopportunitiestobeawhiteknightandensuingprofits
availonlytothosewhohaveliquidity.Thepreferredstockwascon-
vertedintocommonstockin1991,andthecommonstockcontinued
toperformwell.Withoutincludingdividends,Gillettegeneratedarate
ofreturnofabout14percentperyearfrom1991untilitwasacquired
byProcter&Gamblein2005,whereastheS&P500indexgeneratedalittleover7percentperyear.
RecentBerkshire
Investments:
Wrigley,GoldmanSachs,GeneralElectric,
SwissRe,andDowChemical
During2008,Berkshireacquired$4.4billionparamountof11.45per-
centsubordinatednotesdue2018ofWrigley.Thisis
straightdebt,but
theratewashighbecauseoftheturmoilinthecreditmarketsatthetime.
Berkshirealsoacquired$2.1billionofpreferredstockwithadividend
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159
rateof5percentperyearandtheredemptionamountbasedonfuture
Wrigleyearnings.Thus,ifWrigleydoeswell,Berkshirewillshareinthe
upsidewhiletheprincipalisprotected.Buffettcontinuestofollowhis
principlesashesays,“Whenyouthinkofabusinessthat’seasytounder-
stand,withfavorablelong-termeconomics,andableandtrustworthy
management—youthinkofWrigley.”3
Berkshirealsoacquired10percentcumulativepreferredstockof
GoldmanSachsfor$5billionandpreferredstockofGeneralElectricfor
$3billion.Onceagain,thereareconvertiblefeaturesattachedtothese
investments,whichareavailableuntil2013.Inthe
caseofGoldmanSachs,ifthestockpricegoesabove$115pershare,Berkshirewillexerciseits
options—inwhichcase,foreachdollarbeyond$115pershare,Berkshire
willearn$43million.InthecaseofGeneralElectric,foreachdollar
beyond$22.25pershare,
Berkshirewillearn$135million.InMarch
andApril2009,Berkshirealsoinvestedabout$6billioninconvertible
preferredsharesofSwissReandDowChemical.
ThemainlessonwelearnfromrecentBerkshiretransactionsisthat
whenthereissubstantialvolatilityinacompany’sstockorwhenyouare
lessconfidentinthecompany’sfuturegrowth,itmaybeworththinking
aboutformsofinvestmentsinwhichthecapitalispreserved.Youmay
notbeabletodoexactlywhatBuffettdoes,butifyou
haveliquidity,lotsofpatience,andvigilance,opportunitieswillfindtheirwaytoyou.
Conclusions
Donotrushtoinvestinstocksassoonasyouhaveadditionalcashavailableforinvesting.Bepatientandwaitforgoodinvestmentopportunities.
Holdingcashorcashequivalentsisnotjustforsafety;itcanhelpyou
earnmoreonyourinvestmentsbyenablingyoutotakeadvantageof
opportunitiesthatarisewithbriefwindowsinwhichtostrike.From
thisperspective,keepingsomecashorinvestmentsin
liquid,low-risk
securitiesmayprovetobeahigh-returnpropositioninthelongrun.In
somecases,itmightbehelpfultoinvestinconvertiblepreferredstocks
orconvertiblebonds,aslongasyoustaywithestablishedfirmstheway
Buffettdoes.
E1C15
Date:Jan20,2010
Time:11:52am
E1C16
Date:Jan18,2010
Time:9:25pm
Chapter16
Diversification:
HowManyBaskets
ShouldYouHold?
Don’tputallyoureggsinonebasket.
—Proverb
Buthowmanybasketsshouldyouhold?Diversificationisoneof
themosttalkedaboutinvestmentconcepts.Theconceptissim-
ple:“Don’tputallyoureggsinonebasket.”Perhapsamore
interestingquestionis,“Howmanybasketsshouldyoupossess,andhow
doyoudecidethenumberofeggstobeplacedindifferent
baskets?”
Weusethebasicsofdiversificationallthetimethroughoutourday-to-
daylives.Whenwetravel,weusuallypackavarietyofclothingsuited
todifferentweatherconditionsbecausewecannotpredicttheweather
perfectly.Welearntospeakdifferentlanguagessowecancommunicate
withotherswhodonotspeakourownlanguage.Weacquireavariety
ofskillstoprepareourselvestoearnaliving.Apersonwithadiverse
knowledgebasefindsiteasiertodealwiththe
unavoidableupsanddowns
oflife.
161
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risk,diversificatio
n,andwhentosell
Adiverseknowledgebaseenhancesourunderstandingofothers’
viewpointsandhelpsusmakebetterdecisions.Themoredifferentthings
wehaveinourrepertoires,themorepreparedwearefortheunexpected.
Thus,wediversifytoprotectourselvesfromuncertaintiesandunpleasant
situations.Youshoulddothesametoprotectyourwealth.
Diversification
Consideracompanythatownstwostores,onethatsellsexpensiveclothes
andonethatsellsdiscounted
merchandise.Profitmarginsareusually
higherforexpensiveclothes.Whentheeconomyisdoingwell,the
expensiveclothingstorewillyieldhigherprofits,notonlybecauseof
profitmarginsbutalsobecauseofsalesvolume.However,whenthe
economyisinarecession,theupscaleclothingstoremaybecomea
burden.Butrememberthatthecompanyalsoownsthediscountstore,
whichdoeswellinarecession.Theprofitsfromthediscountstoreact
asacushionduringtherecession.Without
diversification,thecompany
canincurenoughlargelossestocausepermanentdamagetothebusiness.
Investinginstocksisinvestinginbusinesses.Ifyouownedsharesof
Abercrombie&Fitchstock,yourfortuneswouldbetiedtothesuccessesofthatstore’sfashionablegoods.
However,ifyoualsoownedWal-Mart
stock,youwouldbesomewhatprotectedfromtheidiosyncratichabits
ofthehigh-fashionteenagerswhoshopatAbercrombie&Fitch.Own-
ingmorethanonestockisthefirststeptowarddiversification.Beyond
holdingAbercrombie&FitchandWal-Mart,ifyoualsoownedIntelor
IBM,youwouldbeevenmorediversified.
Thebasicgoalofdiversificationistoprotectyourinvestmentsfrom
unpredictableevents.Diversificationisaninsurancepolicy.Whenyou
donotdiversifyandputallyourfundsintothestocksofoneortwo
outstandingcompanies,youcaneasilyenduplosingalotofmoneyif
onecompanyfacesunforeseendifficulties.Ifyoudiversifybyinvestingin10outstandingcompanies,youarelikelytoseegoodresultsevenifafewofthose
companiesdonotdowell.Ontheotherhand,ifyoudiversifya
lot,youmayendupwithapproximatelythesamereturnsasthemarket.
So,howmanystocksshouldyouinvestin?Beforewecananswerthis
question,let’sexaminewhatBuffetthasdoneatBerkshire
Hathaway.
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163
HowDiversifiedIs
BerkshireHathaway?
Attheendof2008,outofBerkshire’stotalassetsof$267billion,
$55billionwasinvestedincommonstocksofvariouscompanies.The
largestinvestment—$9.1billion—wasinCoca-Cola.Otherlargeequity
investmentsincludedWellFargo($9billion),Procter&Gamble($5.8billion),ConocoPhillips($4.4billion),andAmericanExpress($2.8billion).
Berkshire’sequityinvestmentsareconcentratedinonlyafewcompanies.
Weshouldthinkofdiversificationonatleasttwolevels—atthelevel
ofthecompany’stotalassetsandthenatlowerlevelssuchasthecompany’sequityportfolio.OutofBerkshire’stotalassetsof$267billion,only$55
billionor21percentareinvestedincommonstocks.Thisimpliesthatthecompanycanhaveareasonablyhighlevelofconcentrationinitsequity
holdingsandstillbewelldiversified.Inparticular,thefivelargestholdingsmentionedheremadeupmorethan50percentofBerkshire’sequity
portfoliobutonly11percentofitstotalassets.Theseseeminglyconcen-
tratedequityholdingsareactuallynotveryconcentrated,asBerkshireas
awholeiswelldiversified.
BuffettinvestedheavilyinCoca-Colain1989–1999.Attheendof
1999,themarketvalueoftheCoca-Colainvestmentaloneat$1.7billion
was18percentofBerkshire’stotalassetsof$9.5billion.BuffettinvestedheavilyinCoca-Colabecausehewas
confidentinitsfuture.Tenyears
later,attheendof1999,theCoca-Colainvestmentwasworth$11.7
billion.Berkshiremadeamuchsmallerinvestmentof$244millionin
2008intwoIrishbanks,whichwentdownby89percentwithintheyear.
BuffettinvestedaverylargesuminCoca-Colabutonlyasmallamount
inIrishbanks.Themainlessonisthattheloweryourconfidenceinthe
futureperformanceofastock,thelessyouinvestinthatstock.
HowManyStocksShouldYouHold?
First,ifyouownassetssuchasahouseandbonds,youshouldn’tworry
muchaboutdiversificationinyourequityportfolio.Inmyopinion,
ifyourcommonstockportfolioconsistsoflessthanhalfofyournet
worth,itdoesnotmakemuchsensetoholdmorethan15
stocksinyour
equityportfoliobecauseitisdifficulttostayinformedabouttoomany
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risk,diversification,andwhentosell
companiesifyouhaveadayjob.Second,themoreyouknowabout
certainstocksandfeelgoodaboutthem,themoreweightyoushould
givethem.Inotherwords,youcanconcentrateyourholdingsinthe
stocksyouhavethemostreasontobeconfidentabout.
Buffettstudiesalargenumberofcompaniesorstocks,butthereare
only16majorholdingsreportedinthe2008Berkshireannualreport.
Thisisprobablybecauseitissodifficulttofindanyoutstandingbusi-
nesses,muchlessagreatmanyofthem.IfBuffettcannotfindalarge
numberofoutstandingbusinesses,itisunlikelythatanaverageinvestor
couldeither.TheDowJonesIndustrialAverage(DJIA)isbasedon30
stocks,butitsreturns,especiallyovermanyyears,
aregenerallysimilartothoseoftheS&P500index,whichincludes500stocks.Forseveral
decades,academicresearchhasshownthatmostbenefitsofdiversifica-
tionareachievedthroughholding20to30stocksinaportfolio.This
evidencehasbeenwell
knownforafewdecadesandisnowwidely
discussedintextbooks.1Figure16.1showsthatonceyouhave20to30
stocksinyourportfolio,addingmorestocksdoesverylittletoreduce
thevolatilityoftheportfolio.2
BenjaminGrahamhasbeenexplicitonthenumberofstocksthata
defensiveinvestorshouldinvestin.Inoutliningvariousrulesforinvestors,hesays,“Thereshouldbeadequatethoughnotexcessivediversification.
1.2
1
0.8
0.6
0.4
StandardDeviation
ofPortfolioReturns
0.2
0
0
10
20
30
40
50
60
NumberofStocksinthe
Portfolio
Figure16.1
StandardDeviationofPortfolioReturnswithNumberofStocksin
thePortfolio
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Diversification:HowManyBasketsShouldYouHold?
165
Thismightmeanaminimumof10differentissuesandaboutamaximum
of30.”3Notehismentionofamaximumaswellasaminimum.Buffett
hasclearlyavoidedexcessivediversification.Similarly,JohnNeff,the
legendarymutualfundmanager,placesheavybetsonstocks.Whenhe
retiredin1995after31yearsatthehelmofthehighlysuccessfulVanguardWindsorFund,hisfourlargestpositionsaccountedfor23percentofthe
portfolio.
PhilipFisherWarnsagainst
TooMuchDiversification
PhilFisher,theacclaimedgrowthinvestor,warnsthattheprinciples
ofdiversificationaresosimpleandwidelyacceptedthatmostinvestors
embracediversificationtothepointofexcess.“Thereisverylittlechanceoftheaverageinvestorbeinginfluencedtopracticeinsufficientdiversification,”hewrites.“Investorshavebeensooversoldondiversification
thatfearofhavingtoomanyeggsinonebaskethascausedthemtoput
fartoolittleintocompaniestheythoroughlyknowandfartoomuchin
othersaboutwhichtheyknownothingatall.Itneverseemstooccurto
them,muchlesstotheiradvisors,thatbuyingacompanywithouthav-
ingsufficientknowledgeofitmaybeevenmoredangerous
thanhaving
inadequatediversification.”4
Onereasonthatdiversificationmaynotbeasimportantasitinitially
seemsisthatmanycompaniesarealreadydiversifiedinternally.General
Electrichas12large
divisionsthatareentirelydifferentbusinessesrangingfromaircraftenginestorefrigerators.Thus,ifyouownGeneralElectric
stock,itisalmostlikeowning12differentstocks.Essentially,youneedtoholdonlyafewlargestocks(suchasMicrosoft,IBM,andWal-Mart)
tobecomewelldiversified.
Sometimes,experiencedinvestorsrecommendinternationaldiver-
sification.Thisrecommendationshouldnotbeoveremphasizedbecause
manyU.S.companies,includingCoca-ColaandMcDonald’s,earna
largepercentageoftheirincomefromtheir
internationaloperations.
Also,itmaybemoreadvantageoustoinvestinglobalU.S.companies
thantoinvestincompaniesoutsidetheUnitedStates.Becausemany
countrieshavelessstringentregulationstoprotectshareholders,theydoE1C16
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risk,diversification,andwhentosell
notofferthesameprotectionasU.S.companiesdo,creatingariskier
investmentportfoliothat
woulddefeatthepurposeofdiversifyingin
thefirstplace.Furthermore,byinvestingincompaniesindeveloped
economies,shareholdersaremorelikelytobepartneringwithawell-
educated,well-trained,superiormanagementteamthaniftheyinvested
incompaniesinthedevelopingworld.Beforeyouinvestincompanies
abroad,youshouldfamiliarizeyourselfwiththecountryanditsfinancialregulations,andnotjustthecompaniesthemselves.
Diversificationand“Diworsification”
“IftheonebasketIowned
wasWal-Martstock,I’dhavebeendelighted
toputallmyeggsintoit,”arguesPeterLynch,whousuallyhadhundreds
ofstocksinhisMagellanFund.5Howdoyoureconcilehisargument
thatyoushouldownalimitednumberofstockswithhisdocumented
practiceofowningalargenumberofstocks?Thebestanswerisprovided
byLynchhimself,whosays,“Inmyview,it’sbesttoownasmanystocks
astherearesituationsinwhich:(a)you’vegotanedge;and(b)you’ve
uncoveredanexcitingprospectthatpassesallthe
testsofresearch.Maybethat’sasinglestock,ormaybeit’sadozenstocks.”6
Inarelatedcontext,Lynchexplainshowsomeprofitablecompa-
niesoftenwastemoneyonfoolishacquisitions.Forexample,General
MillsownedChineserestaurants,Italian
restaurants,steakhouses,ParkerBrotherstoys,Izodshirts,coins,stamps,travelcompanies,EddieBauer
retailoutlets,andFootJoyproducts,manyofwhichitacquiredinthe
1960s.Whileeachacquisitionmayhavebeenjustifiedinsomeway,
GeneralMillscouldnot
manageallthesubsidiarieseffectivelyandsuf-
feredfinancially.Individualsareequallycapableofwastingmoneyon
foolishinvestments.Mostpeopleareunlikelytoinvestefficientlyina
largenumberofstocksfromseveralindustries.Insuchcases,diversificationcan
become“diworsification,”asituationinwhichdiversification
canhurtyourreturns,ratherthanprotectthem.Ofcoursethereare
alwaysexceptions.AsLynchhimselfadmits,“Buffett’sBerkshirehas
boughteverythingfromcandystorestofurniture
storestonewspapers,
withspectacularresults.Thenagain,Buffett’scompanyisdevotedto
acquisitions.”7
E1C16
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Diversification:HowManyBasketsShouldYouHold?
167
Conclusions
BystudyingtheteachingsofGrahamandFisher,andtakingintoaccount
analysesinmodernfinancialliteratureandthepracticesofBuffett,wecanconcludethat
aprudentinvestmentstrategyinvolvesinvestingin10to30
stocks.Thelessemphasized,butmoreimportant,pointdemonstratedby
Buffett’spracticesisthatthemoreyouknowaboutcertainstocksthatyouhavedeemeddesirable,themoreofthemyoushouldown.Iholdabout
40percentofmyequity
portfolioinBerkshireHathawaycommonstock.
E1C16
Date:Jan18,2010
Time:9:25pm
E1C17
Date:Jan18,2010
Time:9:28pm
Chapter17
WhentoSell
Ifyouaren’twillingtoownastockfortenyears,don’teventhink
aboutowningitfortenminutes.1
—WarrenBuffett
Atypicalmutualfund
portfolioholdsastockforoneto
twoyears;aturnoverof100percentisnotuncommon.
NotBerkshireHathaway’sportfolio,though.Byexamining
Berkshire’sturnoverofstocksandthestockssold,wecanlearnwhat
Buffettwouldrecommendaboutthelengthoftimeyoushouldholda
stockinyourportfolioandwhenyoushouldsell.
TurnoverofBerkshire’sEquityPortfolio:
WhyBuffettHoldsAlmostForever
Istartedanalyzing
Berkshire’sbuyingandsellingofstocksinabout1994.
Attheendof1994,Berkshire’sinvestmentportfolioof$70billioncon-
sistedof$15.2billionincommonstocks.During1995,Berkshiresold
$1.35billionincommonstocksfromitsportfolio.In
otherwords,it
turnedoverabout9percentofitsportfolio.Purchaseswere$1.46bil-
lion,slightlyinexcessofsales.Berkshire’scommonstockportfoliogrewto$39.8billionin1999,andtheturnoverfrom1994to1999averagedabout10percentperyear.Inrecentyears,Berkshire’sturnoverhas
169
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170
risk,diversification,andwhentosell
declinedtoabout5percent,
implyinganaverageholdingperiodofabout
20years.
ThisanalysisdoesnotfullycaptureBuffett’sstrongbeliefinlong-
terminvesting.SincesomeofBerkshire’sinvestmentsareforshort-term
arbitrage,thiscomputationis
conservativeinreportingtheaveragehold-
ingperiod.Nevertheless,10to20yearsisstillaverylongholding
period.Icanonlyimaginehowfewinvestorshavesuchlengthyholding
periods.
PartofthereasonBuffett
holdshisstocksforsuchalongtimemustbe
thatheacquiresaconsiderableamountofknowledgeaboutthecompany
beforeheacquiresstockinthecompany.Long-terminvestmentsbest
servethosewho,likeBuffett,buybecausetheyknowalot
aboutthe
companyandhaveconfidenceinitslong-termprospects.Youcould
divideyourportfoliointopermanent,orcore,holdingsandan“other”
categoryconsistingofstocksyouwouldliketolearnmoreabout.With
timeandfurtherexamination,youeventuallydecidewhethertopurchase
moreofthestocksinthesecondcategoryortoselloffthesharesyouhave,dependingonyourmoreeducatedopinionofthecompanies’potential.
Buffettwrites,“[W]henweownportionsofoutstandingbusinesseswith
outstandingmanagements,ourfavoriteholdingperiodisforever.”2
Whyisitagoodthingtoholdstocksforever?Itisonlypreferable
whenthebusinessisexpectedtogiveasatisfactoryreturnforever.Such
stocks,onaverage,donot
comefromhigh-techorhotindustries.This
maysoundcounterintuitive,butmosthigh-techbusinessesdonotsurvive
foralongtime.Ifyouinvestinhigh-techcompanies,youarelikelyto
losemoreoftenthanwhenyouinvestinlow-tech.Ifyouinvestwith
anintentiontopreserveyourcapital,youshouldnotinvestinhigh-tech
companiesunlessyouareextremelyknowledgeableaboutthecompany.
High-techstocksareextremelyvolatileandfraughtwithrisk.Howabout
returns?
Peopleoftenarguethatbusinessesfromeveryday,low-techindustries
cannotearnhighreturns.Buffetthasrepeatedlyprovedthemwrong.
Businessesperformwelleveniftheyarefromtraditionalindustrieswhen
theyareleadersintheirindustriesandwhentheyare
runbyowner-
orientedmanagers.Ownerorientationisespeciallyimportantinthis
casebecausemanagersmustknowwhennottothrowgoodmoney
afterbad.Theymustmakedifficultdecisions.IfBerkshireHathaway
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171
hadnotbeeninsuchgoodhandsinthe1960s,managementprobably
wouldhavetriedtosurviveinthedyingtextilebusinessratherthan
takingmoneyoutofit.Berkshirepulledoutofthetextilebusiness,whileseveralothercompaniesstayedinandwentbankrupt.In2009,most
peoplewouldagreethatonereasonGeneralMotorsfacessuchtrouble
isthatthemanagementnevermadetherightcallonharddecisions.
IfGeneralMotorshadnotexpandedbybuyingcompaniesaroundthe
worldandstartingnewbrands,itwouldhavegivensatisfactoryreturns
toitsshareholders.Overall,Buffett’sprinciplesof
investingineasy-to-understand(low-tech)companieswithexcellentmanagementandthen
holdingthemforevergohandandhand.Together,theyproducehigh
ratesofreturn.
Ofcourse,Buffettdoesnotholdeverystockforever.Togetabet-
terideaofBuffett’sthoughtsonwhentosell,let’sexaminesomeof
Berkshire’smajorsales.
TwoMainReasonstoSell
BuffetthasperiodicallysoldBerkshire’smajorholdings,including
McDonald’sin1998,Travelersin1998,Disneyin
1999,FreddieMac
in2000,andPetroChinain2007.Thelatestreportedmarketvaluesof
thesestockswere$1.4billion,$1.3billion,$1.5billion,$3.9billion,and$4.0billion,respectively.
Firstandforemost,investorsshouldsellwhentheyconcludethat
theyhavemadeamistake.Sometimes,taxlossescanbebalancedagainst
gainstoreducetheoveralltaxbite.Onemajormistake,whichBuffett
admitted,wasthepurchaseofConocoPhillipsstockfrom2006to2008
for$7.0billion.Bytheendof2008,themarketvalueofthe
$7billion
investmenthaddeclinedto$4.4billion,aslideof33percent,whichwas
inlinewiththedropinthestockmarket.In2009,Berkshiresold16
percentofitsConocoPhillipsholdingsandreportedplanstosellmore
inthenearfuture.Whatremainsamysterytomeisthereasonforthis
purchase.Thesimpleexplanationthathewasbettingthatoilprices
wouldriseisnotconvincingbecauseoilpriceshadalreadygoneup
severalhundredpercentinthepriorfewyears.And
Buffettcouldhave
simplybetonoilinthefuturesmarket.
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172
risk,diversificatio
n,andwhentosell
Youshouldsellwhenthestockpriceishighinrelationtoitsintrinsic
value.Inotherwords,youshouldsellwhentherearebetteralternatives,includinginvestinginshort-termsecuritiesorholdingcash.BuffettsoldPetroChinastockinthesecondhalfof2007forabout$4billionafter
itspricehadgoneupeighttimessincethestock’sacquisitionin2002
and2003for$488million.Someinthepressspeculatedthathesold
PetroChinabecausehewascriticizedforinvestinginitinthefirstplace:ItisallegedthatPetroChinasupportedtheSudanesegovernment’sinvolvementingenocide
againstpeopleintheDarfurregion.Buffett,denying
thisspeculation,hassaidthathisdecisionwasbasedonlyonpricecon-
siderations.BothPetroChinaandtheS&P500indexdeclinedbyabout
40percentoverthenext18months.Buffett’stimingonthissalewas
correctfromthepricepointofview.
In1997,Berkshiresoldabout5percentofitsportfoliotoincrease
bondholdingsinrelationtostocks.Buffettwrites,“Someofthesales
wemadeduring1997wereaimedatchangingourbond-stockratio
moderatelyinresponsetotherelativevaluesthatwesawineachmarket,
arealignmentwehavecontinuedin1998.”3In2008,Buffettsoldpartial
holdingsinseveralstocks,includingJohnson&JohnsonandProcter&Gamble.Iestimatethedollaramountofthesesalestobeabout$5billion.
BerkshiresoldthesestockstofundlargepurchasesinbondsandpreferredstockinWrigley,GoldmanSachs,andGeneralElectric.Buffettmust
havethoughtthatthealternativeswerebetter.Becauseofpsychological
reasons,investorssometimesdonotsellwhentheyhavetotakealoss.
Theyshouldthinkaboutthesunk-costfallacyandsell.Overall,ifyou
knowyouhavemadeamistake,oriftherearebetteralternatives,you
shouldsell.
WhyWereMcDonald’sandDisneyStocksSold?
Buffettconfessedthathe
shouldnothavesoldMcDonald’sstock.Justas
withpurchases,itisnotpossibletotimesalesperfectly.Thisisoneadditionalreasontoplanforthelongrunwhenbuyinginthefirstplace.He
wroteinBerkshire’s1998annualreport,“Ineedtomakeaconfession
(ugh):TheportfolioactionsItookin1998actuallydecreasedourgainfortheyear.Inparticular,mydecisiontosellMcDonald’swasaverybigmistake.Overall,youwouldhavebeenbetterofflastyearifIhadregularlyE1C17
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173
snuckofftothemoviesduringmarkethours.”4HesoldMcDonald’s
soonaftertheDairyQueenacquisition,whichwasannouncedinOcto-
ber1997andconsummatedinJanuary1998.Itis
possiblethathedid
notwanttoholdbothDairyQueenandamajorholdinginMcDonald’s
becausethetwocompetedirectlywithoneanother.Acriticcouldargue
thatBerkshirewastryingtomonopolizethefast-foodmarket.Buffett
wouldliketoavoidthosespeculationstoprotecthisreputation.Simi-
larly,whenBerkshireannounceditsacquisitionofBurlingtonNorthern
SantaFeinNovember2009,hesoldBerkshire’s$900millioninvestment
inUnionPacific(2percentstakeinthecompany)and
thecompany’s
roughly$100millioninvestmentinNorfolkSouthern(1percentstake
inthecompany).Evenifthereisnoimproprietyofanysort,impres-
sionsmatter,and,ifso,whyriskreputationatallbyholdingcompetitors’
shares?BuffettprobablyalsosoldDisneysharesforreasonsofreputation.
BerkshiresoldDisneystockin1999.Therearetwopotentialexpla-
nationsforthisdecision.First,hedidnotseemtolikethemanagementatDisneyatthetime.Until1995,Buffett’slongtimefriendTomMurphy
wasthechairmanoftheboardandCEOofCapitalCities/ABCInc.
However,MurphyretiredwhenDisneyacquiredCapitalCities/ABC.
BerkshirereceivedDisneystockinexchangeforitsholdingsinCapital
Cities/ABC.BuffetthasspokenhighlyofMurphybut
hasneverbeenas
complimentaryofDisney’sfollow-upmanagement.
Second,Disney’sexecutivecompensationhadbeensubjecttounfa-
vorablepublicityonatleasttwocounts.MichaelEisner,Disney’s
chairmanoftheboard,
exercisedstockoptionsataprofitofabout$565
millionin1993,followingaprofitof$202millionin1992.Evenwithout
thestockoptions,Eisnerwasamongthehighest-paidexecutivesinthe
UnitedStates.Furthermore,hehadbeengrantedanadditional10-year
contractthatwouldhavekepthimaschairmanandchiefexecutiveofthe
companythrough2006.Thecompensationissueswerehotlydebatedin
severalDisneyannualshareholders’meetings.
Buffettdoesnotbelieveinextremelyhighcompensation.Hence,it
islikelythathewasunhappywiththecontroversysurroundingEisner’s
compensationpackage.Anothercontroversialissuehadbeenthedepar-
tureofthecompanypresident,MichaelOvitz,whoreceiveda$57
millionseverancepackage.Overall,itisnotacomplete
surprisethat
BuffettdecidedtoseverhisassociationwithDisney.
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risk,diversificatio
n,andwhentosell
WhyWasFreddieMacStockSold?
InBerkshire’s2000annualreport,BuffettnotedthatnearlyallFreddie
Macshareshadbeensoldduringtheyear.Why?Hedidnotelaborate
then.However,withtime,we
havelearnedsomethingveryinteresting
anduseful.5InOctober2007,Buffetttestifiedforthegovernmentin
itscaseagainstFreddieMac’sformerCEO.Buffettdisclosedthathe
wastroubledinpartbyaFreddieMacinvestmentthathadnothing
todowithitsbusiness.“Ifollowtheolddictum:There’sneverjust
onecockroachinthekitchen,”Buffettsaid.Hemadetwoobservations
inhistestimony.First,whenexecutivesofferearningsprojectionsand
cannotmakethenumbers,theystartmakingup
numbers.Second,when
companiesengageinotheractivitiesthatseemtobemotivatedbyaneed
tomakethenumbers,investorsneedtobecareful.FreddieMacwas
forecastingearningsgrowthinthemid-teens;anditappearsthatBuffett
thoughtthatthecompany,unabletomakethenumbers,wouldengage
innonproductiveactivitiestomakeupthenumbers.Overall,Buffettwas
abletoreadearlywarningsoftroubleatFreddieMac.In2000,Freddie
Mac’sstockpricewasaround$60pershare.Itremained
between$50
and$70persharebetween2001and2006,butin2009,itwastrading
ataround$1pershare.
Conclusions
Buffettsellshisstockholdingsinfrequentlybecausehebuysonlyafterheisconvincedoftheirlong-
termvalue.Onereasontosellisthepriceofthestockinrelationtoalternativesavailable,includingholdingcash.BuffettsoldPetroChinaforthisreason.HesoldtheDisneyholdingbecause
hedidnotseemtohaveasmuchconfidenceinthenewmanagement
ashehadintheoldmanagement.Onceagain,
thisshowsthatquality
ofmanagementisveryimportanttohim.Finally,Ilikethecockroach
theoryofearningsmanipulationormanagementbehaviorthatBuffett
described.Whenyouseeanysignsofimpropermanagementbehavioror
questionablenumbersthatmakeyouuncomfortablewiththecompany,
youshouldsellthestockbecauseifyouarepickingupononeproblem
fromtheoutside,thereislikelymorewrongwiththecompanyonthe
inside.Thereisrarelyjustonecockroachinthekitchen.
E1PART06
Date:Dec10,2009
Time:12:55pm
PartSix
MARKETEFFICIENCY
Buffettdoesn’tthinkyouneedtohaveahighIQtobesuccessfulin
thestockmarket.Marketsarenotalwaysefficient.In
Chapter18,
Idiscusssomeofthelesscommonlycoveredaspectsofthemarket
efficiencyparadigm,andinChapter19,Iextendthediscussiontothe
relatedfieldofarbitrageandhedgefunds.
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E1PART06
Date:Dec10,2009
Time:12:55pm
E1C18
Date:Jan18,2010
Time:9:35pm
Chapter18
HowEfficientIsthe
StockMarket?
Essentially,it[EfficientMarketTheory]saidthatanalyzingstocks
wasuselessbecauseallpublicinformationaboutthemwasappro-
priatelyreflectedintheirstockprices.Inotherwords,themarket
alwayskneweverything.1
—WarrenBuffett
Fewpeopleconsistentlymakemoneybettingonhorseraces.In
financeterms,thehorseracingmarketisefficient.Butisthe
stockmarketefficient?
Somepeoplearguethatthestockmarketisefficientand
thatyou
shouldnotspendanytimetryingtobeatthemarketaverages.Onthe
otherhand,others,includingBuffett,arguethatthemarketisnoteffi-
cient.Itisnotproductivetodebatewhetherthemarketisefficient;theimportantpointistothinkabouttheextentto
whichitisefficient.We
comeacrossmanyquestionsinourliveswhenasimpleyes-or-noanswer
isnotverymeaningful.Whensomeoneasks,“AmIgoingtobeableto
makealivingifIstudyengineering?”or“AmIgoingtogetajobif
Ihaveadegreeinmathematics?”thecorrectanswerisgenerally“Yes,
ofcourse.”However,itismoreimportanttoknowhowgoodaliving
youcanexpecttomakeifyoubecomeanengineerorwhatkindofjob
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178
marketefficiency
youcanlandifyougetadegreeinmathematics.Inthesamemanner,a
simpleyesornotothemarketefficiencyquestionisnotworthgetting
agitatedabout.Itismoreimportanttoknowhow,when,why,andto
whatextentthemarketisefficientand,especially,how,when,why,and
towhatextentitisnotefficient.
CanIMakeMoneyintheStockMarket?
Insteadofthinkingaboutmarketefficiency,youshouldask,“CanImake
moneyinthestockmarket?”Makingmoneyinthiscasemeansgener-
atingabove-averagereturns.Myanswertothisall-importantquestion
is“Yes,ofcourse.”IfIthoughtotherwise,Iwouldnotbewritingthis
book,Iwouldnotbeinvestinginindividualstocks,andIwouldnotbe
teachingBuffett’sideas.Butitisalsoimportanttorecognizethatmakingmoneyisnoteffortless.Theremaybebargainsoutthere,butthereisno
freelunch.
Asastartingpoint,considerthesetwosimplequestions.Theyshould
helpyoustartthinkingaboutmakingmoneyinthestockmarketand
whetheryoushouldtrytobeatthemarketorwhetheryouarebetteroff
investingyourmoneyinanindexfund.
1.Domostprofessionalmoneymanagersgenerateabove-average
returnsinthestockmarket?
2.Domostindividualinvestorsgenerateabove-averagereturnsinthestockmarket?
Theanswertobothquestionsisno.Ithaspuzzledmeforalong
timethatmostprofessionalmoneymanagerscan’tbeattheS&P500
index.Amongthosewhocan,fewdoitconsistently.Roughlyspeaking,
thisevidencesupportsmarketefficiency.Youthen
needtoask,“Ifmost
moneymanagerscannotbeattheS&P500index,howcanI?”
Firstofall,sincemostmoneymanagersdonotbeatthemarket
averages,itshouldbeclearthatyoushouldnotlistentomostmoney
managers.WhatdoesitimplyaboutreadingtheWallStreetJournalandBarron’sandwatchingCNBC?YoushouldreadthefinancialpressandwatchTVforfacts,forevents,fornews,foranalysis,butnotforopinions.
Youshouldlistentoonlyaselectfew,suchasWarrenBuffett,John
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179
Templeton,andPeterLynch,whohavebuiltapreeminentrecordover
manyyears.Otherwise,you
shouldtuneoutwhenunsolicitedadvice
fromtalkingheadscomesyourway.2
MostAcademicsFavorMarketEfficiency
Mostacademicspromotetheefficientmarkettheoryasthemantrafor
investinginthestockmarket.
Itdoesnotsuggestthatintelligentinvestorscanneverbeatthemarket.Themainreasonacademicshaveinternalized
theefficientmarkettheoryisthatitbuildsonappealingassumptions
ofrationality.Butpeopleareoftenirrational.So,attheveryleast,becarefulintakingacademicadviceto
heart:Useapinchofsalt.Once
again,theresearchfindingsmaybeinterestingtolookat,butyoudo
nothavetoagreewithinterpretationsthatcansometimesbeabitofa
stretch,giventheevidence.Andtheacademicsdonotalwaysagreewith
oneanother;somenewacademicresearchnowcastsdoubtonearlier
evidencethatthestockmarketisefficient.3Inacademia,newideasare
alwayswelcomeanddebatedvigorously.Inawell-knownbook,Profes-
sorsAndrewLoandA.CraigMacKinlayexplainseveral
developments
andarguethatfinancialmarketsarepredictabletosomedegreebutfar
frombeingspecimensofinefficiencyorirrationality.4Ittakesconvincingevidencefromavarietyofresearchfindingsbeforenewideasarewidely
accepted.
Evenifthemarketwereefficient,thereisstillnoharminbuying
individualstocksusingyourownknowledge.Inanefficientmarket,you
cannotlosemoneyevenifyouwantto.Forexample,consideragameinwhichyourfriendtossesafaircoin,andyourandomlycallheadsortails.
Inthisgame,youwillwinhalfthetimeandlosehalfthetimeregardlessofwhatyoucall.Inotherwords,inafairgameofchance,evenifyoutrytoloseyourmoney,youcannotdosoconsistently.Ifthestockmarketis
efficient,youcannot,onaverage,losemoneyevenifyouwantto.You
willincurthecostoftradingintermsofbrokeragecommissions,butas
longasyoudonottradeoften,youwilldoaswellas,orbetterthan,
mostmoneymanagers.Ontheotherhand,ifthemarketisnotefficient,
youcanlearnfromyourtradesandyoumaydevelop
theskillsnecessary
tobeatthemarket.
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marketefficiency
Otherevidenceinthe
academicliteraturesuggeststhatacademics
stillknowlittleabouttheworkingsofthestockmarket.Forexample,
theyhavenotyetcomeupwithagooddefinitionofriskthatworkswell
inpredictingindividualstockreturns.Oneproblemwithreportedbeta
isthatitisonlyanestimate.TruebetacouldbesubstantiallydifferentfromtheestimatedbetainvariouspublicationssuchasValueLine.Inacademicparlance,thestandarddeviationaroundtheestimatedbetais
verylarge.Forexample,whenthereportedbetais1.0,truebetacould
easilyfallanywherebetween
0.5and1.5.And,thereisgenerallynoway
totellifanerrorhasbeenmade.
Mostevidenceinsupportofmarketefficiencycomesfromresearch
thatfallsintothecategoryofso-calledeventstudies,whicharecarefullydoneandpresentsomefascinating
findings.Theyoftenexamineperformanceofaportfolioofstocksafterselectedevents,suchasannouncementsofearningsandmergers.Manyofthesestudiesconcludethataftersuch
anannouncementismade,itisgenerallytoolateforanaverageinvestor
toinvestinthatstock.Thereinliestherub.These
studiesshouldnotbeinterpretedtoimplythatyoucannotidentifystocksthatarelikelytobegoodlong-terminvestmentsinthefirstplace.
Whydopricesdeviatefromfundamentals?Thishappenswhenan
unusualnumberofbuyersorsellerscometothemarketinashorttime,
creatinganimbalance.Thisisaclassicexampleoftheeffectofsupply
anddemandonprices.Forexample,considerasituationwhenyoucome
acrossmanyhousesforsaleinyourneighborhood.Thiscanhappenby
chancealone,withnolong-termeffectonthehousing
pricesinthe
neighborhood.Priceswillthentemporarilyfallandwillremainlow
untilthenumberofhousesonthemarketrevertsbacktonormal.The
mainpointhereisthattherearefrequentimbalancesindemandand
supplythatcausepricestodeviatefromtheirintrinsicvalues.
Inthestockmarket,demandandsupplyseemtofalloutofbal-
ancefrequently.Ifaninfluentialfinancialanalystadviseshisclientstosellaparticularstock,thesupplyofsellersmayoutpacethesupply
ofbuyers.Pricescanthenfallquicklyandmaygowellbelowwhat
thefundamentalswouldsuggest.Thisexamplecanbegeneralizedto
includetheeffectofanynewsordisclosureoffinancialinformation.
Someinvestorsreacttosuchdisclosuresoptimistically
whileothersreactpessimistically.Whenonegrouportheotherdominatesanyparticular
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181
situation,pricescandeviatefromthefundamentals.5Thiscanalsohap-
penfortheentiremarket.In1987,theso-calledportfolioinsuranceschemepracticedbymutualfundmanagersrequiredthemtosellmoreandmore
stocksaspricesfell.On
October19,1987,aninitialdeclineofafew
percentagepointsinthemarketindexesinthepreviousfewweeksmade
portfoliomanagersselladditionalstocks,leadingthemarkettodecline
by23percentinoneday.Investorswhounderstoodthecircumstances
benefitedfromthebuyingopportunity.Ingeneral,individualstocks,
ratherthanthemarketasawhole,aremorelikelytoaffordgoodinvest-
mentopportunitiesbecauseasmallerdollaramountcanaffecttheirpricesconsiderably.
RecentEvidenceonMarket
Inefficiency
Manyrecentacademicstudieshavebeguntoprovideevidencethateven
withinthesimpleresearchframeworkofeventstudies,themarketmay
notbeefficient.Academicresearchersareatalosstoexplainwhy,afteragoodearningsreport,acompany’s
stockpricecontinuestomove
up—andsimilarly,afterabadearningsreport,whythestockpricecon-
tinuestomovedown.Thisevidenceonmomentuminpriceshasalso
beendocumentedforotherevents,suchasspin-offsandstocksplits.6
Theresultsfromotherstudiesshowthatstocksthathavedonewellin
therecent6to12monthscontinuetodowellduringthefollowing
6to12months.Similarly,theevidencesuggeststhatyoushouldavoid
stocksthathavebeenperformingpoorlyinthe
recent6to12months.7
Evidencealsoshowsthatstocksthatunderperformovera5-yearperiod
dowellinthefollowing5-yearperiodandviceversa.8Afterarigorous
examinationofthedata,ProfessorsLouisChan,NarasimhanJegadeesh,
andJosefLakonishokruleoutthepossibilitythatmarketrisk,size,and
book-to-marketeffectscanexplainmomentuminstockprices.9They
concludethattheresultssuggestamarketthatrespondsonlygradually
tonewinformation.Theseresultsaredisturbingto
marketefficiency
advocatesbutmaygiveyouopportunitiestoearnsuperiorreturnsinthe
stockmarket.
Foracriticalthinker,itiseasytocriticizeanyevidence,includingtheevidenceonmarketinefficiency.SomestudiesfindthatthemarketreactsE1C18
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marketefficiency
slowly(underreacts)toearningsandotherannouncements.However,
otherstudiesshowthatthemarketoverreactstosome
othertypesof
announcements.Thisleadstotheconjecturethatresearcherslookfor
patternsinhistoricaldata,andgivenenoughcomputertime,theymay
concludethattherearepatternswheretherearenone.Essentially,we
shouldbeawarethatweusehindsightwhenweconcludesomething
fromourresearchfindings.Often,wecanconcludethingsaboutthe
past:thatthemarketwasundervaluedin1974orovervaluedin1972,
forinstance.Withoutthebenefitofhindsight,canwe
reallytellwhen
themarketisover-orundervalued?Notreally.Puttingitanotherway,
therearealwaysenoughpunditswithbullishandbearishsentiments,and
someoftheminevitablyendupbeingcorrect.Overall,insideacademia,
thereisanongoinglivelyandhealthydebateontheextenttowhichthe
marketsareefficientandhowtomeasurerisk.
WarrenBuffettdoesnotsaythatbeatingthemarketiseasy.Inhis
discourseonmarketefficiency,heconcludes,“Aninvestorcannotobtain
superiorprofitsfromstocksbysimplycommittingtoaspecificinvestmentcategoryorstyle.Hecanearnthemonlybycarefullyevaluatingfactsandcontinuouslyexercisingdiscipline.”10Buffettmakesthreemainpoints
aboutchoosingstocksandtryingtobeatthemarket.
1.Tobeatthemarket,you
mustinvestonlyincompaniesaboutwhichyouarelikelytoknowmorethanmostparticipantsinthemarket.
Itisabasicprincipleofmostgames.Ifyouarenotbetterthan
youropponent,youareprobablynotgoingtowinveryoften.Like
Buffett,youshouldfocusononeormoreindustriesthatappealto
you.
2.Buffetthasproposedthatinvestorsthinkofmakingonlyalim-
itednumberofstockmarketdecisionsintheirlifetime.Oncethey
havemadethosedecisions,theyshouldnotbeallowedtomake
anymoredecisions.Ifyoukeepthisinmind,youareunlikelyto
makemanymistakes.Tocementthisthought,thinkabouttheeffort
youexpendedbeforeyouboughtahouseora
computer,before
youdecidedtoattendaparticularcollegeoracceptajoboffer.
Becausethesedecisionsarenoteasytoreverse,mostpeoplemake
gooddecisions.Ifyouthinkofbuyingastockasasimilarlylong-term
commitment,youwillmakebetterdecisions.
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183
3.Tobeatthemarket,youmustlearntoignoreitsvolatility.Itiscommonforinvestorstobecomeanxiousandsellwhenstockpricesgo
downorbuywhenstockpricesgoup.Butwhenaninvestorbuys
astockforthelongrunafterlearningaboutthecompany,market
volatilitywillhavelessofapsychologicalimpactontheinvestor.
Ignorancemaymakevolatilityyourenemy,butknowledgemakesit
yourfriend.
Conclusions
Overall,thestockmarketcanhelpyoumakemoneyifyou
arewilling
toputinthetimeandefforttodevelopthewinningmind-settolearn
toplaythegamewell.Sincemostpeopledonotputmucheffortintoit,
itisnotsurprisingthatmostofthemdonotbeatthemarketaverages.
Forthesepeople,themarketsareefficient.Forthosewhoarewillingto
dowhatisnecessarytomasterthegame,evenifonlyinsmallcornersof
asingleindustry,itshouldbepossibletobeattheopponent:themarket
averages.
E1C18
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E1C19
Date:Jan18,2010
Time:9:39pm
Chapter19
Arbitrageand
HedgeFunds
Wewillengageinarbitragefromtimetotime—sometimesona
largescale—butonlywhenweliketheodds.1
—WarrenBuffett
Thefancywordarbitrageisnothingtobeafraidof.Anarbitrageis
nothingmorethanthesimultaneousbuyingandsellingofoneor
moresecuritiesthatareeitheridenticalorsimilartoeachother.
ThinkaboutstockbrokeragefirmssuchasCharlesSchwab.Beyondthe
brokeragefee,brokersoftenmakeasmallprofitfroma
transactionwhen
buyingastockfromoneclientandsellingthesamestocktoanotherclientbecausethebuyingandsellingpricesareslightlydifferent.Essentially,thebrokerplaysalittlegameofarbitragingtheprofitbetweenthebuyerandtheseller.
Anarbitrageisnotrisk-free,
becausethebrokeragefirm,likea
wholesaler,carriesinventory.Someofthedealsthatsuchmiddlemen
orarbitrageursputtogetheraremoresophisticatedthansimplyholding
inventory.Manyhedgefundsspecializeinsimilardeals,andfromtime
totime,Buffetthasalsoengagedinarbitragedeals.Thereisnoreason
foryoutobecompletelyaversetothemifyouunderstandtherisks
involved.
185
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marketefficiency
ArbitrageinMergerDeals
Onecommonformofarbitragethatmanycantakeadvantageofismerg-
ers.ConsiderthemergerbetweenGeneralReandBerkshireHathaway
in1998(discussedinChapter8).Accordingtothedeal,200sharesof
GeneralRewouldbetransferredinto21sharesofBerkshireHathaway,
classB.Iftherewasnouncertaintysurroundingthe
merger,theprice
for200sharesofGeneralReshouldbethesameasthepriceof21shares
ofBerkshireHathaway,classB.Formanymonthswhilethemergerwas
pending,youcouldhavebought200sharesofGeneralReforabout5
percentlessthanthepriceyouwouldhavepaidfor21sharesofBerkshireHathaway,classB.
Consideranotherexample.InDecember1998,Exxonannounced
itsintentiontobuyMobil.ThetermsofthedealcalledforMobilshare-
holderstoreceive1.32015
ExxonsharesforeachMobilshare.Aslateas
May1999,Mobilsharesweretradingataround$105,andExxonshares
weretradingat$84.Itwasabout6percentcheapertobuyMobilshares
thantobuyExxonshares.Thus,thewaytoplaythatarbitragewastobuy
MobilsharesandsimultaneouslysellshorttheExxonshares.Sincethe
mergerwastotakeaboutfourmonthstocomplete,theinvestorwould
haveearnedanannualizedreturnofabout18percent.Thisisabout
twicetheaveragereturnonthestockmarket.
Notallannouncedmergerdealsarecompleted,andwhenadeal
isnotcompleted,thearbitrageurmaylosealargepercentageofthe
investment.Therefore,youshouldnotgamblealargeamountinthese
transactions,andwhenadealseemsrisky,itisbestto
avoidit.Itappearsthatimmediatelyafterafaileddeal,investorslookingforarbitrageopportunitiesbecomemorerisk-averse,andtheexpectedpercentagereturns
fromsuchdealsincrease.Thisissimilartothesituationintheinsuranceindustryinwhichinsurancepremiumstendtogoupafterahurricane
oranaturaldisaster.Notonlyarethearbitrageurslesswillingtoinvesttheirmoneyinsuchdeals,butitalsoappearsthatonlythemore-likelyto-succeedmergersarebroughttothemarket.
So,asavvyinvestorshouldincrease,ratherthandecrease,themoney
devotedtosucharbitrageactivitiessoonafterafailed
merger.Thepro-
posed$3.1billiontakeoverofAmericanBankersInsuranceGroupby
Cendantcollapsedin1998whenitwasdiscoveredthatCendanthad
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187
engagedinaccountingirregularitiesandfraudanditsstockpricefell
70percent.Almostimmediatelyafterthisfailure,theexpectedreturns
fromarbitragedealsincreasedsubstantially.Anotherconsiderationisthatwhenanumberoflargemergersaretakingplaceatthesametimeinthe
market,thereisnotenoughmoneytogoaround,andexpectedarbitrage
profitsgoup.
Insomesituations,
companiessuchasBerkshireHathawaycangener-
ategoodreturnsforashorttimeatalowerriskthananaverageinvestorcan.Thus,notonlyisBerkshireabletogenerategoodreturnsonits
investingactivitiesinthestockmarket,butitalsogeneratesanoverallsuperiorreturnpartlybecauseofitsarbitrageactivities.For
example,
whenacompanybidsforanothercompanyandneedsmoneyonshort
notice,Berkshiremaybeabletoprovidecashquicklyinexchangefora
higher-than-normalreturn.
AnExampleofaSuccessful
ArbitrageDealbyBuffett
Thefollowingexampleillustratesthatthebetteryouunderstandthe
financialmarkets,themorelikelyyouaretofindarbitrageopportunities.
HereiswhatWarrenBuffettwroteinthe1988Berkshireannualreport:
Someoffbeatopportunitiesoccasionallyariseinthearbitragefield.
IparticipatedinoneofthesewhenIwas24andworkinginNew
YorkforGraham-NewmanCorp.Rockwood&Co.,aBrooklyn-
basedchocolateproductscompanyoflimited
profitability,hadadopted
LIFOinventoryvaluationin1941whencocoawassellingfor5cents
perpound.In1954atemporaryshortageofcocoacausedtheprice
tosoartoover60cents.ConsequentlyRockwoodwishedtounload
itsvaluableinventory—quickly,beforethepricedropped.Butifcocoa
hadsimplybeensoldoff,thecompanywouldhaveowedtaxofclose
to50%ontheproceeds.
The1954TaxCodecametotherescue.Itcontainedanarcaneprovi-
sionthateliminatedthetaxotherwisedueonLIFOprofitsifinventory
wasdistributedtoshareholdersaspartofaplanreducingthescopeof
acorporation’sbusiness.Rockwooddecidedtoterminateoneofthe
businesses,thesaleofcocoabutter,andsaid13million
poundsofits
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marketefficiency
cocoabeaninventorywasattributabletothatactivity.
Accordingly,the
companyofferedtorepurchaseitsstockinexchangeforthecocoa
beansitnolongerneeded,paying80poundsofbeansforeachshare.
ForseveralweeksIbusilyboughtshares,soldbeans,andmadeperiodic
stopsatSchrodderTrusttoexchangestockcertificatesforwarehouse
receipts.Theprofitsweregoodandmyonlyexpensewassubway
tokens.2
Long-TermCapitalManagement:TheStoryof
aHedgeFundand
BerkshireHathaway
ConsiderafamouscasethatexplainswhyBuffettwantedtopurchasea
hedgefundandliquidateit.InSeptember1998,BerkshireHathawaypro-
posedacquiringLong-TermCapitalManagement(LTCM),througha
$4billionlimitedpartnershipcomprisingBerkshireHathaway,Goldman
Sachs,andAmericanInternationalGroup.Manyindividualinvestors
thinkthathedgefundstakelargepositionsbutaresomehowhedged
againstlosingmoneyandproduceconsistentlyhigh
returns.Asthenear
bankruptcyofLTCMhedgefundssuggests,investinginhedgefundsis
notashedgedasyoumaybelieve.Sowhataretheimportantlessonsfor
anindividualinvestor?
TheonedistinguishingfeatureofLTCMwasthe
extentofitslever-
age:about25to1.Thefundreportedlyhad60,000tradesonitsbooks,
includinglongsecuritiespositionsofover$50billionandshortpositionsofanequivalentmagnitude.Thegrossnotionalamounts(totalvalueof
leveragedpositions)ofthe
fund’scontractsonfuturesexchangesexceeded$500billion,swapcontractsmorethan$760billion,andoptionsand
othersover$150billion.
LTCM’ssizeandleverage,aswellasitstradingstrategies,madeitvul-
nerabletotheextraordinaryfinancialmarketconditions
thatemerged
followingRussia’sdevaluationoftherubleanddeclarationofadebt
moratoriuminAugust1998.Russia’sactionssparkedaflighttoqual-
ityinwhichinvestorsavoidedriskandsoughtliquidity.Asaresult,riskspreadsandliquidity
premiumsrosesharplyinmarketsaroundtheworld.
DuringthesinglemonthofAugust,LTCMsufferedlossesof$1.8bil-
lion,bringingthelossofequityfortheyeartomorethan50percent.
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BySeptember21,LTCM’sliquiditysituationwasbleak,andfurther
unfavorablemarketmovementscouldhavecausedittodefaultinafew
days.3
OnthemorningofSeptember23,Berkshireandpartnersproposed
purchasingLTCM’sportfolio.However,atthesametime,aconsortium
of15firmsthatwerethemselvessignificantlyexposedinadefaultsce-
narioproposedinvestinginLTCM.WhileBerkshire’sproposalwasto
takeover100percentofthefund’sequity,thecounterproposalallowed
thecurrentprincipalsandinvestorstokeep10percentoftheequity.
Berkshire’sproposalwasrejected.Buffett’sinterestin
LTCMwasnotan
isolatedeventconsideringhisongoinginterestinarbitrage.InJuly1998,Berkshirecontributed90percentofthecapital($270million)forthe
WestEndCapitalfund(essentiallyahedgefund)managedbyMark
Byrne.Overall,toaknowledgeableperson,hedge
fundsmayofferrisky
butprofitableopportunities.
ThemainlessonfromtheLTCMepisodeisthatlargeleverageposi-
tionseveninthebiggestoffundscanleadtobankruptcy,becauseevents
suchastheRussiandefaultcannotbeplannedintoany
model.Atthe
timeofitsnearfailure,LTCMwasthemosthighlyleveragedlargehedge
fundreportingtotheCommoditiesFuturesTradingCommission.Its
assetswerenearlyfourtimestheassetsofthenextlargesthedgefund.
TheliquidityproblemsfacedbyLTCMwerecompoundedbythesize
ofitspositions,asitcouldnotunwinditspositionseasily.
How,then,couldBerkshirebenefitfromacquiringLTCM?The
basicpointtorecognizeisthatinsuchvolatile
situations,margincallsrequiretheleveragedpartytoliquidateitsportfolioatunfavorableprices.
Marketsbecomeinefficient.SinceBerkshireundoubtedlyhadenough
liquidity,itwouldnothavehadtoliquidateLTCM’spositionsinahurry.
Inanorderlyliquidationover
alongtime,LTCMwouldhavebeenmuch
moreprofitable.AfirmsuchasBerkshirewithexcellentliquiditywill
probablycomeacrossopportunitieslikethisfromtimetotime.
Thisisalsolikelytobetrueforindividualinvestors.Whenmajor
exogenousshocksinthemarketcreatevolatility,pricesgenerallyfall
temporarilybecauseinvestorspreferlessriskyinvestmentssuchasinvestinginTreasurysecurities.Ifyouhaveinvestedinthestockmarket,you
willsufferpaperlosses,butyouarelesslikelytopanicifyouarenot
highlyleveraged.Ifpossible,youshouldtakeanadditionalpositionin
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marketefficiency
stocks.WhentheLTCMsagawasinfullswing,equitymarketsalso
declined.Asaninvestor,youcouldhavebenefitedifyouhadinvested
inyourfavoritecompanies.WeknowthatBerkshire’sequityholdingin
AmericanExpresswasincreasedbyabout1million
sharesduringthat
period.
Buffett’sinterestinLTCMmighthavecomefromthefactthatthe
financialmarketsweredownheavilywhentheRussiangovernment
defaultedonitsdebt.AlthoughBerkshire’sbidto
acquiretheassetsof
LTCMwasdenied,Buffett’sconjectureprovedtobecorrect:LTCM
earnedhighreturnsinthemonthsfollowingthecrisis.Thisepisode,
onceagain,showstheimportanceofinvestingwhenothersarefearful.
Furthermore,anyoneinterestedininvestinginpositionsthatareriskyintheshortrunhadbetterhavealargecapitalbaseincasethereissuddendemandforadditionalcapital.
ShouldYouInvestinHedgeFundsor
PrivateEquityFunds?
Itisdifficulttocreate
reliablehedgefundindicesbecausehedgefundsarenotrequiredtoreleasetheirperformancedatapublicly.Severalindices
arefrequentlyreportedinthemedia,themostpopularofwhichis
CSFB/TremontHedgeFundIndexandincludesdatasince1993.If
youeverplantousethem,youshouldknowthattherearetwoseri-
ousproblemswithmosthedgefundindices.First,someoftheindices
backfillthedataasfundsreporttheirhistoricalperformance.Fundshaveincentivestoreportonlyfavorablehistoricaldata.Second,mostanalysessuffer
fromwhatisknownassurvivorshipbias:Returnsofindicesmayincludeonlythecurrentlyexistingfunds,omittingthedatafromfunds
thathavegonebankrupt.BurtonMalkielandAtanuSahaexamineda
reasonablycomprehensivedatabaseofhedgefundreturnsandestimated
theeffectsofthesetwobiases.4Aftercorrectingforbiases,theyfindthathedgefundshavereturnslowerthancommonlysupposed.From1995to
2003,thehedgefunduniverseasawholeearnedannualizedreturnsof
8.82percent,versus12.38percentfortheS&P500.Withadditionalanalysis,
theyconcludethathedgefundsareextremelyrisky,astherangeof
individualhedgefundreturnsarefargreaterthantheyarefortraditionalE1C19
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191
assetclasses.ProfessorAndrewLo—oneoftheworld’smostrespected
financialeconomists—comestosimilarconclusions.5Healsopresentsa
detailedanalysisofrisk,returns,andliquidityofhedgefunds.
Privateequityandventurecapitalfundsareusuallyregardedasthe
mostsophisticatedinvestmentvehicles.Thefundsaregenerallyrunby
creative,experienced,andarticulatemanagerswhohaveproventrack
recordsinmanagingmoney.Theyarealsoverysecretive
anddonot
readilysharetheirperformanceresults.Hence,thereislessresearchon
returnsfrominvestinginprivateequityfunds.However,theconclusions
fromthebestavailableresearchsuggestthatoutsideinvestors(thosewhodonotparticipateinmanagement)
donotearnabove-averagereturns.
Basedonvoluntarydatafortheperiodfrom1980to2003providedby
about2,000largeprivateequityinvestors,LudovicPhalippouandOliver
Gottschalgfoundthat,onaverage,net-of-feesannualizedperformance
is3percentbelowthatoftheS&P500index.6AnearlierstudybySteveKaplanandAntoinetteSchoarconcludedthatthereturnsareaboutthe
sameasthoseontheS&P500index.Inaddition,thecross-sectional
variationacrossmanagersishigh.7
Onaverage,thereseemsto
benoadvantageininvestinginhedge
fundsbecausethereturnsarenotlargerthanthemarketindices.Ahighervolatilityofreturnsalsoresultsinabiggerbiteintaxesbecausetaxesarepaidwhenreturnsarehighbutmaynotberecoupedwhenreturnsare
low.Finally,thefeestructureofhedgefundsisnotfriendly
toinvestors.
Inthehedgefundindustry,itiscommontochargeafeeof2percentof
theassetsundermanagementand20percentmoreofthereturnsbeyond
acertainlevel.Ifafundreturnis8percentperyearandtheexpensesareabout2percent,youeffectivelylose
25percentofyourearnings,and
thatdoesnotincludetheadditionalamountyouwouldlosewhenthe
hedgefundsdowell.Thismanagementfeestructurebordersonhighway
robbery.
Conclusions
Thehedgefundindustryismadeupofinvestorswhomanagehighly
leveragedpositionsandgenerallyeitherearnextremelyhighreturnsor
earnpoorreturnsthatoftenleadthemtofacebankruptcy.Itisnottrue
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marketefficiency
thathedgefundsconsistentlyearnhighreturnsandthatcapitalishedgedfromlargelosses.Highleveragedoeswhatitissupposedtodo:increase
volatility.Whenlossesoccur,theyarefierce,asillustratedbytheLTCM
example.Hedgefundmanagersdowellbecauseofhighfees.Investors
inhedgefundsdonot.Theremaybesomegoodhedgefunds,butitis
closetoimpossibletoidentifythem.Mysuggestion
istoavoidinvesting
inhedgefundsaltogether.
E1PART07
Date:Dec10,2009
Time:1:17pm
PartSeven
PROFITABILITYAND
ACCOUNTING
Buffetthasoftenmentionedthatstudyingaccountingandunder-
standingfinancialstatementsarenecessarytobecomeasuccessful
investor.InChapters20to24,Idiscusssomeideasessentialto
understandingBerkshire’simpressiveprofitabilityandlearningtobecome
abetterinvestor.
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E1PART07
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E1C20
Date:Jan29,2010
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Chapter20
M=Monopoly=Money
Amonopolyexistswhenacompanycontrolstheentiremarketfora
specifiedproductorserviceandwhentherearesignificantbar-
rierstoentryinthatmarket.Wecandebatewhether
Microsoft
orGooglehavemonopoliesintheirrespectivemarkets,butwewillcer-
tainlyagreethattheyhavelargemarketsharesinpersonalcomputer
operatingsystemsandWeb-basedsearch,respectively.Muchhasbeen
writtenaboutmonopoliesandnear-monopolies,butonethingisclear:
Almostallofthemmakegoodmoney.Therehavebeenlargemonop-
oliessuchasStandardOilandMicrosoftandsmallmonopoliessuchas
tollboothsacrossbridges.Inthemindsofinvestors,the
letterMshouldstandnotonlyfor“money”butalsofor“monopoly.”So,startsearching
fornear-monopoliesorcompanieswithwhatBuffettreferstoaswide
moatsaroundthem.
WidentheMoat
Buffetthasoftendiscussed
theideaofamoataroundacompany,which
meansanenduringcompetitiveadvantageforthecompany,orameans
ofprotectiontomaintainthecompany’sprofitabilityforalongtime.He
fullyunderstandsthepowerofearningsuperiorreturnsthroughsuch
businesses.ThisisevidentinamemohewroteshortlyafterSeptember
11,2001,urgingBerkshiremanagerstoremainfocused:“Whatshould
195
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196
profitabilityandaccounting
youbedoingrunningyourbusinesses?Justwhatyoualwaysdo:Widen
themoat,buildenduringcompetitiveadvantage.”1
Youdon’thavetoidentifyandinvestinamonopolyinitsearlystages
ofdevelopment.Forexample,Microsoftwentpublicin1986.Youcould
havewaitedfiveyearsandboughtMicrosoftsharesin1991,oryoucould
havewaitedanotherfiveyearsandboughtin1996.
Onlyifyouhad
waiteduntilabout1999—whenMicrosoftstockwasalreadyovervalued,
thecompanywasbeingscrutinizedbythegovernment,andgrowthwas
slowing—wouldyouhavebeentoolatetothegametomakemoney.
ProfitabilityofMonopolies
Monopoliesmakeabove-averagereturns—whichappealstocommon
senseandcaneasilybesupportedbydata.Thereisnobettercontempo-
raryexampleofanear-monopolythanthatofMicrosoft.Microsofthas
considerablepowertosetthepricesitchargesforseveralofitsproducts.
Thenumberofpeoplebuyingacomputerisnotlikelytochangemuch
whetherMicrosoftcharges$199or$299fortheoperatingsystemthat
mustresideinsidemostpersonalcomputers.Most
buyers,whethernew
orrepeat,prefertheMicrosoftoperatingsystembecausesomanycon-
sumersalreadyhaveacompatiblesystem.Thesameistrueforsomeof
Microsoft’sotherproducts.
HowprofitableisMicrosoft?Onewaytojudgeisto
compare
Microsoft’sprofitabilitywiththatofanotherlargecomputercompany.
Forillustrationpurposes,IBMisareasonablebenchmark.AlthoughIBM
hasastakeinboththesoftwareandhardwaresegmentsofthecomputer
industry,theprofitabilityofitssalesrevenueandthatofassetsemployedcanstillbecomparedbecausebothcompaniesareinanindustrythat
requiressignificantresearchanddevelopment.
Table20.1presentsthefinancialhighlightsforMicrosoftandIBM.
Thebasicmetricforcomparingthetwocompaniesisoperatingincome
asapercentageofrevenuesorasapercentageoftotalassets.Overthepastsixyearsforwhichdataareavailable,Microsoft’soperatingincomeasa
proportionofrevenues,oroperatingmargin,on
average,was34percent.
Incomparison,IBM’soperatingmargininthesameperiodwasonly
14percent.Comparingoperatingincometototalassetsratioacrossthe
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197
Table20.1
ProfitabilityComparisonsofIBMandMicrosoft
FinancialHighlights—IBM
2008
2007
2006
2005
2004
2003
Revenues
$103.6
$98.8
$91.4
$91.1
$96.3
$89.1
Totalassets
$120.4
$109.5
$103.2
$105.8
$111.0
$106.0
Operatingincome
$15.9
$13.5
$13.3
$12.2
$12.0
$10.9
Operatingincome
asapercentage
ofrevenues
15.3%
13.7%
14.6%
13.4%
12.5%
12.2%
Operatingincome
asapercentage
oftotalassets
13.2%
12.3%
12.9%
11.6%
10.8%
10.3%
FinancialHighlights—
Microsoft
2008
2007
2006
2005
2004
2003
Revenues
$60.4
$51.1
$44.3
$39.8
$36.8
$32.2
Totalassets
$72.7
$63.2
$69.6
$70.8
$94.4
$81.7
Operatingincome
$24.3
$18.5
$16.5
$14.6
$9.0
$9.6
Operatingincome
asapercentage
ofrevenues
40.2%
36.2%
37.2%
36.6%
24.5%
29.7%
Operatingincome
asapercentage
oftotalassets
33.4%
29.3%
23.7%
20.6%
9.6%
11.7%
Dollaramountsinbillions.
twocompaniesalsosuggeststhatMicrosoft(21percentoversixyears)is
muchmoreprofitablethanIBM(12percentoversixyears).2
Wheneveracompanycreatesanear-monopolyoran
enduringcom-
petitiveadvantage,itoffersagoodinvestmentopportunity.Inmany
situations,itmaynotbepossibletoinvestinthosecompaniesbecause
theyarenottradedpublicly.Forexample,DeBeersisconsidereda
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profitabilityandaccounting
monopolyindiamondmininganddistribution,especiallyinthehigh-
qualitydiamondmarket.However,youcannotinvestinDeBeers
becauseitisaprivatelyheldcompany.
Amonopolystillneedstobemanagedwelltoprotectitsprofitabil-
ity.Becauseoftheirhighprofitability,monopoliesattractcompetition,
andunlessthemonopolistcanmaintainitsmonopoly,profitabilitywill
declineovertime.Inthedrugindustry,acompanymayhaveamonopoly
onadrugforaparticulardisease.Wheneveradrugisahugesuccess,
otherdrugcompaniesstartresearchinginthesamearea
todiscovera
similarchemicalthatisequallyormoreeffectiveintreatingthedisease.
Drugpricesremainhighaslongasthecompanyhasamonopolyover
theproductbutdeclinewhencompetitionemerges.Conversely,con-
sidertheexample(discussednext)ofaBerkshire-ownednewspaperthat
wentfromlosingmoneyinacompetitiveenvironmenttobecoming
highlyprofitablewhenthemajorcompetitorfolded.However,monop-
oliesdonotlastforever.Forexample,unlessnewspapers
reactefficientlytoInternet-basednewsandadvertising,theyarelikelytofaceadecline
intheirprofitabilityandmayevenbecomeextinct.
BuffaloNews:HowProfitabilityChangedDramatically
BerkshireHathawayownstheBuffaloNews,adaily
newspaperinBuffalo,NewYork,acityknownforitsblue-collarworkersandtraditional
industries.WhenBerkshireboughtitfor$32.5millioninearly1977,
theBuffaloNewswasadistantsecondtothelocalCourier-Expressandwaslosingmoney.3ButsinceOctober1982,ithasbeenthe
onlydailymajor
newspaperservingtheBuffaloarea.Themonopolycameaboutbecause
ofeventsthatincludedalonglegalbattleemanatingfromactionbythe
Courier-Express.Inearly1982,CharlieMungerwrote,“Ifthelitigationcontinuesandifthecompetingpaper
succeedsinsomehowchanging
thelawasenunciatedbytheFederalCourtofAppealsandinobtain-
ingthekindsofinjunctionsitisseeking,orifanyextendedstrikeshutsdowntheBuffaloNews,itwillprobablybeforcedtoceaseoperationsandliquidate.”4However,theBuffaloNewspersevered,
anditsvictorywasindeedsweet.In1983,thefirstfullyearafterthecompetitorclosed,the$19millionthecompanyearnedinoperatingprofitscoveredthelosses
fromthepreviousyearswithsomeprofitleftover.
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199
Figure20.1illustratestheadvantageofamonopolisticenvironment.
Usingtheavailabledatafrom1979to1999,Ireporttheprofitability
(operatingprofitsasapercentageoftotalsales)oftheBuffaloNewsinrelationtotheprofitabilityofallothernon-insuranceBerkshiresubsidiaries,includingSee’sCandies,NebraskaFurnitureMart,andBorsheim’s.The
BuffaloNews’sprofitsjumpedsignificantlyin1983whenitbecametheonlynewspaperintown—whenit
becameclosetoamonopoly.
Inthesubsequentfiveyears,profitsmorethandoubledto$41.8million.
In1999,theBuffaloNewsearnedmorethan$55milliononrevenuesof$160million.Ingeneral,ifyoufindacompanythatislikelytoincreaseitsmonopolisticstance—orwidenitsmoat—growthinprofitswillfollow,
andyouwillprobablyearnahighreturnonyourinitialinvestment.
DominanceDoesNotMeanHighProfits
Whenyoulookforamonopoly,becarefultoinvestigatewhetherthe
companyislikelytoremainprofitablefortheforeseeablefuture.Alargeoreven
dominantcompanyisnotalwaysamonopolyornear-monopoly.
GeneralMotors(GM)hasbeentheworld’slargestcarmanufacturerand
currentlyhasannualrevenuesofabout$200billion,yetitgenerates
almostnoearningsforitsshareholdersandwent
bankruptin2009.It
hasnotbeenearningmonopolisticprofitsforatleast20years.GM’s
declineillustratestheinevitable:Monopoliesdonotlastforever.Their
allurefromaninvestmentpointofviewdiminishesascompetitionsets
inorgrowthpotentialdiminishes.Microsofthadlostitsappealasan
investmentby1999onceitwasnolongerabletoexpanditsbusinessand
profitseasily.IBM,oncethelargestcomputercompanyintheworld,
wasessentiallyamonopolyfromthe1950stothe1970s,
butitappears
tobeanaveragecompanyatbesttoday.
FacingstiffcompetitionfromtheInternet,theNewYorkTimesandmanyothernewspapersin2009remaindominantandmonopolisticso
farasnewspapercirculationisconcernedintheirregion,
butmostof
themarenolongerprofitable.Theirstockpriceshavegonedownwith
theirdecliningprofitability.Inaspanofsevenyearsstartingin2002,thestockpricesoftheNewYorkTimesCompanyandGannett(publisher
ofUSAToday)havedeclined
byabout90percent.TheWashingtonPostE1C20
Date:Jan29,2010
Time:3:29pm
1999
1998
1997
1996
BuffaloNews
Berkshire’sallother
non-insurancebusinesses
1995
1994
1999
1993
to
1992
1979
1991
omfr
1990
ear
1989
Y
ofitabilityPr
1988
1987
News
alo
1986
Buff
1985
20.1e
1984
1983
Figur
1982
1981
1980
1979
5%
0%
40%
35%
30%
25%
20%
15%
10%
–5%
–10%
OperatingProfit
200
E1C20
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M=Monopoly=Money
201
hasalsosuffered,anditsstockpricetradesatabouthalfofitspeakpriceofafewyearsback.Somenewspapers
willtransformintoprofitable
businessesbyshrinkinginsizeorinvestingjudiciously,whileotherswillmakebaddecisionsbythrowinggoodmoneyafterbad.Foraninvestor,
itisatimetowatchandnottoinvestinthesecompanies.
Inmostcases,utilitiesdominatetheirlocalmarkets
andarenear-
monopolies.However,thesecompanies’profitabilityisoftenregulated
becausetheyareconsideredtobenaturalmonopolies;andtheirreturns
toshareholders,whileadequate,arenothigh.Duopolies,ormarketdominationbytwo
companies,aremorefrequentthanmonopolies.Probably,
CokeandPepsi,BoeingandAirbus,andFedExandUPSfallinthis
category.Oftentheyarehighlyprofitable,buttheirstockpricesarealsohigh.Hence,returnstoinvestorsmaynotbehigh.However,ineconomicslowdowns,theirpricesdeclinealongwiththe
restofthemarket.
Then,theyoffergoodopportunitiestobuybecausetheirprofitsalmost
surelyrevertbacktonormalwheneconomiesrecover.
HowtoLookforMonopolies
Thebestwaytoidentifyamonopolyistolookaround.
Generally,smaller
companiesinregionalmarketsaresomewhatmonopolistic.Whilethe
bankingsectorisslowlybecomingcompetitive,someregionalbanks
haveverylittlecompetition.Someresorts,cruiselines,andthemeparks
havelong-established,well-managedmonopoliesintheirregions.Disney
islikelytoearnmonopolisticprofitsinFlorida.CarnivalCruiseLines
alsohaslong-establisheddominancethatmakesitanear-monopoly.You
caninvestigatecompaniesthatoperatetollroads,as
manystateslook
toprivatizetheirtollroads.Monopoliesornear-monopoliesthatareas
large,well-known,ordominantasMicrosoft,Intel,andCiscoarenot
common.Manyotheropportunitiesmaybefoundinlessglamorous
industries,suchasexportersorregionalsuppliersforotherfirms.Everysooften,youmaystumbleuponamonopoly,andwhenyoudo,donot
letitgowithoutathoroughinvestigation.
Simplybecauseafirmappearstobeamonopolydoesnotnecessar-
ilymeanthatitisagoodinvestmentopportunity.Youshouldconfirm
yourinitialimpressionsbyexaminingthecompany’sreturnonassets
E1C20
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profitabilityandaccounting
andonequityand,ofcourse,computeitsintrinsicvalueandmargin
ofsafety.Youshouldtrytoestimatethesustainabilityofitsprofitabilityforanumberofyearsinthefuture.Somesportsfranchises,suchasthe
BostonCelticsbasketballteam,usedtobepubliclytraded.Theremaybe
others.Sportsfranchisesoftenappeartobemonopoliesintheirmarkets,
althoughitisnotobviousthatprofitabilityissustainableinthesamewaythatMicrosoft’sprofitabilityissustainable.Sportsfansdon’thavetogotothe
games.Whenthemarketpunishestheteam’ssharepricebecause
opponentsarepunishingtheteam,youmightstartthinkingofbuying
somesharesinthecompanyifyouthinkthattheteamwillrecover.
Beyondprofitability,thepriceyoupayisevenmore
important.The
stockofamonopoly,suchasMicrosoft,Intel,orCisco,generallytrades
atahighP/Eratio.EvenatahighP/Eratio,sharesofamonopolyare
usuallynotexpensiveforalong-terminvestor.Althoughnodefinitive
ruleexistsforchoosingacutoffP/E,Ihavedevelopedaworkingruleafter30yearsofwatchingthemarket.IftheP/Emultipleisabout200percent
oftheaveragemultiplefortheS&P500,Iwaitforadeclineinthestockprice.Inabsoluteterms,aP/Emultipleof35ishighforme,evenfor
afirmthatseemstobewideningitsmoatorisanear-monopoly.Stock
pricesdeclineperiodicallyforavarietyofreasons,includingnotmeetinganalysts’salesorearningsexpectations,bearishreportsonanindustry,orfearsofinterestratehikesorarecession.Foralong-terminvestor,thesepricedeclines,suchasthoseinearly2009,
signalgoodopportunitiesforinvesting.
DoNotSellaMonopolyinaHurry
IhavemetmanypeoplewhoboughtMicrosoftstockwhenitwasayoung
companyoritspricehaddippedforonereasonoranother.However,
theywerequicktotakeprofitswhenthestockpricewentup50percent
to100percentevenwhentherewasnocompetitoronthehorizon.More
oftenthannot,itisamistaketosellyoursharesinanear-monopolyor
evenagrowingcompanyonceyouhavebecome
knowledgeableabout
thecompanyanditsproducts.PeterLynchsharedhisexperienceswith
owningPhilipMorrisandSubarustock,explainingthatifthegrowth
storyisstillgood,oneshouldnotsell.5Whenyouthinkthatthereisa
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203
highprobabilityofacompetitor’ssuccess,youshouldsell.Thestockmayappearexpensivefromtime
totime,anditmaynotbeagoodtimeto
addmoresharestoyourportfolio.Butsellingisoftenamistakebecause
thepricemaynotcomedownforawhileforyoutobuyitagain,andby
thetimeitdoes,youmighthavelostinterestinthestockornolonger
havethefundstoreinvestinit.
Periodically,stockpricesofamonopolyoranear-monopolycom-
panygoupsubstantially.Ifthepricedoesbecomeexcessive—say,a
price-to-earnings(P/E)ratioof50—doesitmakesensetosellthe
stock?Themaintoolinyourarsenal,onceagain,isyourestimateof
thecompany’sintrinsicvalue.TheP/Eratioisjustashortcuttocom-
putingintrinsicvalue.Youshouldalwayscomputeastock’sintrinsic
valuebeforemakingadecision.Usually,there
comesatimewhena
company’smonopolisticedgeerodes,whichshouldshowupinyour
estimatedintrinsicvalue.Ifyoufindyourselfinthatsituation,youshouldsellyourshares.Inrecentyears,IsoldmysharesinWashingtonPostandWholeFoodswhentheP/EwasveryhighorIsawthatthe
profitability
wasdeclining.Inboththesecases,itappearedthatcompanydominance
wasslipping.Itbecametoodifficulttopredictthefuture,indicatingthatitwastimetosell.
Conclusions
StandardOilwasamonopoly
intheearlypartofthetwentiethcen-
tury.Currently,Microsoftseemstobeanear-monopoly,althoughit
islosingmarketshare.Foralongtime,allthesecompaniesrewarded
theirshareholderswelluntil,ultimatelyandinevitably,competitionset
in.Althoughlargeandpowerfulmonopoliesarenoteasytofind,many
well-runcompanieswithenduringcompetitiveadvantagesareexcellent
long-runinvestmentsiftheirstockpricesarenotexcessive.Amongthe
stocksownedbyBerkshire,suchcompaniesinclude
AmericanExpress,
Procter&Gamble,Wal-Mart,Coca-Cola,andWellsFargo.
E1C20
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Time:3:29pm
E1C21
Date:Jan18,2010
Time:10:23pm
Chapter21
WhoWinsinHighly
CompetitiveIndustries?
[W]ebelievethat[GEICO’s]costofnewbusiness,thoughdefi-
nitelyrising,iswellbelowthatoftheindustry.Ofevengreater
importance,ouroperatingcostsforrenewalbusinessarethelow-
estamongbroad-basednationalautoinsurers.Bothofthese
competitiveadvantagesaresustainable.Othersmaycopy
our
model,buttheywillbeunabletoreplicateoureconomies.1
—WarrenBuffett
Insuranceisahighlycompetitiveindustry,butGEICOisfarmore
profitablethanitscompetitors.Retailingisalsoconsideredhighly
competitive,butWal-Martismoreprofitablethanothers.What
characteristicsarehelpfulforacompanytoremainaleaderinanindustrythatmaybeclassifiedasacommoditybusinessorahighlycompetitive
business?Let’strytofindsomeanswersbylookingatGEICO,Wal-Mart,
andothercutthroatcommoditybusinesses.
InsuranceIsaCommodityBusinessLikeRetailing
Wal-Martclearlydominatesthediscountretailindustry.Itissofaraheadofitscompetitionthatitisdifficulttotellwhoissecond.Kmartand
205
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206
profitabilityandaccounting
SearstogetherareunderonecorporateumbrellaknownasSearsHold-
ings,consideredtobeWal-Mart’smaincompetitor.Wal-Mart’sannual
revenuesareabout$400billion,whereasSearsHoldings’annualrev-
enuesareabout$50billion,onlyone-eighthofWal-Mart’s.Butitwas
notalwaysthatway.BothKmartandWal-Martwere
majorretailers
untilWal-Martpulledintotheleadandeventuallywontherace.Before
KmartandWal-Martbecametheindustryleaders,otherdominantretail-
ersincludedJ.C.Penney,Sears,andW.T.Grant.YoumaynotrecallW.T.
Grant,whichwentbankruptin1975becauseitcouldnotcompetewith
Kmarteffectively.ThenKmartwentbankruptin2002becauseitcould
notcompeteeffectivelywithWal-Mart.Clearly,othercompaniesare
nowtryingtotakemarketshareawayfromWal-Mart.
WhileSearsHold-
ingsisnowconsideredtobeWal-Mart’smaincompetitor,Targetand
CostcoalsocompetewithWal-Marteffectivelyinclothingandwholesale
markets,respectively.And,internationally,CarrefourandTescodovery
wellagainstWal-Martinsomecountries.IfyouarewatchingWal-Mart,
youshouldalsowatchitscompetitors.
Inmanyotherindustries,suchasgrainprocessing,goldcoinmint-
ing,high-endretailing,long-distancetelephoneservice,home-building
materials,andcarsandmotorcycles,afewleadersemergeovertimeas
businessesbecomecommoditybusinesses.SimilartoWal-Mart’ssuc-
cessinretailing,thesuccessofMcDonald’sinfast-foodrestaurantsand
GEICO’ssuccessinautoinsurancehavethesame
underlyingreasons.
TwoMainCharacteristicsofaLeader:
LowCostandCustomerSatisfaction
“Wesellforless”and“Satisfactionguaranteed”aretwoofWal-Mart’s
slogansthateffectivelycapturetwoimportant
principles:lowcostand
customersatisfaction.ToansweraquestioninBerkshire’sannualshare-
holdermeetinginApril2000,BuffettessentiallyechoedWal-Mart’s
slogans.HesaidthatGEICO’ssustainableadvantageswerelowoper-
atingcostsandhigh-qualityservice.LikeWal-Mart’s,theMcDonald’s
operatingmodelhasbeenacasestudyinbusinessschoolsforalong
time.Sofar,BurgerKing,Wendy’s,andmanyothershavebeenunable
toreplaceMcDonald’s.Aslongasyouknowthat
McDonald’ssellsforless
E1C21
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WhoWinsinHighlyCompetitiveIndustries?
207
anditscustomersarehappy,
youarelikelytoearnrespectable,ifnothigh,returnsoveranextendedperiodbyinvestinginMcDonald’s.InNovember2009,BerkshireannouncedtheacquisitionofBurlingtonNorthern
SantaFefor$34billion.Theacquisitionseemstohavebeenmotivated,
atleastinpart,bythefact
thatrailroadsareamorecost-efficientmethodoftransportinggoodsthantruckers.2
Aracefordominancecanlastalongtime,andthereisnounique
pathtosuccess.Intheautomobilesector,thereweremanymanufactur-
ersfordecadesbefore
GeneralMotors,Ford,andChryslerbecamethe
BigThree.Buteveninthe1920sand1930s,itwasprobablynotdiffi-
culttodiscernwhichonewasemergingastheleader:GeneralMotors
wasbecominglargerandlargerbysuccessfullycombiningOldsmobile,
Chevrolet,Cadillac,andothermanufacturers.Inthe1980s,Wal-Mart’s
strategywasdifferent.Wal-Martdidnotemphasizebuyinglocalretailers.
Instead,itbuiltstoresanddrovethecompetitionoutofthemarket.Lestweforget,outstandingmanagersareinvariablytherealjewelersbehind
developingthesejewels.AlfredP.SloanandSamWaltonweretoGeneral
MotorsandWal-Mart,respectively,justasWarrenBuffettistoBerkshire
Hathaway.
GEICO,undertheleadershipofTonyNicely,focusesondirectmar-
ketingtokeepcostslow.Slowlyandsurely,ithasincreaseditspresenceinthemarketbyadvertisingand,ifnecessary,reducinginsurancepremiums.Typically,asacommoditybusinessaddstoitsmarketshare,its
per-capitacosttokeepitssustainableadvantagegoesdown.Consider,
forinstance,advertisingcosts.Afull-pageadvertisementintheNewYorkTimesdoesnotdependonthesizeoftheinsurancecompany.So,thecostpercustomerissmallerforalargercompany.A30-secondTVspot
onaSuperBowlSundaywillbecheaperforWal-Martforeachdollarin
salesthanforKmart.Inaddition,givenitssmallersalesrevenue,Kmart
maynothaveasmuchofabudgetforadvertisingasWal-Mart.Oncea
competitiveadvantageisestablished,itisdifficulttounseattheleader.
However,watchoutforthepotentialofolddominant
playersto
becomedinosaurs.ThemainreasonKmartfailedwasthatitstarted
expandinginunrelatedbusinessessuchasdo-it-yourselfstores(Builders
Square)anddrugstores(PaylessDrugStores).Technologicalchangesalso
affectthecompetitivefield,especiallywhenadominantplayertakesits
competitiveadvantageforgranted.AcaseinpointisIBM,whichwas
E1C21
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profitabilityandaccounting
aleaderinthecomputerindustryforyears.Inthe1980s,whenthe
personalcomputermarketstartedtobloom,IBMtookitforgranted
thatitwouldmaintainits
leadershipposition.Butthatwasnottobe.
ThedevelopmentoftheInternethastakenatollonBarnesand
Noble’sleadershipinthebookindustry.Amazon.comhasemergedas
theleaderinrevenuesfrombooksalesovertheInternet.Withtime,
Amazon.comisincreasingitsdominanceand,hence,itscostadvantage.
ItisalsotakingsomemarketsharefromWal-Mart.Somehow,someday,
Wal-Mart’sdominancewillerode,butIcan’tpredictwhichcompeti-
torwillemergetochallengeWal-Mart.Ifretailingisin
yourcircleof
competence,youmayspotsuchacandidateearlyandinvestinthat
company.
Thesecondimportantingredientforsuccessinthecommoditybusi-
nessiscustomerserviceorcustomersatisfaction.
AmericanExpresswas
notthefirstcreditcardcompany;DinersClubwas.ButAmerican
Expresscamefrombehind,establisheditsnameonthestrengthofits
customerservice,andcapturedmarketshare.Interestingly,VISAthen
camefrombehindand,usingalow-coststrategy,becamethemarket
leader.Atleastfornow,VISA,MasterCard,andAmericanExpressseem
tobesurvivingwellinthismarketbydifferentiatingtheirproducts.ThemainadvantageforAmericanExpressisitsexcellentcustomerservice.
Overall,itearnsaboutonepercentagepointmoreonchargesthanVISA
andMasterCard.Butitisexpensivetoprovidegoodcustomerservice.
Forthisreason,youmaynoticethatcompaniesoftendecidetoservice
onesegmentofthemarketortheother.Increditcards,
AmericanExpress
preferstoservicehigh-endcustomersbychargingahigherannualfee
andahigherfeetobookairlinetickets.
GoodcustomerserviceisoneimportantreasonforBerkshire’ssuc-
cessintraditionalindustries.
BuffettexplainsBerkshire’semphasison
customerservicethroughthefollowingexample:“Ourtwopipelines,
KernRiverandNorthernNatural,werebothacquiredin2002.Afirm
calledMastiorankspipelinesforcustomersatisfaction.Amongthe44
rated,KernRivercamein9thwhenwepurchaseditandNorthern
ranked39th.Therewasworktodo.InMastio’s2009report,KernRiver
ranked1standNatural3rd.CharlieandIcouldn’tbemoreproudofthis
performance.”3Inthe2008AmericanCustomer
SatisfactionIndexsur-
veyconductedbytheUniversityofMichigan,GEICOrankshigherthan
E1C21
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WhoWinsinHighlyCompetitiveIndustries?
209
itmajorcompetitorsAllstate,Progressive,andStateFarm.Itseemsthat
itisneitherlowcostnorcustomerservicebutacombinationofthetwo
thatresultsinthewinningstrategyforcompaniesinhighlycompetitive
industries.
Justasacompany’scostadvantagegrowswithmarketshare,the
sameistrueofcustomersatisfaction.Asthenumberofretailcustomers
increased,manyWal-Martstoresstartedtoremainopen24hoursaday.
Inmyneighborhood,Wal-Martisopen24hours,whereasKmartisnot.
Longerstorehoursoftenreducecostsandleavecustomersmoresatisfied.
HowDoCompaniesKeepCostsLow?
Companieskeepcostslowinavarietyofways.Wal-Marthaskeptthe
companyheadquartersinthesmalltownofBentonville,Arkansas.Its
executivessharehotelroomsanddonotdineatfancyrestaurantswhile
traveling.Eventhoughthelargestcostforcompaniesisthecostofgoodssold,costadvantageseemstoemanatemorefromindirectoroverhead
costs.Forexample,haveyoueverwonderedwhylunchpricesarea
fractionofdinnerpricesatmanyfancyrestaurants?Restaurantspaya
fixedmonthlyrent,soiftheycanserveextrameals,theircostpermeal
goesdown.Also,evenifthereareplentyofcustomers
availabletonice
restaurantsduringregulardinnerhours,areducedpricecanhelpattract
additionaldinersearlierintheday.Atoneofmyfavoriterestaurants
inNewOrleans,afixed-pricedinnerbefore6:30p.m.isonly$19,
whereasthesamemealafter6:30p.m.coststwiceasmuch.Extend-
inghoursofoperationalsoreducesoverheadcostsandattractsadifferentsetofcustomers—amechanismknownaspricediscrimination,ineconomicterms.Airlinesthatofferreducedpricesonafternoonflightsor
onnonbusinessdaysalsousethisprincipletoboosttheirprofits.
Youmaybesurprisedtoknowthatitisnotthehighgrossmargin
thatisthedrivingforcebehindWal-Mart’sprofitability.GrossmarginsatWal-MartandKmarthavebeensimilarforyears.ButWal-Mart,whose
inventoryturnoverismuchhigherthanKmart’s,isknownformaintain-
ingahighlysophisticatedandtechnologicallyadvancedsystemtokeep
inventorymoving.Thissystemconsiderablyreducesoverheadcostsper
itemsold,whichbringsabouthigherprofitability.
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profitabilityandaccounting
Properuseoftechnologycancutoverheadcostssubstantially.Before
thetelephonebecameubiquitous,GEICOcouldnotpossiblyhavesold
insurancepoliciesdirectlytocustomers.Today,manycompaniesexploit
theInternetandothertechnologiestooperatetheirbusinessesindra-
maticallynewways.Asaninvestor,keepyoureyeson
howtechnology
isbeingusedtoimproveacompany’scoststructure.Youdon’tneedto
buythestockofthecompanythatinventsanewtechnology;itmaybe
easiertofindacompanythatusesthattechnologyeffectively.
Thereisatleastoneadditionalexampleofalow-costcompany
amongBerkshire’ssubsidiaries.Afterbuyinganairplane,Buffettmust
haverecognizedthattheplanewassittingidlemostofthetime.Ifa
mechanismcouldbedevelopedtomakegreater
useoftheairplane,
overheadcostscouldbereduced.In1998,BerkshireboughtNetJets,a
companythatsellsandmanagesfractionallyownedairplanes.InNetJets,
Buffettfoundabusinessthatadherestothesamecost-reducingprinci-
plesthatGEICOandWal-MartfolloweventhoughNetJetscaterstothe
rich.Whiletherearedifferencesacrossbusinesses,itishighlylikelythatNetJetswillgrowintimeasGEICOdid.Mostbusinessesfinallyface
fiercecompetition.SurvivorsfollowWal-Mart’sstrategyoflowcostand
customersatisfaction.
Conclusions
ThenexttimeyouvisitWal-Mart,thinkaboutothercompaniesthat
maybesimilar.Theyneednotbeinthesameindustry.Youshouldask,
“WhoislikeWal-Mart?Whosellsforlessthantheir
competitorsand
providescustomersatisfactionlikeWal-Mart?”Forexample,whenthe
airlineindustrywasderegulated,SouthwestAirlines,undertheleadershipofHerbKelleher,emergedasalow-costproviderwithgoodcustomer
service.Ithasrewardedits
shareholdershandsomely.
E1C22
Date:Jan29,2010
Time:2:26pm
Chapter22
Property,Plant,
andEquipment:
GoodorBad?
WarrenandIhavehatedrailroadsourentirelife.Theyarecapital
intensive....[They]havelongbeenaterriblebusinessandhavebeenlousyforinvestors.1
—CharlieMunger
DespitewhatCharlieMungerclaimed,from2006to2008,
Berkshireacquired70.1millionsharesofaU.S.railroad,
BurlingtonNorthernSantaFe.Itiscurrentlyoneofthelargest
Berkshireholdings,withamarketvalueof$5.3billionattheendof
2008.WiththeNovember3,2009,Berkshire
announcementofaplan
toacquiretheremainingshares,BurlingtonNorthernwillbecomea
whollyownedsubsidiaryin2010.So,haveBuffettandMungerchanged
theiropiniononinvestingincapital-intensivecompanies,oristheremoretoit?EvenbeforetheBurlington
investment,Berkshireofteninvested
incapital-intensivecompanies.BuffetthadinvestedinU.S.Airways,
PetroChina,andPOSCO(aKoreansteelcompany),allofwhichare
relativelycapital-intensive.
211
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212
profitabilityandaccounting
CapitalIntensity
Let’sexamineBerkshire’s10
largestcommonstockholdingstounder-
standwhetherBuffettpreferslow-capital-intensitycompanies.In
Table22.1,IpresentananalysisofBerkshire’s10largestholdingsto
understandtheirlevelsofcapitalintensity.
Thereareonlythreecompaniesthatcouldeasilybeclassifiedas
highlycapitalintensive,withproperty,plant,andequipment(PPE)asa
shareoftotalassetsabove50percent.ThesethreeareBurlingtonNorth-
ernSantaFe,ConocoPhilips,andTesco.Threeoutofthe
10(American
Express,U.S.Bancorp,andWellsFargo)needalmostnoproperty,plant,
andequipment,andareclearlyontheotherextreme.Itappearsthat
Buffettdoesnotprefertoinvestinhighlycapital-intensivecompanies.
Shouldweconcludethatanaverageinvestorshouldnotinvestorshould
Table22.1
Berkshire’sHoldingsandTheirCapitalIntensities
Berkshire’s
Property,
PPEasa
commonstock
Totalassets
plant,and
percentageof
investments,
(TA)ofthe
equipment
TA(capital
Company
marketvalue∗
company
(PPE)
intensity)
AmericanExpress
$2.8
$126.1
$2.9
2.3%
Burlington
Northern
SantaFe
5.3
36.4
30.8
84.6
Coca-Cola
9.1
40.5
8.3
20.5
ConocoPhillips
4.4
142.9
83.9
58.7
Johnson&
Johnson
1.8
84.9
14.4
17.0
Kraft
3.5
63.1
9.9
15.7
Procter&Gamble
Company
5.7
138.2
19.0
13.7
Tesco
1.2
45.0
31.8
70.7
U.S.Bancorp
1.9
265.9
1.8
0.7
WellsFargo&Co
9.0
1309.6
13.5
1.0
Dollaramountsinbillions.
∗AsofDecember31,2008.
E1C22
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Property,Plant,andEquipment:GoodorBad?
213
investverylittleincommonstocksofhigh-capital-intensitycompanies?
Thequestionmeritsdiscussion.
Becauseoftheirlargeinvestmentsinproperty,plant,andequipment,
high-capital-intensitycompaniesareusuallyslowinrespondingtomar-
ketforcesorchangesintheeconomy.Forexample,itisverydifficultforanautomobilemanufacturertochangeitscurrentproductwhenacompetitor’sproductsetsanewtrendinthemarket.High-capital-intensity
companieshavelowvariablecostsandhighfixedcosts,whichequals
highoperationalrisk.Whentimesaregood,profitsgoupfasterthan
sales.Whentimesarebad,profitsalsogodownfasterthansales.This
cyclicalityisfurtheraccentuatedbyfinancialleverage,whichalsotendstobehighforhigh-capital-intensitycompaniesbecauseitiseasytoborrow
againstproperty,plant,andequipment.
Thecombinationofoperationalandfinancialriskssuggeststhathigh-
capital-intensitycompanieshaveahigherprobabilityoffacingasevere
financialhardshipthatcouldthreatentheirexistence.Inotherwords,
thedownsideriskfrominvestingintheirstocksishigh—andthatisone
goodreasontoavoidinvestinginthem.Ifmarketsviewedriskthisway,
stockreturnsforhigh-capital-intensitycompanieswouldalsobehigh.
Butthisdoesnotappeartobethecase.WecanusetheDow
Jones
TransportationIndexasaproxyforhigh-capital-intensitycompanies
becausemostcompaniesintheindexarehighlycapitalintensive.Data
fromDowJoneswithdividendsincludedareavailableonlyfrom1993.
From1993until2008,annualizedreturnsincludingdividendsonthe
DowJonesTransportationIndexare7.1percent(201percentover16
years)versus8.6percent(276percentover16years)fortheDowJones
IndustrialAverage.
Onereasonthathigh-capital-intensitycompaniesdonotdowellin
thelongrunmaybethattheyfaceproblemsinrestructuringthemselves
whenitmaybenecessarytodoso.Consideranairline.Whendemand
fallsandairplanesareonlyhalffull,itisdifficultto
reducethenumberofpilotsandthenumberofairplanes.Ontheotherhand,alow-capital-intensitycompanysuchasAmericanExpresscantrimthenumberof
employeesrathereasily.
Beyondcommonstockinvestments,whichtradeindependently,
Berkshireownsseveral
businessesthatareinhigh-capital-intensityindustries,andtheircommonstocksdonottradeindependently.Theutilities
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profitabilityandaccounting
andenergysegmentemploys$41.6billionintotalassets,ofwhich$28.5
billionor69percentisinproperty,plant,andequipment.FlightSafety,
Iscar,andMarmonarealsoinhigh-capital-intensityindustries,inwhich
IestimatethatBerkshirehasinvestedmorethan$10billion.So,Buffett
doesn’tavoidallhigh-capital-intensitybusinesses,andthesebusinesses
seemtohaveincreasedintheBerkshireportfolioovertheyears.
CapitalIntensityandManagementQuality
WhendoBuffettandMungerthinkthatahigh-capital-intensitybusiness
isworthinvestingin?Let’sgobacktoairlinesbecauseBerkshirewasnotverysuccessfulwithitsinvestmentinU.S.Airways.Anequallycapital-intensiveSouthwestAirlines,ontheotherhand,generatedoutstanding
returnstoitsshareholders.WhatisthedifferencebetweenSouthwest
andotherairlines?
ThemaindifferenceisthatanexcellentCEO,HerbKelleher,was
runningSouthwestAirlines.Notonlydidhestartthecompany;healso
maintainedalargepersonalstakeinit.In2009,thecompanyhadamarketvalueofabout$8.0billion,andKelleherownedabout12percentofthe
commonstock,whichhehasownedsincetheairlinewasstartedin1971.
HeranSouthwestasalow-costairlineduringhistenureasCEOand
didnotdiversifyintootherbusinesses.Atage76,Kelleherisstillthe
chairmanoftheboard,althoughhehasrelinquishedhisCEOposition.
Whenitcomestomanagement,ownershipstake,anddedicationtothe
company,KelleherissimilartoWarrenBuffett.
Forahigh-capital-intensitycompanytobesuccessful,thequalityof
itsmanagementisfarmoreimportantthanitisforalow-capital-intensitycompany.Whentimesaretough,managementofhigh-capital-intensity
companiesneedstohangonandnotgiveintochangeforthesakeof
change.Duringrecessionaryperiods,ifahigh-capital-intensitycompany
makesaseriousmistake,itmayfinditselfinfinancialstraitsandmayevenfacebankruptcy.Manyairlineshavegonebankruptovertheyears,and
somehavedonesotwice.SeveralrailroadsandU.S.Steelhavegone
bankrupt,atleastonce.Ingeneral,itiseasyforhigh-capital-intensitycompaniestoinvestlargesumsofmoney,borrowalotfromcreditors,
andcompoundtheirchancesofgettingintotroubleduringdownturns
E1C22
Date:Jan29,2010
Time:2:26pm
Property,Plant,andEquipment:GoodorBad?
215
orrecessions.Onesolutiontothisproblemistoholdalargestakeinthecompany,asBerkshireoftendoes.
In1963,justbeforeBuffettinvestedheavilyinBerkshire
Hathaway,
thecompany’scapitalintensitywashigh,withitsnetPPEconstituting
about32.5percentofitstotalassets.2Tenyearslater,bytheendof1973,netPPEwasonly1percentoftotalassets.Indiscussinghismistakes
overtheprior25years,Buffettsaid,“Myfirst
mistake,ofcourse,was
inbuyingcontrolofBerkshire.”3Asthecompanylostmoney,itwas
noteasytoquicklywithdrawtheinvestmentsfromthemill.Plantassets
neededtobeutilizedforseveralmoreyearsbeforethemillcouldbeshutdown.Notonlyistheprocessof
respondingtodecliningdemandslow,
andchangingtechnologytroublesome;suchadjustmentsalsoconsume
preciousmanagerialtime.
Yourtemperamentmayalsoworkagainstyouwhenyouinvestin
ahigh-capital-intensity
company.Profitabilityofhigh-capital-intensity
companiesishighlychangeable,sostockpricesmayperiodicallydrop
significantly.Aninvestormaybecomenervousandsellthestockinthe
high-capital-intensitycompaniesinadownyear,whenitistheabso-
lutelywrongtimetosell.Pessimisminthemarketplacemayactuallybe
agoodtimetobuyifthelong-termprospectsarenotaffected.Con-
sidertheNovember2009Berkshireannouncementoftheacquisition
ofBurlingtonNorthernSantaFe.WhileBerkshire
purchasedtheini-
tial22percentstakeinBurlingtonNorthernat$78pershareduring
2006–2008,thepricehadgoneupto$114persharebyJune2008as
thestockmarketasawholewentup.However,withthemarketcrashof
2008–2009,BurlingtonNorthern’sstockpricecamedownsubstantially,
andBerkshiremadeanoffertobuytheremainingsharesat$100per
sharewhenthestockwastradingat$76pershare.Ifthemarketandthe
BurlingtonNorthernstockpricehadnotcomedown,it
isunlikelythat
Buffettwouldhavemadeanoffertobuytheremainderofthecompany.
Hehasreportedlysaidthat$100persharewasthemaximumhewas
willingtopay.
Youshouldalsoconsiderwhetherthecompanyisinits
growth
period.High-capital-intensitycompaniesareevenmoreprofitablethan
othercompaniesintheirgrowthphasebecausetheoverheadsarespread
overalargeroutput.Thus,theirstockpricesincreaseratherquickly.Youmayrecallthatsteelcompanies,
infrastructurecompanies,andhousing
E1C22
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Time:2:26pm
216
profitabilityandaccounting
companiesprosperedinafewyearsleadingupto2007,whentheecon-
omywasdoingwell.Theyalsoinvestedheavilyinproperty,plant,and
equipmentbecauseitwaseasyforthemtoraisecapital.Astheeconomy
sloweddownin2008and2009,theywerelikelyto
sufferheavily.
Conclusions
Foranaverageinvestor,itisbesttoavoidinvestinginstocksofhigh-
capital-intensitycompaniesbecausethedownsideriskappearshigh.This
isnottosuggestthatyoushouldpassonagood
opportunityifyou
understandahigh-capital-intensitycompanywell.Itappearsthatfor
suchcompanies,qualityofmanagementisevenmoreimportantthan
forothercompanies.Berkshire’slargerecentinvestmentinBurlington
NorthernwouldallowBerkshireandthecompanymanagementtorun
thecompanymoreefficiently,andthatmaybeoneadditionalreasonthat
Buffettdecidedtoinvestinthecompany.
E1C23
Date:Jan19,2010
Time:8:40am
Chapter23
KeytoSuccess:
ROEandOtherRatios
Thebestgaugeofthesuccessofanenterpriseisthepercentage
earnedoninvestedcapital.1
—BenjaminGraham,DavidDodd,andSidneyCottle
Youarelikelytoearnagoodreturnonyourstockinthelong
runonlyiftheunderlyingbusinessisearningagoodreturnon
itscapital.Fromtheshareholders’perspective,returnonequity
(ROE)isusuallythebest
yardstick,asitisolatesthereturnsthatbelongtotheshareholdersfromthereturnstotheenterpriseasawhole.
ROE:UnderlyingPerformanceofaBusiness
Buffettoftenmentionsfinancialratioswhendiscussingabusiness’sunderlyingperformance.Themostimportantofthemall—returnonequity
(ROE)—isnetincomedividedbythebookvalueofshareholders’equity.
BecauseCostcoisawell-runbusiness,Iuseitasanexampletoillus-
tratesomeofthenotableaspectsofROEandrelatedissues.Let’slookatCostco’sROEsforthepast12yearsinTable23.1.
Yearafteryear,CostcohasproducedanROEinexcessof10per-
cent,averaging12.9percentoverthemostrecent12years.Havethe
217
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Time:8:40am
218
profitabilityandaccounting
Table23.1
Costco’sConsistentReturnonEquityandReturnofAssets
Interest
expenseafter
Fiscal
Net
Shareholders’Returnon
Total
adjustingfor
Returnon
year
income
equity
equity
assets
taxes
assets
1997
$312
$2,468
12.6%
$5,476
$46
6.5%
1998
460
2,966
15.5
6,260
29
7.8
1999
397
3,532
11.2
7,505
27
5.6
2000
631
4,240
14.9
8,634
23
7.6
2001
602
4,883
12.3
10,090
19
6.2
2002
700
5,694
12.3
11,620
17
6.2
2003
721
6,555
11.0
13,192
22
5.6
2004
882
7,625
11.6
15,093
22
6.0
2005
1,063
8,881
12.0
16,514
20
6.6
2006
1,103
9,143
12.1
17,495
8
6.3
2007
1,083
8,623
12.6
19,606
38
5.7
2008
1,283
9,192
14.0
20,682
61
6.5
Dollaramountsinmillions.
stockreturnsbeenaboutthesame?Costco’sfiscalyearusuallyendsat
theendofAugust,andearningsdataarepubliclyknownbyNovember
ofthesameyear.Forcomparingthe12-yearROEstostockreturns,
weshouldthereforeusethe12yearsofstockreturnsfromtheendof
November1996untiltheendofNovember2008.Duringthisperiod,
Costco’sstockprice(splitadjusted)wentupfrom$11.60to$51.47,
givingannualizedreturnsof13.2percentwithout
dividends.Withdivi-
dends,theannualizedreturnsareabout13.8percent.Thus,theROEand
stockreturnsareclosetooneanother.Theannualizedgrowthinearn-
ingspersharewassimilarly13.6percent.However,forvariousreasons,
itmaynotbethesameforotherfirmsandevenforCostcoforother
periods.Forexample,returnsareaffectedbyP/Eexpansionorcon-
tractionindependentofROE.Overall,anexaminationofROEover
anextendedperiodoftimeshouldhelpaninvestor
determinetheper-
formanceoftheunderlyingbusinessthatfinallyisreflectedinstock
returns.
E1C23
Date:Jan19,2010
Time:8:40am
KeytoSuccess:ROEandOtherRatios
219
SinceROEiscomputedfromaccountingdata,youshoulduseitas
astartingpointforinferringstockreturns,butbecarefulnottofollowthenumbersblindly.Asyoumayknow,therearefartoomany
caveats
toconsiderwhenyouuseaccountingnumbersincomplexsettings.For
example,whenacompanypurchasesitsownsharesinthemarketor
paysdividends,bookvalueofequityisreducedandtheROEmaytem-
porarilybecomeveryhigh.Ingeneral,youshouldnotrelyonanyone
financialratio.Youshouldstudygrowthinearningspershareoveran
extendedperiodbeyondexaminingthelevelsofROE.Anyfinancial
ratiocanbemeaninglessorleadyoutomisleading
inferencesunder
certaincircumstances.Hereisanexampletoillustratethispoint.
IanalyzedIBM’s2004financialdatain2005anddiscoveredthatthe
averageROEforthesixyearsthatendedin2004was31.5percent.Atfirstglance,thisseemedtobeverygood.
However,IBM’sgrowthinearnings
pershare(EPS)waspitiful.EPSwas$4.25in1999andremainedabout
thesame,exceptforanincreasein2004to$4.93.Onacompounded
basis,theannualgrowthratewasonly2.5percent.IftheROEwas31.5
percent,whydidtheEPSfailtogrow?Wherewerethoseearningsused?
Withalittlemoreanalysisofthefinancialstatements,Idiscoveredthe
mainreason.Thecompanypurchasedsharesatmarketpricesbutissued
themtoemployeesbelowcostascompensation.For
IBM,thenetresult
wasthatshareholders’equitydidnotgrowbecausesomeoftheearnings
wereeffectivelyusedforemployeecompensationandforrepurchases.As
theIBMexampledemonstrates,ifearningsarenotincreasing,youshould
determineiftheshareholdersaregettingdividends,ifthecompanyis
buyingsharesback,orifthefundsarebeingusedinanunproductive
manner.
WhenyouarenotcomfortablewiththecomputedROEandgrowth
inearnings,youmightstillask,“Whatisthevalueofthecompany’s
commonstock?”Thereareusuallynoeasyanswers,butyoushouldbe
abletofindoutwhatisgoingonbyanalyzingthefinancialstatement.
Unlessyouknowtheanswer,avoidinvestinginthat
company.Thisadvice
issimilartoBuffett’sargumentthatinvestorsshouldstayintheircirclesofcompetence.Inthiscase,insteadoffocusingonthecompany’sproducts,
Iamfocusingonthecompany’saccountingoutputsuchasearnings.In
thecaseofIBM,dividends
hadgrownattherateof6percentinrecent
years.Usingthisgrowthrateandadiscountrateof10percent,Ivalued
E1C23
Date:Jan19,2010
Time:8:40am
220
profitabilityandaccounting
IBMat$25pershare,whichseemedridiculousgiventhestockpriceof
$90pershare.Ididnotinvestinthestock.2
ROA:ReturnonAssets
AcompanionratiotoROEisreturnonassets(ROA).The
mainobjec-
tiveincomputingROAistoobtainameasureofperformancethat
isindependentoffinancing.ROApresentsperformanceofalltheassets
employedbythecompany,notjustequity.Thus,thedenominatoristotal
assetsandthenumeratorisearningsbeforeinterestexpenses,adjustedfortaxes.ROAinTable23.1isgivenbynetincomeplusafter-taxinterest
expensedividedbytotalassets.Also,forsimplicity,Iusetheend-of-the-yeardatainbothnumeratoranddenominator.Overallconclusionsare
similarwhetherweusetheaveragesortheend-of-the-yearnumbers.
AcomparisonofROAtoROEtellsustheextenttowhichthe
companymaybeusingimplicitorexplicitleverage.Manyoftheitems
intheliabilitiessectionofthebalancesheetarenon-
interest-bearing,soanexaminationofinterestexpenseorthebalancesheetanalysiswould
nottellyoutheextentoffinancialleverage.Forexample,thereisusuallynoexplicitinterestexpenseforaccountspayableorforfloatininsurancecompanies.ForCostco,theimportantpointtonoteisthatbecauseof
implicituseoflow-costliabilities,theaverageROEof12.9percentis
abouttwicetheaverageROAof6.4percent.ItappearsthatCostco
hasalsobeenabletousenon-interest-bearingliabilitiessuchasaccountspayabletoaccomplishahighROEfromalowROA.
ThisdiscussiononROEandROAshouldmakeyourealizethat
knowledgeofaccountingisyourfriendinunderstandingtheunderly-
ingprofitabilityofthecompany.Theanalysiswouldalsohelpyouassess
thequalityofmanagement.Ifmanagementqualityisgood,
thefinan-
cialstatementsaregenerallyeasiertounderstand.Youshouldviewthe
financialratiostohelpyouassesstheperformanceofthemanagement
ratherthanlifelessassetsandequity.Ultimately,therearepeoplebehindperformancemetrics.Ihavediscussed
onlytwooftheimportantratios,
butthatdoesnotmeanthatthesearethemostimportantratiosforeach
company.Itdependsonthebusinessmodelofthecompanyandwhat
aspectoftheunderlyingperformanceyouwanttobetterunderstand.
E1C23
Date:Jan19,2010
Time:8:40am
KeytoSuccess:ROEandOtherRatios
221
Youshouldthinkaboutfinancialratioscarefullyindecidingwhatratios
touseandhowtointerpretthem.Inparticular,themainpurposeofdig-
gingdeeperintofinancialstatementsistofinallydevelopbetterforecastsoffutureearningsandbetterestimatesofintrinsicvalue.
BuffettandAccounting
Buffettencouragesinvestorstodevelopagoodknowledge
ofaccounting.
InaBerkshireshareholders’annualmeeting,aNewYorkUniversity
MBAstudentaskedBuffettforhisadviceonhowtodevelopBuffett-like
skills.Inhisresponse,Buffettmentionedthatthestudentshouldtakeasmanyaccountingcoursesas
possible.Rememberthatyouareaconsumer
andnotaprepareroffinancialinformation.Actlikeadetectivetrying
tounderstandthecompany’sbusinessfromreadingfinancialstatements.
Buffettreadsalotoffinancialreports;andforhim,perhaps,thatislike
readingdetectivenovels.Asareaderoffinancialstatements,youcould
havefundiscoveringbehind-the-curtainstories.
Accountingnumbersarebasedonalargenumberofestimates,and
hence,theyarenotreallyhardnumbers.Yet,academicresearchshows
thatlong-shortinvestingstrategiescanoftenbedevelopedbyusing
accountingknowledge.3Whenyoustudyfinancialstatements,beaskep-
tic.Buffettwrites,“Managersthinkingaboutaccountingissuesshould
neverforgetoneofAbrahamLincoln’sfavoriteriddles:
‘Howmanylegs
doesadoghaveifyoucallhistailaleg?’Theanswer:‘Four,because
callingatailalegdoesnotmakeitaleg.’Itbehoovesmanagersto
rememberthatAbe’srightevenifanauditoriswillingtocertifythatthetailisaleg.”4Mostaccounting
numbersarereliable,butyoumustremainvigilant.Herearesomeaspectsofaccountingthatyoushouldkeepin
mind:
1.Accountantsmakemanyassumptions.Everyreportednumber
isbasedonassumptionsthataredifferentacross
companiesandon
accountingrulesthatchangeovertime.Herearetwoexamples.First,
ifacompanyownsabuilding,itsreporteddepreciationexpenseis
basedonassumptions.Second,expectedfutureexpensessuchas
promisedhealthcarebenefitstoretireesarebasedonassumptions
aboutlifeexpectanciesandfuturecosts.
E1C23
Date:Jan19,2010
Time:8:40am
222
profitabilityandaccounting
2.Mostaccountingnumbersarehistoricalinnature.When
someoneasksyouthevalueofyourhouse,youarelikelytogive
itscurrentmarketvalue.Incontrast,mostaccountingvaluations
ofproperty,plant,andequipmentaremadeattheirdepreciated
amounts.Inthecaseofland,itisneverdepreciated.Assumethata
companysuchasGeneralElectricpurchasedsomelandfor$5mil-
lion100yearsago.Even100yearslater,thereportedvalue
ofthe
landonfinancialstatementswillbe$5million.
3.Accountantsmayormaynotusemarketpricesforliquid
assets.Thispracticeisconfusingbecausecompanieshaveachoice
inselectingaccounting
methodsdependingonthedeclaredpurpose
andtheamountsofstocksandbondsheldasinvestments.Someassets
andliabilitiesaremarkedtomarketwhileothersarenot.
4.Accountantsaresupposedtobeconservative.Oftentheyare
indeedconservative,butinmanycasestheyareaggressive.Don’t
forgetthatWorldComaccountantsweretooaggressivetoreport
highearnings.Theapproachtheyusedisnotdifficulttodiscern.
From1999to2002,WorldCommisclassified
$8.1billioninexpenses
asassets.5Theamountwassolargethatwhenitwasdetected,the
companywentbankrupt.Soyoushouldnotassumethataccountants
arealwaysconservative.
Buffetthasoftendiscussedaccountingissuesin
Berkshire’sannual
reports.Ingeneral,thebetteryouareataccounting,thebetteryouwillbeatunderstandingfinancialstatementsand,byextension,understanding
andvaluingcompanies.
Conclusions
Ultimately,thereturnon
yourinvestmentsincommonstockswill
dependontheunderlyingreturnonthecapitalusedinthebusiness,
whichcanbemeasuredbyreturnonequityandreturnonassets.Those
returns,whenusedproperly,giverisetogrowthinearningspersharethat
engendersincreasesinthepriceofthestock.Thus,itisimperativethatyoucomputeROE,ROA,andotherfinancialmetricssuchasgrowth
inper-shareearningsandbookvaluetoexaminehowtheunderlying
businessisperforming.
E1C24
Date:Jan29,2010
Time:2:29pm
Chapter24
AccountingGoodwill:
IsItAnyGood?
Youcanliveafullandrewardinglifewithouteverthinking
about[accounting]Goodwill....But,studentsofinvestment
andmanagementshouldunderstandthenuancesofthesubject.1
—WarrenBuffett
Hereisasurprisingfact:TheaccountingGoodwillamountshown
infinancialstatementshas
almostnothingtodowiththeword
goodwillineverydayuse.However,itisoftenasignificantper-
centageoftotalassetsonacompany’sbalancesheet.TobetterunderstandaccountingGoodwill,IpresentdataonGoodwillandotherassetsfor
severalwell-known
companies.Ialsodiscussitsimplicationsforyouin
evaluatingcompanyprofitability.
AccountingGoodwillandItsEconomicValue
Table24.1reportssummarybalancesheetsalongwiththerecent
Goodwillamountsforseveral
well-knowncompanies.Goodwillasa
proportionoftotalassetsforthesecompaniesisbetween3percentfor
ConocoPhillipsand42percentforProcter&Gamble.Thereisno
223
E1C24
Date:Jan29,2010
Time:2:29pm
&
3
0
7
8
38
60
27
42%
octer
$
$144
Pr
Gamble
1
6
osoft
10
13
14
12
16
73
$
$
17%
Micr
ic
Electr
48
21
14
79
82
365
189
$
$798
10%
General
1
0
5
4
2008
12
84
37
3%
$
$143
ConocoPhillips
Companies,
5
6
3
2
8
4
Large
12
40
$
$
10%
ewF
Coca-Cola
a
of
e
8
away
26
29
45
34
24
Assets
102
267
$
$
13%
Berkshir
Hath
Other
and
billions.
centage
and
in
Goodwill
net
pera
les
as
assets
ies
plant,,
24.1
vab
assets
amounts
assets
total
blea
vestments
ventor
operly
equipment,
of
otal
T
Cash
In
Recei
In
Pr
Goodwill
Other
T
Goodwill
Dollar
224
E1C24
Date:Jan29,2010
Time:2:29pm
AccountingGoodwill:IsItAnyGood?
225
apparentassociationbetweenthesepercentagesandtheeverydaymean-
ingofthewordgoodwill.ForMicrosoft,reportedGoodwill
of$12billionisonly17percentofitstotalassets.Bycontrast,Procter&Gamble’sGoodwillof$60billionis42percentofitstotalassets.How,then,shouldyouanalyzethereportedGoodwillinfinancialstatements?
ConsiderBerkshireHathaway’s$34billionofreportedaccounting
Goodwill.Wherediditcomefrom?Thisamountrepresentsthevalue
givenincashorstockbyBerkshireinvariousacquisitionsinexcessof
identifiablenetassets.Forexample,BerkshireacquiredGeneralRein
1998for$22billion,butGeneralRehadonly$7
billionofnetassets.Theadditional$15billionBerkshirepaidisreportedasGoodwill.Similarly,
whenBerkshireacquiredGEICOin1996,Berkshireadded$1.6billion
ofGoodwill.ThetotalamountofGoodwillof$34billionderivesfrom
variousBerkshire
acquisitionsovertheyears.InadditiontoGeneral
ReandGEICO,DairyQueen,ExecutiveJetAviation,andIscarMetal
WorkshavecontributedtoBerkshire’sGoodwill.
Asaninvestor,youwouldliketoknowiftheeconomicvalueof
accountingGoodwillisworthmoreorlessthanthe$34billionfor
Berkshire.First,Berkshiredidpay$34billionincashorstocktoacquireGoodwill.Hence,fromaninvestmentpointofview,reportedGoodwill
issimilartootherassetssuchasproperty,plant,andequipment.The
objectivethenshouldbetoanalyzetheGoodwillandfinancialstatements
totheextentthatthisassethelpsproduceearnings.
GoodwillandEarnings
WhydidBerkshireacquireGEICO,GeneralRe,andIscarwithacquisi-
tionpremiums?Themain
reasonthatapremiumispaidisthepotential
growthinacquiredbusinesses.Buffettexpectedthesecompaniestogrow,
andhepaidpremiums.ConsiderGEICOagain.GEICO’srevenues
increasedfrom$3billionin1996to$12billionin2008,agrowthrate
of12percentperyear.IfthisgrowthrateishigherthanwhatwaspricedinGoodwillatthetimeofacquisition,theeconomicvalueofGoodwill
ishigherthanwhatthefinancialrecordsshow.Wedonotknowwhat
Buffettexpectedthegrowthratetobeatthetimeofacquisition,but
12percentisaverygoodgrowthrategiventhatGEICOisinamature
E1C24
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profitabilityandaccounting
industry.Thus,theeconomicvalueshouldbehigherthanthe$1.6bil-
lionBerkshirepaidfortheaccountingGoodwill.Inthiscase,accounting
Goodwillislikerealestatewhosevaluehasgoneupwithouthavingthat
increasereflectedonthebalancesheet.
OneshouldconsiderwhethertheCEOoftheacquiringcompany
wantedtoincreaseshareholdervalueorhadanotherreasonfortheacqui-
sition.Ifthereappearstobesomeothermotive,suchastheCEO’sego,itmaybebesttoavoidthatcompany’sstock.AtleastthevalueofGoodwill
wouldbemuchlower,andinmanycases,itmaybeassumedtobeclose
tozero.InthecaseofBerkshire’sCEO,theanswerisclear.WeknowalotaboutBuffett’shistoricalrecordintermsofownerorientation,andsinceBuffettandMungereffectivelyownacontrollinginterestinBerkshire,
theyhavenoincentiveto
undertakeamergerforthesakeofincreasing
thecompany’ssizeorsomeotherperversereason.
BuffettdiscussesGoodwillregardinghisacquisitionofSee’sCandies.
“In1983,See’searnedabout$27millionpretaxon$11millionofnet
operatingassets;in1995,itearned$50millionononly$5millionofnetoperatingassets.Clearly,See’seconomicGoodwillhasincreaseddramaticallyduringtheintervalratherthandecreased.”2Asplantassetsareused,theirvaluesoftendeclineowingtodepreciation.Youshouldnotthink
ofGoodwillinthesame
manner.TheinternallygeneratedGoodwillis
notreportedonthebooks.So,howshouldonethinkaboutprofitability
andGoodwill?
GoodwillandProfitabilityofAcquiredBusinesses
Berkshire’sbusinessesfallintothreemaincategories:
insurance;man-
ufacturing,service,andretailingoperations;andfinanceandfinancial
productsbusinesses.Inthissection,Ipresentrecentdatafromthesec-
ondcategorytoshowhowinvestorsmaylookatreportedaccounting
Goodwilltothinkaboutfutureprofitability.
Table24.2givesthebalancesheetofvarioussubsidiariesinBerk-
shire’smanufacturing,service,andretailingbusinesses,whichincludes
MiTek,ShawIndustries,NetJets,McLane,andothercompanies.At
theendof2008,theequityinthisgroupwas$30,779million,and
netincomefortheyearwas$2,283million.Forsimplicity,usingthe
E1C24
Date:Jan29,2010
Time:2:29pm
AccountingGoodwill:IsItAnyGood?
227
Table24.2
Berkshire’sManufacturing,Service,andRetailingOperations
BalanceSheet,12/31/08
Assets
LiabilitiesandEquity
Cashandequivalents
$2,497
Notespayable
$2,212
Accountsandnotes
Othercurrentliabilities
8,087
receivable
5,047
Inventory
7,500
Totalcurrentliabilities
8,103
Goodwillandother
Deferredtaxes
2,786
intangibles
16,515
Fixedassets
16,338
Termdebtandother
liabilities
6,033
Otherassets
1,531
Equity
30,779
$49,897
$49,897
Dollaramountsinmillions.
year-enddata,thereturnonequity(ROE)(2,283/30,779)was7.4
percent.
Successfulinvestingisaboutlookingahead.ThinkaboutwhatBerk-
shire’sfutureincrementalrateofreturnmightbe.A
simpleapproachis
toimaginativelyfast-forwardseveralyearswhenBerkshiresubsidiariesinthissectorwillbetwicetheircurrentsizeandearntwicetheircurrent
profits.Inotherwords,considerthesituation,maybein10years,when
netincomewillbedouble,or
$4,566million.Togeneratetheadditional
netincome,totalassetsneednotbetwicetheinitialamountbecause
theGoodwillpartoftotalassetsdoesnothavetobepurchasedagain.
SomefundsmayhavetobespenttomaintaintheGoodwill,butitis
hardtobelievethattheamountneededwouldbetwicetheinitialsum.
Thisisbecauseexpensesforadvertisingorresearchanddevelopment
thatarerequiredtomaintainGoodwillaresubtractedfromrevenuesin
computingnetincome.
Forthisillustration,Imakethereasonableassumptionthatno
additionalamountinGoodwillwillbeneededforgrowth.Ignor-
ingGoodwill,additionalassetsneededare$49,898millionminus
$16,515million,or$33,383million.Iftheliabilities
amountsequal
E1C24
Date:Jan29,2010
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228
profitabilityandaccounting
thosein2008($19,118),the
newequityneededwouldbe$14,265
million.Theincrementalreturnonequityof$14,265millionwould
be$2,283/$14,265,or16percent.Thiswouldbeaverygoodreturn
indeed.IfyouhadignoredthespecialaspectofGoodwill,youwould
haveincorrectlyassessedROEtobeonly7.4percentascomputedear-
lier.Irepeatthatinallsuchpredictions,wemakemanyassumptions,andoneshouldalwayskeepthatinmind.Overall,ifacompanyislikelyto
growandhasgoodmanagement,youmaycomputetherateofreturn
withoutreportedGoodwill.Youmaythenuseyourprojectednumbers
tocomputethecompany’sintrinsicvalue.
Conclusions
ReportedGoodwillinfinancialstatementsrelatesonlytoacquisitions
andistheamountpaidabove
thenettangibleassetsacquired.Ifacom-
panyafterbeingacquiredcontinuestogrowinrevenueswiththesame
levelofprofitmargin,thereturnonequitywillalsogrowbecause
noadditionalinvestmentinGoodwillisgenerallyneeded.Account-
ingGoodwillisindeedavaluableassetinwell-managedcompanies.In
computingreturnonequityandintrinsicvalue,youshould,therefore,
payspecialattentiontoGoodwill.
E1PART08
Date:Dec10,2009
Time:3:11pm
PartEight
PSYCHOLOGY
Buffetthasoftenmentionedthatitisdifficulttopredictthemarket
intheshortrunbecausemarketparticipantsarenotallrational.
Youwillbeabetterinvestorifyouareabletodealwith
the
market’supsanddowns.InChapters25and26,Idiscussimportant
ideasfrompsychologytohelpyoubetterunderstandthemarketsand
yourself.
229
E1PART08
Date:Dec10,2009
Time:3:11pm
E1C25
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Chapter25
HowMuchPsychology
ShouldYouKnow?
Thedumbestreasonintheworldtobuyastockisbecauseit’s
goingup.1
—WarrenBuffett
Manyinvestorsmakedumbdecisionsbychasingstockprices.
Doyou?Ifso,whatcanyou
doaboutit?Wewillgetbetter
answersbystudyingpsychologythanbyboninguponfinance
alone.Thefascinatingfieldofpsychologyisnolongerlimitedtohuman
behaviorinsocialsettings.Inrecentyears,behavioralfinancehasshed
lightonthepsychologyofstockpricesandfinancialdecisionsbymarket
participants.Essentially,twomainforcesaffectstockpricesinthemarket:thefundamentalsofthecompanyandhumanbehavior.Bothforceshave
aroletoplay.However,acombinedknowledgeofthetwoshouldmake
amorepowerfulfoundationformakingintelligentdecisionsinthestock
marketthanrelyingonfundamentalsalone.Sincealongdiscussionof
psychologywilltakeusawayfromourmaingoalof
becomingbetter
investors,onlyissuesthatareimportantfromaninvestingpointofview
willbecoveredhere.
231
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psychology
HerdingandYou
Youdonotneedadegreeinpsychologytounderstandthatintheshort
run,thepriceofastockcandeviatesubstantiallyfromits
basicvalue
becausemarketparticipantsmaybetrayaherdinstinctintheirbehavior.
Thisisprobablythemostimportantconceptthatyouneedtoknow
aboutmarketpsychology.Whenpeopledonotunderstandacompany
well,theyfollowthecrowd:Theychasethewinnersanddumpthelosers
indiscriminately.
Becauseofthisherdmentality,individualstocks—andtheentire
market—maygoupordowndramatically.Herdingstemsfromgreed
orfear.Wheninterestratesriseorwhentherearefearsthatanimpor-
tantcountry’seconomywillfalter,worldmarketsreactsubstantially.It
isextremelydifficulttotimethemarketortoforecasteventsthatmake
marketsmovedramatically.Thelessontolearnisthat
whenthemarket
doesgodownsignificantly,primebuyingopportunitiesmaysurface.
Doyouknowwhetheryouhavetheherdinginstinct?It’sagood
ideatofindthatoutifyoucan.ThemostcommonphenomenonI
haveobservedisthatpeoplefeellikebuyingastockwhenitspricehas
recentlygoneuporwhenthemarkethasgoneup.Ifyoudosowith-
outevaluatingthecompany,youareprobablyherding.Doyouevaluate
thepriceincreaseinalogicalmanner?Youareprobably
notherding
ifyoucomputeastock’sintrinsicvaluebeforeyoumakeabuyorsell
decision.
Investorsoftenextrapolateevidencefromrecenttrendsandthen
decidetobuyorsell.Ifitwereeasytopickstocks
basedonrecentpricetrendsalone,mostmutualfundmanagerswouldbeabletobeatthe
marketindices.Butmostofthemdon’t.Foreverytrendthatcontinues,
thereisprobablyanotheronethatdoesnot.Considertwoleadersinthe
personalcomputerindustry
inthelate1990s:DellandCompaq(now
HewlettPackard).By1998,Dell’sstockpricehadgoneupbyseveral
hundredpercent,atrendthatcontinuedfortwomoreyears.Howabout
Compaq?LikeDell,Compaqhadatremendousrununtil1998,but
in1999,itspricewentdownby50percent.Bothstocksbelongedto
thesameindustryandfacedsimilarmacroeconomicenvironments.If
youhadboughtCompaqinsteadofDell,youwouldhaveregrettedyour
decision.Youweremorelikelytohavechosenthe
betterstockifyouhad
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triedtoidentifythe
fundamentalreasonsbehindthesuccessesofDellandCompaq.By1998,Compaq,inanuntestedstrategy,waspushinginto
IBM’smainframeterritorybyacquiringDigital.Giventheuncertainty,
ahighpriceforCompaqwasnotjustified.
Investorsherdoftenandin
somecasescreatemarketeuphoria.Inthe
late1990s,everyoneboughthigh-techstocks.Thetech-heavyNASDAQ
indexpeakedat5,048onMarch10,2000.Investorswereherding.One
interestingpointtonoteisthatmanyinvestorswhothoughtthemselves
tobeindependentoftheherdmentalityavoidedhigh-techstocksbut
boughtotherstocks.Duringthisperiod,mostnon-high-techstocksalso
becameexpensive.Forexample,Coca-Colatradedat$80pershareat
aprice-to-earnings(P/E)ratioofabout50.Whatcould
explainthis
highpriceotherthanherding?Itisindeeddifficulttoavoidherding;
eventhosewhothoughttheywerenotherdingwereinfactalsoherding
bybuyingnon-high-techstockssuchasCoca-Cola.Theyallsuffered
laterin2000andinfollowingyears.IfyouboughtBerkshireHathaway
stock—forwhichthepricewentdownduringthesameperiod—you
werenotherding.(IdidbuysomeadditionalBerkshirestock.)Inthe
early-tomid-2000s,peopleboughthomes.Theywere
herding.Many
otherswhothoughtthattheywerenotherdingboughtstocks.Theydid
notknowit,buttheywerealsoherding,asstockpriceswerealsohigh.
Allassetpriceswereinabubble.Mostinvestorssufferedinthedownturnin2008.
Thebestantidotetoherdingliesinknowledgeandinfocusingonthe
longrun.Buffett’ssuggestionofbuyingonlywhatyouknowmayhelp
youavoidfollowingtheherd.Inaddition,concentrateonfundamentals.
PeterLynchhascapturedthisideainthechapter“Earnings,
Earnings,
Earnings”inhisbookOneUponWallStreet.Heexplains,“Whatyou’reaskinghereiswhatmakesacompanyvaluable,andwhyitwillbemore
valuabletomorrowthanitistoday.Therearemanytheories,butto
me,italwayscomesdownto
earningsandassets.Especiallyearnings.”2
ReadingPeterLynchorWarrenBuffettwasagoodstartforme,but
notenough.IunderstoodthembetteronlyafterIdelvedintolearning
behavioralfinanceandevaluatingmydecisions.Andittookmeseveral
yearstounderstandthatIhadaherdmentality.Toavoidherding,Itrytozeroinonthelongterm.FollowPlato’scenturies-oldwisdom:“Know
thyself.”
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psychology
ExamineYourBuyingandSellingPatterns
Howcanyoudeterminehowyoumakedecisions?Myapproachisto
writedownmyreasonsforbuyingandsellingastockimmediatelyafter
Imakeadecision.IfIdon’tdothis,IfindthatI’mnothonestwith
myselflater.Withthebenefitofhindsight,Icanalwaystrytojustifymychoices—whichpreventsmefromunderstandingmyselfandimproving
mydecision-makingabilities.Afterafewyearsofthispractice,Icame
tounderstandmanyofmyhabits.Talkingwithothers,Ihaverealized
thatmanyofmyweaknessesarecommon.IsawthatIwasmuchmore
influencedbypricemovementsthanIthoughtIwas.Igotexcitedto
buywhenamergerwasannounced,whenaproduct
waslaunched,when
thedollar-yenexchangeratechanged,orwhenanineffectiveCEOleft
acompany.
Intheshortrun,whenevermydecisionsprovedtobecorrect,I
foundmyselftalkingaboutthem.Ipaidlessattentionto
myincorrect
decisions(Kmart!).Ialsorealizedthatmylong-runresultswereusually
notrelatedtowhathappenedtothestockpricerightafterIboughtthe
stock.ButIwaspayingmoreattentiontothestockimmediatelyafter
Ihadpurchasedit,whenIshouldhavebeenpayingmoreattentionto
thestockbeforepurchasing.Idothatnow.AlthoughIalwaysbelievedintheimportanceofearningsandassets,Ididnotunderstandtheirfull
significanceinmydecisionmakinguntilIstartedwriting.Ilearnedthe
valueoflookingatalonghistoricalrecordofperformance.
Inadditiontowritingdownyourdecisionsandanalyzingthemlater,
youmaytryothertechniquestolearnmoreaboutyourdecisionmaking.
Forexample,youmayseparateallthemonthsthe
marketwentupfrom
themonthsthemarketwentdown.Fromyourbroker’sstatements,you
canfindoutwhetheryouwereanetbuyeroranetsellerduringvarious
months.Ifyouwereanetbuyerduringthemonthsthestockmarket
declined,youaremorelikelytobeacontrarian.Butifyouwereanet
buyerwhenthestockmarketdidwell,youmayhaveaherdmentality.
Ifyoudelayyourdecisionswhenthemarketisgoingupordown,
youmightwanttoanalyzeyourbuyingandselling
patternsinthemonths
followingtheperiodwhenthemarketmovesupordown.Asimpleanal-
ysislikethiscantellyoualotaboutyourself.Youcouldalsoredesign
thisapproachtosuityourneeds.Forexample,youcanexaminewhether
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youbuylowP/EstocksorhighP/Estocks.Themosttellinginforma-
tionaboutyourbehaviorwouldcomefromidentifyingtheeventsthat
triggeradecision,becauseadecisionisnotsomethingyoudreamup
fromnothing.Youshouldknowtheprincipalvariablesthattriggeryour
decision.Areyoumotivatedbythemarket,theevening
news,afriend’s
recommendation,orsomethingelse?Agoodinvestorshouldknowwho
heorsheis.Self-reflectioncanbechallengingbutveryrewardingtoan
investor.
CanYouChangeYourself?
Tobenefitfromthemarket’sgyrations,youneednotonlytounderstand
thebasicsofmarketpsychologyandyourselfbutalsotofindoutwhether
youcanchange.Ifyoufinditdifficulttochange,thenunderstandingmarketpsychologyoryourselfmaynotbeenough.Considerthefollowing
example.Sayyouacknowledgethatifyoudriveafterdrinkingalcohol
ataparty,youincreaseyourchancesofhavinganautoaccident.Itis
alsoimportanttoknow,though,whetheryoucanchangeyourbehavior
andcontroldrinking.Ifyoucannotchangeyourbehavior
attheparty
byrefusingtodrink,areyouwillingtochangeyourbehaviorafterthe
party?Canyouleaveyourcaratyourfriend’splaceandtakeataxihome?
Itisonethingtoknowtherightthingtodo;itisanothertochange
yourbehavior.BenjaminGrahamputsthissuccinctly:“Itiseasyforus
totellyounottospeculate;thehardthingwillbeforyoutofollowthisadvice.”3
Buffetthasoftenmentionedthatdifferentpeoplearewireddiffer-
ently.Forexample,hehasjokinglysaidthathewould
havebeenan
animal’slunchifhehadbeenbornafewhundredyearsago,implying
thathisskillsaremoresuitedtothemodernworld.Themainmessage
isthatitisnoteasytochange.AfterreadingBuffett’spartnershiplettersfrom1958to1969,his
annualletterstoshareholdersfrom1970to2008,
andmanyofhisarticles,IfindthatBuffetthasalteredverylittleinhisapproachtobusinessandinvesting.Thegoodthingabouthisconsistent
behavioranddecisionmakingisthatwecanlearnfromhisinvesting
practices.Thisdoesnotmeanthatonecanchangeeasilyandfollowhis
principles.EvenafteryearsofscouringBuffett’swritingsandgoingtotheE1C25
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psychology
annualshareholdermeetings,Ilookatstockpricesseveraltimesduring
theday.IsometimesbuyorsellstockswithoutanalyzingthemaswellasIshould,andIoccasionallytradeoptions.ButIhavechangedsomewhat.I
havecertainlyrealizedthatit
takesmealongtimetochange.Thisseemstobeacommonphenomenon.
HowPsychologyMayHelpYou
InhishighlycelebratedbookTheAlchemyofFinance,GeorgeSorospointsoutthattheoutcomesinsocialsciencessuchaseconomicsarrivefrom
adifferentprocessthantheprocessesinnaturalsciences.4Innaturalsciences,onesetoffactsfollowsanotherwithoutinterference.Thescientistdoesnotinfluencetheprocess.Specifically,nothingthescientistdoeswillturnbasemetalsintogold.
Now,toconsiderthefinancialmarkets,let’suseanexamplesimilar
totheoneSoroscites.Assumethatunderreasonableconditions,Widget
Company’sstockpriceshouldbeabout20timesitsearningspershare.If
thecompany’searningspersharegoupfrom$0.80to$1,itsstockprice
shouldgoupfrom$16to$20
pershare.Ifallmarketparticipantsact
rationally,thepricemaygoupto$20andstaythere.However,financial
marketparticipantsdonotallbehaverationally.Asmarketparticipants
observestockpricesgoingupafterearningsincrease,morebuyersmay
comeinandthepricemayclimbhigherthan$20.Thefinalpricewill
dependontheavailabilityofmoney,participants’experienceswithother
investments,andperhapsevenweather(becausetheirmoodsmayvary
withtheweather).Themainpointisthattherelation
betweenearnings
andpricesintheshortrundependsonparticipants’perceptionsand
actions,notonfundamentalsalone.
Butthestorydoesnotendhere.Let’ssaythatthestockpricegoes
upto$30.Thecompany’s
managementmayevaluatethestockpriceand
concludethatitis,atthatpoint,overvalued.Thecompanymaythenuse
itsstockasacurrencytobuyanothercompanyortoissuenewshares
atthishigherprice,whichgeneratesmorecashforthecompany.This
actionmayindeedpushtheintrinsicvalueofthecompany’sstockfrom
$20persharetoahigherprice.Ontheotherhand,ifthemanagerspay
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andtheremayactuallybealoss.Themanagers’behaviormaydetermine
whetherthecompanybecomessuccessfulorwastesthenewlyacquired
resources.Thefinaloutcomeisgenerallynoteasytopredict,butitis
usefultothinkintermsofpossibleoutcomesandtotakeintoaccount
bothfundamentalsandpsychology.
InJanuary2000,arelativelynewbutsuccessfulInternetcompany,
AmericaOnline(AOL),announcedthatitwasbuyingtheestablished
publisherandmediagiantTimeWarner.Basedonthetradingprices
ofthetwocompaniesatthetime,thecombinedmarketvaluewould
be$350billion.InApril2009,thecombinedmarket
valuewasonly
$30billion.Inthistransaction,AOLuseditsovervaluedstockasa
currencytopurchaseTimeWarner.Thecombinedfirmwasnotas
successfulasmergerplanshadanticipated,buthadAOLnotengagedin
theacquisition,itmightnothavesurvivedasaviablecompanyatall.
Pricesdonotfollowfundamentalsalone,becauseinvestorsoften
wanttogetrichquicklywhenthemarketisrising(greed),andthey
wanttoprotecttheirinvestmentvaluewhenthe
marketisfalling(fear).
Inarisingmarket,initialpricechangesmayleadtofurtherpricechangesasinvestorspourin,whichthenmakesthemarketovervalued.Onthe
otherhand,whenpricesarefalling,moresellerscometothemarketto
protecttheirinvestmentsand
themarketbecomesundervalued.Nobel
LaureateGeorgeAkerlofandRobertShillerdescribethisphenomenon
asprice-to-pricefeedbackleadingtoaviciouscircleofpricesgoingup
orgoingdownforawhile.5
Markettrendsleadingto
bubblesandbustsdonotlastforever;they
finallyreverse.Thereareseveralimplicationsforanaverageinvestor.First,abubble(overvaluation)usuallystartsinonesectoroftheeconomyand
thenspreads.Inthelate1990s,thebubbletookshapeinthehigh-tech
industry;andinthemid-2000s,thehousingindustryledthecharge.
Second,relativevaluationsmayoftennotbeagoodguideforinvesting.
Aftertheinitialriseofthehigh-techstockpricesduringtheInternet
bubble,mostotherstocksalsobecameovervalued.AsI
notedearlier,
evenCoca-Colawastradingata50P/Einthelate1990s.Third,it
seemsimpossible(atleasttome)totellhowlongabubbleorbearmarketwilllast.Finally,totakeadvantageofthesebubblesorbearmarkets,youshouldbuyorsellastockonlyafteryouhaveobjectivelycomputed
its
intrinsicvalueasdescribedearlierinChapter5.
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psychology
HowtoThinkaboutPsychologicalBiases
Manypsychologicalstudiesshowthatthehumandecision-making
processisimperfect.Inparticular,individualsdeviatefromeconomic
rationality.Forexample,theymakedifferentchoicesdependingonhow
agivenproblemispresentedtothem.Individualsarealsoknowntovio-
lateseveralprinciplesofstatisticaltheory(forexample,Bayes’theorem)inpredictinguncertainoutcomes.
However,simplybecausesomeinvestorsplacealotofweighton
psychologicalfactorsandlessweightonfundamentalsdoesn’tmeanwe
shouldgetcarriedawaywiththeideathatthefinancialmarketsarecrazy.
Wedonotknowwhethertradingbyonegroupofirrationalinvestors,
onaverage,cancelsouttradingbyanothergroup.In
general,ifboth
optimistsandpessimiststradeinthemarket,theremaynotbeanydesta-
bilizingeffect.Itisdifficulttofindasmokinggunthatlinkspsychologicalforcesinindividualstomispricinginthemarketplace.Whileitisbeyondthescopeofthisbooktoexaminevariousmodelsinpsychology,itis
appropriatetodiscusssomeoftherelevantissues.Ingeneral,whenyou
readapsychologicalexplanationofmovementsinthemarket,evaluate
itrationallyjustasyouwouldevaluateasalesperson’spitchofaproduct.
Let’sstartwiththeso-called
overconfidencebias.Overconfident
peoplehaveatendencytooverestimatetheirskills.Thosewhothink
thattheycandrivewellevenafterdrinkingthewholenightaresimply
overconfidentintheirabilities.Iwanttouseoverconfidenceasanexam-
pletoshowthat,inmyopinion,overconfidenceinstock-pickingability
doesnotnecessarilymeanthatapersonwillpickwrongstocksandlose
alotinthestockmarket.Takethefollowingthoughtexperimentasan
example.
First,imagineasituationwhereapersonthinksthathecanpick
undervaluedstocksbutdoesnothavetheability.Evenifhedoesnot
haveasuperiorability,hewillnotnecessarilyunderperformthemarket.
Withoutanyabilitytopickundervaluedstocks,hewill
essentiallypick
stocksrandomlyasamonkeywould.Somestockswillunderperform
themarket,andotherswilloutperformthemarket.Overall,eveninthe
absenceofsuperiorstock-pickingability,hewilldojustfine—thatis,
hisperformancewillmatchthemarket’sperformance.
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Nowconsideranotherpersonwhoisalsooverconfidentbuthassome
abilitynonetheless.Notallhispicksmaydowell,butmorethanfiveoutoftenwill,becauseofhisability.Assumethathepicks10stocksthatheis(over)confidentabout.Sincehehassomeskill,hewilloutperformthe
marketonaverage.Theresultwilldependonhisoverallabilitytofind
undervaluedstocks,notonhislevelofconfidenceinthem.Onaverage,
ifyouareabletopinpointundervaluedstocks,itdoesnotmatterwhetheryouarehighlyconfidentornotsoconfident.Thus,theoverconfidence
biasbyitselfisnotabadhumancharacteristicinpickingstocks.
Insomesituations,biasesmayindeedbedestructive.Onecommon
biasthatIalsohaveisthatofnotsellingastockataloss.Butifyoubelievethatthestockisovervalued,thenyoushouldsellevenifthe
currentpriceisbelowyourcostandyouhavetotakealoss.Professor
TerranceOdeanexaminedtradingrecordsfor10,000accountsatalarge
discountbrokeragehouseandfoundthatinvestorsarereluctanttorealizetheirlosses,whichmaybeonereasonfortheirunderperformancerelative
tothemarket.6Consideranotherbiasormisperception:comparingthe
stockmarkettoacasino.Ifyoubelievethatyoucandowellingamblingatacasino,youaremorelikelytobewrongthanright.Thestockmarket
foryoubecomesacasinowhenyoutrytotimethe
short-termprice
movements.Inthatcase,yourbeliefsmayleadyoutotradeexcessively,
andtradingcostswillharmyourperformance.7Similarly,ifyouare
bettingintheoptionsorfuturesmarkets,youmaylosebecausetime
isnotonyourside,andyouareprobablyplayingagainstthehouse.
Everyonehasbiases.However,youneedtothinkabouthowbiasesmay
affectyourbehaviorandwhetherthatbehaviorisharmful.
Wheredothesebiasescomefrom?Whiletheyprobably
havetheir
rootsinfactorssuchasgenesorgeography,let’sjustconsideronesource:youandyourownexperiences.IfyoulivedinSeattleandsawscoresof
softwareengineersbecomingmillionairesfromworkingforMicrosoft,
youwouldhavelinedupata
localuniversitytobecomeasoftware
engineer.Youmayhavedisregardedthepossibilitythatyoudidnothave
suitableskillstobecomeagoodsoftwareengineer.Maybeyoushould
havegonetolawschoolinstead.Similarly,ifyoulivedinFayetteville,
nearWal-Mart’sheadquarters,youwouldhavegivenyourlefthandto
workforWal-Martwhenitwasgrowingfast.
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psychology
Whydopeoplebelievethatatrendinpriceswillcontinue?Probably
becauseoftheirownexperienceswithawidevarietyofchartssince
childhood,theynaturallyseepatternsevenwhentherearenone.Inmost
charts,whethertheydepictper-capitaincome,numberofcarsproduced
eachyear,orconsumerprices,thereisanoticeabletrend.InmostchartsthatIhavecomeacrossinmylife,thereisanupwardtrend.Giventhis
vastexperience,whenweobserveapricechart,weintuitivelyimagine
atrendevenwhenthereisnone.
Likewise,whydoinvestorsflocktoinvestingwithpreviouslysuc-
cessfulmutualfundswhenitiswellknownthatpastsuccessesgenerally
donotpredictthefuture?Onceagain,theyareprobablyreactingonthe
basisoftheirexperienceswithpatternsinlifeingeneral.Asuccessful
surgeoncontinuestobesuccessful,agoodmanagerremainsagoodman-
agerandmayevengetbetterwithage,agoodartistcontinuestobea
goodartist,andagoodresearchercontinuestobea
goodresearcher.But,thispatterndoesnotapplytomostmutualfundmanagersbecausethe
luckfactorloomslarge.8Overall,mostofusdonothaveenoughknowl-
edgeoftherightvarietytothinkindependentlyallthetime.Weform
biasesbecausewe
extrapolateknowledgefrompasttofutureorfrom
onefieldtoanother.However,ifyoureadwidelyandlearnfromothers’
experiencesbeyondyourown,youshouldbeabletoreduceyourbiases.
SomeImportantQuestionsforYoutoConsider
Thepurposeofunderstandingpsychologyistoreducetheirrational
componentinyourdecisionmaking.9Toapplypsychologyinyourstock
buyingandsellingdecisions,thefirstthingyoushouldexploreisyour
primaryreasonformakingthatdecision.Considera
situationinwhich
youdecidetobuyastockbecausethestock’sP/Eratioislow.Knowing
theprimaryreasonforyourdecision,youshouldaskyourself,“Isbuying
alowP/Estockrational?”Thereisplentyofevidenceintheliterature
tosuggestthatinthelongrun,buyingalowP/Estockresultsinhigher-
than-averagereturns.Thus,yourmotivationappearsrational.Youmay
havefollow-upquestions:“WhyistheP/Elow?”or“Whatpercentage
oflowP/Estocksactuallyoutperformsthemarket
withinthreeyears?”
or“HowlongshouldIholdastockafterIbuyalowP/Estock?”Because
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yourealizethatyouarenotverypatient,youmaynotliketheanswer
thatyoushouldholdastockforthreetofiveyears,andyoumaydecide
nottoinvestinlowP/Estocks.
Inanycase,systematic
thinkingwillhelpyoudeterminewhatyou
knowordonotknowandovercomeyourpsychologicalbiases.When
youdonotknowtheanswer,youneedtomakeajudgmentcall.In
thecaseofbuyingalowP/Estock,youmightfindthatonepossible
reasonforthelowP/Eisthattheearningsaretemporarilyhigh.Itmay
notalwaysbepossibletogaugetheextenttowhichearningsaretem-
porarilyhigh,andyoumayhavetomakeajudgmentcallbasedonyour
knowledgeofavailablefinancialdata.Inestimating
theintrinsicvalue
ofBurlingtonNorthernSantaFeearlier,Ientertainedthispossibility
becausetheeconomywasdoingwelluntil2007.ButIamunabletotell
theextenttowhichearningsmaydecreasein2010or2011.Incomputing
intrinsicvalue,wehavetomakeestimatesorjudgmentcalls.Ultimately,
everyonehastomakejudgmentcalls,butfollowingasystematicapproach
willhelpyouknowwhenyouaremakingajudgmentcall.
Consideracompanythathasanexcellentproductlineandwhose
stockyouarethinkingofbuying.Youwillprobablyexaminethehistori-
calsalesgrowthorpastpricepatterns.Youwillalsolookatthecompany’sfundamentalsandmanagement;butfinally,youwillhavetomakeajudgmentcall.Youmightconcludethatyoudonotknowenoughaboutthe
company’sprospectsbutthatthepricelooksattractivebasedonwhat
youknow.Inotherwords,youdonothaveenoughconfidenceinyour
decision.Youmaydecidetoinvestonlyasmallamountofmoneyinthe
stockandrevisittheinformationsetafterafew
months.
Yourultimatequestionshouldalwaysbe“Isthisrationalbasedon
allthatIknow?”Onaverage,ifyougothroughasetofbasicquestions
aboutthestockandpsychology,youshoulddowellinthestockmarket.
Ofcourse,intheprocessoflearningaboutyourself,ifyouconcludethatyouarelikelytomakeirrationalchoicesmoreoftenthannot,maybeyou
shouldstayawayfromthestockmarket.Inthatcase,yoursituationmay
besimilartosomeonewhoknowsthedangersofexcessivedrinkingbut
cannothelpbutdrinkwhenhevisitsabar.Heshouldlearnnottogo
nearabar.Overall,knowledgeoffundamentalsshouldhelpyouestimate
thecompany’slong-termfuture,andknowledgeofpsychologyshould
helpyouinjectrationalityintoyourdecisions.
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Conclusions
Everyonehasopinionsandpsychologicalbiases.
However,peoplemay
notknowtheirownbiases.Themoreyouknowaboutyourpsycho-
logicalbiases,thebetteryoucanfunctioninthevolatilestockmarket.
Theentiremarketmaybeinfluencedbypsychologicalreasons,notby
fundamentalreasonsalone.Fromaninvestmentperspective,thebot-
tomlineisthatthemarketwillcontinuetofluctuateandgiveyou
solidopportunitieseverysooften.Valueinthelongrunisdetermined
byfundamentals,whileshort-termgyrationsreflect
marketparticipants’
psychologicalweaknesses,suchasherding.Knowledgeisthebestanti-
dotetomakingwrongdecisions.Ifyouarealong-terminvestor,the
rationalthingtodoistomakedecisionsbasedonlong-termfundamentals
ofthebusiness.
E1C26
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Chapter26
HowtoLearn
fromMistakes
Whatwelearnfromhistory
isthatpeopledon’tlearnfrom
history.1
—WarrenBuffett
BothWarrenBuffettandCharlieMungerbelieveinlearningfrom
mistakes.DuringBerkshire’s1997annualmeeting,Mungersaid
thatinthepast,Berkshire
boardmembershavediscussedtheir
mistakestolearnfromthem.Membersbroughtuponeortwoimportant
mistakestheyhadmadeintheircareers.Mostofusfinditeasytotalk
aboutoursuccessesbutdifficulttotalkaboutourmistakes,andoftenwe
attributeourmistakestobadluck.
MistakesversusBadLuck
Weshoulddifferentiatemistakesfrombadoutcomesorbadluck.Abad
outcome,forexample,wasthedropinthestockpriceofJohnson&
JohnsonwhenTylenolwas
foundtobelacedwithpoisonandseveral
consumersdied.2IfyouhadownedJohnson&Johnsonstockthen,it
wasbadluck,notamistake.WhenSalomonBrothersgotintotroublein
1991,BerkshireHathawaysufferedfinancially,andBuffettalsosuffered
243
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psychology
personallywhenhetookoverastheCEOofSalomonto
sortoutthe
problems.ThescandalatSalomonthatledtoBuffett’sinvolvementwas
arareevent,andsotherewasverylittletolearnfromit.ItwasalmostimpossibletopredicttheSalomonscandal.Itwassimplybadluck.
Itisalsonotamistakewhenyouconsciouslydecidenotto
do
somethingthatturnsouttobegoodluck.Forexample,ifyoudonot
participateinyourofficelotterypoolandthepoolwinsamega-million-
dollarjackpot,youhavenotmadeamistake.Althoughaclosefriendof
BillGates,Buffettissaidtohaveboughtonly100sharesofMicrosoft.
WasBuffettmistakeninnotinvestingmoreinMicrosoftstock?No.
Buffetthasconsciouslydecidednottoinvestoutsidethecirclesofhis
competence.
NordidBuffettbuysharesinFannieMaeinthemid-1980sbefore
thestockdidverywell.InoneofBerkshire’sannualmeetings,hesaidthatnotbuyingFannieMaewasamistake.Buffettknowsalotaboutfinancial
companiesandfeltheshouldhaveknownthat,ultimately,FannieMae
waslikelytobesuccessful.From2006to2008,Berkshireinvestedmore
than$7billioninConocoPhillipsstockwhenoilandgaspriceswerenear
theirpeak.Thestockpricesubsequentlydroppedby50percent.Inthe
2009annualmeeting,Buffettmentionedthatbuyingthe
ConocoPhillips
stockwasamajormistake.
LearningfromMistakes
In1965,BuffetttookcontrolofBerkshireHathaway.Ondifferentocca-
sions,hehasmentionedthatitwasamistake.Heknewthattheprospects
oftextilemanufacturingwereunpromising,butheboughtitbecausethe
stockpricelookedcutrate.(Hemayhavealsoboughtitforitscashflows.)Helearned,Ibelieve,thatreasonablegrowthprospectsareimportant.
Healsoseemstoavoidhigh-capital-intensitybusinessessincethenunlessheisina
positiontoinfluencemanagerialdecisionsbyholdingalarge
stakeinthecompany.
Weoftenmakemistakesbecausewedonotthinksystematicallyabout
ourdecisions.MichaelMauboussin,chiefinvestmentstrategistatLegg
Mason,recommendscreatingalisttoconcentrateonstepsneededto
E1C26
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HowtoLearnfromMistakes
245
makeagooddecision.3Onmanyoccasions,Ihaveaskedmyfriendsif
theyhadmadeamistakebynotinvestinginBerkshire.Someofthem
answeredyes.However,whenIaskthemwhattheyhavelearnedfrom
thatmistake,theyusuallydrawablank.Making
mistakesisnotabad
thing,notlearningfromthemis.Myusualsuggestiontomyfriendsis
toexaminewhetherBerkshireisstillagoodstock.IfBuffetthasbeensogoodinthepast,shouldwehavesomeconfidencethathewillproduceat
leastreasonablygoodresults
inthefuture?Thissequenceofquestioning
ledmetocontinuetoinvestinBerkshire.Inearly2009,Iboughtmore
ofBerkshirestockwhentheclassBsharesweretradingataround$2,500
pershare.
Learningfrominvestment
mistakesiseasierwhenyouarealready
somewhatknowledgeableabouttheindustryinwhichyouinvest.For
example,ifyouknowsomethingaboutretailingandyouinvestinTarget
orWal-Mart,youwillhavetheopportunitytolearnfromyourinvest-
ments.Inthelate1990s,IinvestedinKmartbecausethestocklooked
cheapandIwasexpectingthecompanytogrow.However,Isuffered
significantlosses.Ishouldhavevisitedthestoresmorefrequentlyto
examinethequalityofcustomerserviceandthe
availabilityofprod-
ucts.Later,IalsolearnedthatKmart’slowinventoryturnoverratiowas
oneindicationthatthecompanywasnotdoingwell.Thismistakehas
nudgedmetobecomebetterinusingfinancialratios.Myknowledgein
accountingandfinancehashelpedmeinthisregard.Thus,expertiseand
learningfrommistakesgohandinhand.Thisisoneadditionalreason
thatinvestorsshouldinvestintheircirclesofcompetence.
Thefirststepinlearningfrommistakesisto
acknowledgethata
mistakewasmadeandbyitself,makingmistakesisnotabadthing.4To
avoidfuturemistakes,Iwritedownmyerrorsintheprivacyofmyhome.
Second,Iwritepotentialreasonsformymistakes.OnceIhaveanalyzed
thereasons,Itakethethirdhardstepoftalkingaboutmymistakestomyfriends.Ievenhangthenow-worthlessKmartsharecertificateonmy
officewall.IusedtobuyandsellfrequentlyafterreadinganarticleintheWallStreetJournalorBarron’s.Butnow,throughthisconstantwritingandevaluationprocess,Iammuchless
likelytobuyorsellonawhim.Most
ofmyholdingsarenowlong-termholdings.WheneverIfeellikeselling
mylong-termholdingsofBerkshireHathaway,Wal-MartdeMexico,
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psychology
andAmericanExpress,IgobacktothereasonsIboughttheminthe
firstplaceandevaluatecurrentconditions.
MistakesofCommission
andMistakesofOmission
BerkshireHathawaypurchased200millionsharesofCoca-Colaforabout
$6.50pershare(split-adjusted)inthelate1980s.DuringtheInternet
bubbleperiodinearly1998,theCoca-Colastockpricewas$85per
share,which,bymostvaluationmetrics,wasovervalued.Forexample,
theP/Eratiowasover50.BuffetthassubsequentlyhintedthatnotsellingBerkshire’sCoca-Colastockwasamistake.By2003,thestockpricehad
fallento$40,andinearly2009,itwasstilltradingataround$45per
share.Wedon’tknowwhyBuffettdidnotsellthestock,butwecan
speculateandpossiblylearnfromthisepisode.
First,BuffettwasadirectorontheCoca-Colaboardofdirectors.Any
directorwouldfinditdifficulttosellahugepositioninthecompany
stock.Buffettresignedfromhisdirectorshipin2006after17yearsontheboard.Second,itispossiblethatwhenacompanyhassignificantcash
flowsasBerkshiredoes,evenpeoplelikeBuffettmaynotbeattentiveto
thepriceofaninvestment.Afterall,theideainlong-terminvestingis
nottofocusontheday-to-dayprice.Finally,itisworthmentioningthatifBuffetthadsoldtheCoca-Colastockatclosetoitspeak,sayin1999
or2000,andinvestedtheafter-taxproceedsinthemarketindex,the
lossesby2009wouldhavebeenaboutthesame.Thisisagoodexample
tothinkaboutwhenyoulookatyourownmistakes;themainlesson
probablyisthatyoushouldsellastockwhenitisclearlyovervalued.I
alsodonotknowwhyBuffettboughtConocoPhillipsstockandthen
soldit.Myguessisthatherealizedthatbecauseofhigh
volatilityinoilprices,oilcompanystockpricesarespeculativeinnature.
Buffetthasoftentalkedaboutmistakesofomission—theinvestments
thatshouldhavebeenmadebutwerenotmade.Inoneinstance,he
discussednotbuyingWal-Martstock,whichwasinhis
circleofcompe-
tence.Itwasnotahigh-techcompany,anditwasgrowingsuccessfully
intheU.S.MidwestwherehishometownofOmahaislocated.Ithink
itwouldhelpusallifwelearnedtoevaluateourmistakesnotonlyof
commissionbutalsoofomission.
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247
Conclusions
Everyonemakesmistakes,andbadluckstrikeseverywhere.Thereisnot
muchyoucandoaboutbadluckexcepttodiversifyandshyawayfrom
hugerisks.Whenyoudomakemistakes,takethetimetoponderthem
andfindwaystoavoidmakingthesameonesagain.
E1C26
Date:Jan18,2010
Time:10:57pm
E1PART09
Date:Dec10,2009
Time:3:32pm
PartNine
CORPORATE
GOVERNANCE
HowdoesBuffettsuccessfullymanagealargeconglomerate?
Whenyouthinkaboutinvestinginthestockmarket,you
shouldalsoconsiderthequalityofcorporategovernanceprac-
ticesatthefirm.InChapters27through30,Ireviewseveralprinciples
thatBuffetthasadoptedinrunningBerkshireHathaway.
249
E1PART09
Date:Dec10,2009
Time:3:32pm
E1C27
Date:Jan29,2010
Time:2:33pm
Chapter27
Dividends:DoThey
MakeSenseinThis
DayandAge?
[D]ividendpolicyis
irrelevantforthedeterminationofmarket
prices,giveninvestmentpolicy.1
—MertonMillerandFrancoModigliani
Thepracticeofpayingregulardividendsisalong-standingpuz-
zle.Inawell-knownarticle,twoNobellaureatesin
economics,
FrancoModiglianiandMertonMiller,wrotethatacompany’s
valuedoesnotdependonitsdividendpolicy;rather,valuedependson
howthecompanyinvestsitsresources.Afterall,dividendsareequivalenttotransferringshareholders’
moneyfromtheiraccountswiththecompanytotheirpersonalaccounts.Whenacompanypaysadividend,its
sharepricedropsbyalmostthesameamountasthedividend.
BerkshireDoesNotPayDividends
Buffettseemstoagreewithacademicthoughtonthe
topicofdividends.
BerkshireHathawayhasnotpaidanydividendsforthepast42years.MIT
251
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corporategovernance
professorandGoldmanSachspartnerFischerBlackarguedthatbecause
oftheU.S.double-taxationstructurewherecorporationsfirstpaytaxes
onearningsandthen
individualsagainpaytaxesondividends,both
corporationsandindividualsshouldprefernodividends.2Corporations
shouldonlyreturnearningstotheirshareholdersascashdividendswhen
theydonothaveprojectswithreasonableratesofreturnandtheirown
sharepricesarehigh.Ifthesharepriceislow,theyshouldrepurchase
theirownshares.
ConsiderCitigroup,alargefinancialinstitutionwithamarketcap-
italizationofabout$200billioninlate2007.Itscommonstockwas
amongthehighestdividend-yieldingstocks,payingstockholders7per-
cent.During2007,thestockpricedeclinedbyover40percentbecause
thecompanysufferedlossesofabout$10billioninitshousing-related
investments.InthewakeofCitigroup’sdecline,CEO
CharlesPrincehad
toresign.Toregainitsfinancialstrength,Citigroupissued$7.5billionofconvertiblesecurities,yielding11percenttotheAbuDhabiInvestment
Authority.Byanyyardstick,11percentishigh,inlightofthefactthatthegoingrateofintereston10-yearTreasurynotesatthetimewasonly
4.25percentandthe30-yearmortgagerate,about5.8percent.
AlthoughCitigroup’sstockpricehaddeclinedandthecompanywas
forcedtoraisefunds,itcontinuedtopayalmost$10billionayearin
dividends.ItwasobviousthatCitigroupneededcashin
ahurry:The
marketdidnotthinkhighlyofCitigroup’sfinancialstrengthbecauseof
thehugelossesithadincurred.WhydidCitigroupnotcutitsdividends
immediatelywhenitwasobviouslyinseriousfinancialtrouble?Some
havearguedthatonceacompanystartspayingadividend,themarket
expectsthecompanytopaythedividendatregularintervalsforever.
Thisargumentmayhavesomejustificationinnormalcircumstances,
butthelogicisquestionableinthiscase.Sincethe
companyalready
indicatedthatitwasinfinancialtroubleandneededtoraisefundsby
issuingpreferredstock,adividendcutwouldhavebeenamorelogical
choicethanraisingequity.WhileCitigroupisanextremeexample(and
itfinallycutitsdividend),itiscommonforcorporationstoraiseequityandpaydividendsatthesametime.Suchcasesareoftenexamplesof
poorfinancialmanagement.
Receivingregulardividendsiscostlytoyou.First,ifyouownshares
inyourname,youreceive
checkseveryquarterthatyouthenhaveto
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Dividends:DoTheyMakeSenseinThisDayandAge?
253
taketothebank,spendingtimeonthischore.Depositingofdividends
canbemadeautomaticifyouownsharesinabrokerageaccount,but
manypeopleprefertoholdsharesthemselvesbecausetheyaresaferthat
way.Second,youhavetospendmoretimeandeffort
keepingtrackof
yourdividendsfortaxpurposes.Finally,youhavetopaytaxesonthese
dividends,oftenataratehigherthanthecapitalgainstaxrate.Ifsomeshareholdersneedregularinfusionsofcash,itisnotclearthatwhattheyreceiveindividendsistherightamountforthem.Shareholderscaneasilysella
fewsharesiftheyneedcash.Also,shareholderscandecidewhich
sharestoselltominimizetheirtaxburden.Perhapssomeintermediaries
andconsultantswhogiveadviceondividendsearnfees,andthatmay
beonereasonmostcompaniescontinuetopay
regulardividendsinthis
dayandage.
Sowhatshouldyoulookforinadividendpolicy?Aregulardividend
paymentfromacompanythatgeneratesregularfreecashflowsbutdoes
nothavegrowthopportunitiesindicatesa
companywithself-disciplined
management.Inacademicfinance,thisisknownasthemonitoringrole
ofdividends.Becauseofthecommitmenttopayregulardividends,suchcompaniesarelesslikelytowasteresourcesandaregoodcandidatesfor
furtheranalysis.Costcostartedin1983anduseditscashflowsforgrowthuntil1994,whenitstartedpayingdividends.Itwasagoodcompanyto
investinbeforeitpaidanydividendsandalsoafteritstartedpayingregulardividends.Ifyouhadfocusedonlyondividend-payingcompanies,
youwouldhavenotinvestedinCostcoorforthatmatterinBerkshire
Hathaway.
Aregulardividendpaymentbyitselfisnotastrongenoughvariable
tocharacterizeacompanyasagoodinvestment.Whenacompanypaying
regulardividendsalsoraisesfundsinthefinancialmarketsandthebal-
ancesheetisnotstrong,youshouldbecarefulaboutinvestinginitsstock.
Dividendpaymentisjustonepossibleuseoffreecashflows.Whatismostimportantisyourcomfortlevelwithacompany’susageofitsfreecash
flows.Companieshavemanychoicesotherthanpayingdividends:They
canundertakenewprojects,repurchasetheirownshares,andinvestin
financialassets.Ifyouarenotcomfortablewithmanagementdecisionson
itsusageofcashflows,especiallyitsinvestment
policy,youshouldnotbuythestockinthefirstplace.Ifacompanyhasexcesscashwithoutareasonableprobabilityofprofitablenewprojects,itcandowhatMicrosoftdid.
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254
corporategovernance
MicrosoftandaSpecialDividend
Microsoft’spolicypresentsagoodexampleofwhatacompanycanperi-
odicallydowithexcesscash.ItisclearthatMicrosofthas
beenhighly
profitable(seeTable27.1).Insteadofpayingregulardividends,thecom-
panyrepurchasesitsownshares.Byrepurchasingitsownshares,Microsoftiseffectivelyreturningcashtoitsshareholderswithoutmakingthem
liableforadditionaltaxes.
Second,Microsoftdoesnothavetorepur-
chaseitssharesveryoften;itdoessoonlyperiodicallywhenithasexcesscashandthestockpriceislow.
Bytheendof2002,Microsoftwasinanenviablefinancialposi-
tionwithabout$70billionincashandshort-term
investments.Itwas
increasinglybeingcriticizedfornotpayingcashtoitsshareholders.In
2003,Microsoftpaiditsveryfirstcashdividend:$857million,orabout
10percentofitscurrentearnings.WhydidMicrosoftstartpayinga
Table27.1
Microsoft’sEarningsandReturnofFunds(DividendsandShare
Repurchases)toShareholders
Dividends
Total
Fiscal
Repurchaseof
paidto
returnedto
year
Earnings
ownshares
shareholders
shareholders
1996
$2,195
$1,344
$
1,344
1997
3,454
3,010
3,010
1998
4,490
2,631
2,631
1999
7,785
2,850
2,850
2000
9,421
4,896
4,896
2001
7,346
6,074
6,074
2002
5,355
6,069
6,069
2003
7,531
6,486
$
857
7,343
2004
8,168
3,383
1,729
5,112
2005
12,254
8,057
36,112
44,169
2006
12,599
19,207
3,545
22,752
2007
14,065
27,575
3,805
31,380
1996–2007
$94,663
$91,582
$46,048
$137,630
Dollaramountsinmillions.
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Dividends:DoTheyMakeSenseinThisDayandAge?
255
regularcashdividend?Themotiveisuncertain,butMicrosoftmayhave
donesoinresponsetodemandsfromthemedia.Theinitiationofcash
dividendscertainlyhelpedreducecriticism.Theamountoftheregular
dividendisnotlargerelativetoMicrosoft’searningsorits
cashandshort-terminvestments.In2005,thecompanyused$44billiontorepurchase
sharesandtopayaone-timedividendinexcessof$36billion.Inrecent
years,IhavenotseenanycriticismofMicrosoftforitsdividendpolicy.
Maybethemainreasonfora
regulardividendpaymentisthemisguided
perceptionamongmanyinvestorsthatdividendsarealwaysgoodfor
shareholders.
Conclusions
Inmostcases,companiespayregulardividendssimplybecauseithas
beenalong-standingcorporatepractice.Therearenostrongreasonsto
supportpayingregulardividends,however,especiallywhenthebalance
sheetisnotstrong.Insteadoffocusingonthedividendpolicy,youshouldspendmoretimeanalyzingthesourcesandusesofacompany’scashflows,
whichultimatelydeterminethestockprice.
E1C27
Date:Jan29,2010
Time:2:33pm
E1C28
Date:Jan29,2010
Time:2:52pm
Chapter28
ShouldYouInvestin
CompaniesThat
RepurchaseTheir
OwnShares?
Companiesinwhichwehaveourlargestinvestmentshaveall
engagedinsignificantstockrepurchasesattimeswhenwide
discrepanciesexistedbetweenpriceandvalue.1
—WarrenBuffett
Whenapubliclytradedcompanybuysitsownshares,the
outcomeisasmallernumberofshareholdersowningthe
business.Throughrepurchases,thecompanymaysignal
thatitssharesareundervalued.Repurchasesarealsoatax-freemethod
toreturncashtoshareholders.Theacademicliteraturesupportstheview
thatcompaniesrepurchasingtheirownsharesare
frequentlyunderval-
ued.InanarticleintheJournalofBusinesspublishedbytheUniversityofChicago,AmyDittmarconcludes,“Firmsrepurchasestocktotake
advantageofpotentialundervaluation.”2
257
E1C28
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258
corporategovernance
ShareRepurchasingIsGoodNews
SupposeyouandJohnjointlyownatractofancestralland.Youdivideit
intotwoequalpartsforfarmingpurposes.Eachofyoucanfarmwhatever
youwantandkeeptheoutputs.Inhispieceofland,Johncultivates
cotton.Youuseitforsugarcane.Afterseveral
years,Johnproposesto
buyyourpieceofthelandatanattractiveprice.Whetheryousellor
not,itshouldbeimmediatelyclearthathiscottonfarmingisdoingwell.
Throughhisdesiretoincreasehislandholding,hehasrevealedtoyou
thatheisinaprofitablebusiness.Sharerepurchasingissimilar.
Investorscaninferthatacompanythatrepurchasesitssharesfre-
quentlyisunlikelytowastefreecashflowinunproductiveacquisitions.
ConsiderthecaseofCoca-Cola,whichhashad
significantfreecash
flowsinrecentdecades.In1982,itacquiredColumbiaPictures.The
Columbiaacquisitiondidnotworkoutandwassoldin1989.Buffett
explained,“Corporateacquisitionprogramsalmostneverdoaswelland,
inadiscouraginglylargenumberofcases,failtogetanythingcloseto
$1ofvalueofeach$1expended.”3Coca-Colasubsequentlydecidedto
investitscashflowsinitselfbypurchasingsomeofthesharesback.From1989to1999,thenumberofthecompany’scommonsharesoutstandingdecreasedfrom
2.79billionto2.49billion—adropof11percent,
orabout1percentperyear.Atcurrentprices,thisamountstoabout
$1billionannually.
ShareRepurchasesbyCompaniesinWhich
BerkshireHasInvested
InTable28.1,IexaminetherepurchasepracticesofsomeBerkshire
holdings.Thesedataareforthefive-yearperiodfrom2004to2008.
ThefivecompanieslistedinTable28.1invested34percentto
76percentoftheirnetincomeinpurchasingtheir
ownsharesback.
Iftheirmanagementqualityhadnotbeenexcellent,themanagers
wouldprobablyhaveusedthecashtoexpandtheirempiresbyinvest-
inginother,potentiallylessprofitable,projects.WashingtonPost,WellsFargo,andMoody’shave
engagedinrepurchasepractices.Inthecase
E1C28
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CompaniesThatRepurchaseTheirOwnShares
259
Table28.1
BuffettLikesCompaniesBuyingTheirOwnShares
Repurchasesas
Netincome
Repurchases
apercentageof
Company
(2004–2008)
(2004–2008)
netincome
Coca-Cola
$26,587
$9,164
34%
AmericanExpress
17,597
13,314
76
Anheuser-Busch
9,907
6,518
66
Burlington
NorthernSantaFe
8,153
4,317
53
Kraft
13,848
7,602
55
Dollaramountsinmillions.
ofWashingtonPost,thecompanymadeasignificantinvestmentin
Kaplan,acommercialtrainingcompany,anddidnotbuybackshares
in2004and2005.However,
itrevertedtoasharerepurchaseprogramin
2006.
Buffettwrites:
Bymakingrepurchases,whenacompany’smarketvalueiswellbelow
itsbusinessvalue,managementclearlydemonstratesthatitisgiven
to
actionsthatenhancethewealthofshareholders,ratherthantoactions
thatexpandmanagement’sdomainbutthatdonothingfor(oreven
harm)shareholders.4
Hecontinues:
Investorsshouldpaymoreforabusinessthatislodgedinthehands
ofamanagerwithdemonstratedpro-shareholderleaningsthanfor
oneinthehandsofaself-interestedmanagermarchingtoadifferent
drummer.5
Sometimes,sharerepurchasescanboostreportedearningsbecause
thenumberofsharesgodownduetorepurchasing.Beforeinvestingin
acompanythatisrepurchasingitsownshares,youshouldinvestigatethe
companyfundamentalsanditsmanagementquality.
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corporategovernance
WhyDoesn’tBerkshireRepurchaseItsOwnShares?
Inearly2000,whenBerkshireHathawayclassAcommonstockwas
tradingatabout$40,000pershare,downfromahighof$81,000per
share,manyarticlesinthepopularpresssuggestedthatBerkshireshould
considerrepurchasingitsownshares.Givenwhat
Buffetthasexpressed,
itseemedtobeareasonablesuggestionbecausethestockpricewas
barelyaboveitsbookvalueof$38,000pershare.Theannualletter
toBerkshireshareholderswaswidelyanticipated,andwhenitfinally
appearedonMarch11,2000,itfurtherclarifiedBuffett’sthinkingon
sharerepurchases:
Thereisonlyonecombinationoffactsthatmakesitadvisablefor
acompanytorepurchaseitsshares:First,thecompanyhasavailable
funds—cashplussensibleborrowingcapacity—beyondthenear-term
needsofthebusinessand,second,findsitsstocksellinginthemarket
belowitsintrinsicvalue,conservatively-calculated.6
Ifprofitableinvestmentopportunitiesexist,thenmanagementshould
notrepurchasethecompanysharesevenwhenthepriceisattractive.This
isprobablyonereasonBuffettdidnotchoosetorepurchaseBerkshire
shares.Ofcourse,evenBuffettadmitsthathehasmademistakesinthe
past,forwhichhehascriticizedhimself:“At
certaintimesinthepast,Ihaveerredinnotmakingrepurchases.MyappraisalofBerkshire’svaluewasthentooconservativeorIwastooenthusedaboutsomealternative
useoffunds.”Investorsshouldalsoconsiderthepotentialvalueadded.
Buffettcontinues,“Arepurchaseof,say,2%ofa
company’ssharesat
a25%discountfromper-shareintrinsicvalueproducesonlya1/2%
gaininthatvalueatmost.”Thus,whenmanagementreputationiswell
established,asinBuffett’scase,theadvantageinrepurchasingmaynotbesubstantial.Buffettfurther
emphasizeshisinterestinshareholderwealth:
“Pleasebeclearaboutonepoint:WewillnevermakepurchaseswiththeintentionofstemmingadeclineinBerkshire’sprice.Ratherwewill
makethemifandwhenwebelievethattheyrepresentanattractiveuseof
theCompany’smoney.”7Overall,ifacompanypurchasesitsownshares
onaregularbasisanditsfundamentalsappearsound,youshouldconsider
buyingsharesinthecompany.
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CompaniesThatRepurchaseTheirOwnShares
261
Conclusions
Whenacompanybuysitsownsharesandyouhaveconfidenceinthe
qualityofthatcompany’s
management,chancesarethatthestockis
undervalued,andyoushouldexpectthestockpricetoriseovertime.
Ontheotherhand,iftherepurchaseofstocksseemstobemotivatedby
adesiretoreducethenumberofsharesand,hence,increaseearningsper
share,youshouldavoidinvestinginthecompany.
E1C28
Date:Jan29,2010
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E1C29
Date:Jan19,2010
Time:9:9am
Chapter29
CorporateGovernance:
Employees,Directors,
andCEOs
WarrenBuffett’sannualsalaryfor2008was$100,000andhis
totalcompensationwas$175,000.
—BerkshireHathawayProxyStatement,2009
WarrenBuffetthasoftenremarkedthathelovestorunBerk-
shireHathaway.Why?Itiscertainlynothis$100,000salary
thatmotivateshiminhisrolesasBerkshireHathaway’s
CEOandchairmanofthe
board.Onenecessaryingredienttoensurethe
successofanyorganizationistohavemotivatedemployeesandtopman-
agement.ThischapterexplainsthesalientfeaturesofBuffett’sthinking
onhowtomotivateemployees,directors,andCEOs.
EmployeeCompensationatBerkshire
In1996,BerkshireacquiredtheautoinsurerGEICO.Immediatelyafter
thepurchase,afocusedcompensationplanwasputinplace.Examining
thissimplebuteffectivechangebyBuffettgivesusinsightintopractices263
E1C29
Date:Jan19,2010
Time:9:9am
264
corporategovernance
designedtomotivateemployees.Theobjectiveofthecompensation
planwastokeepemployeesfocusedonthoseaspectsofthebusinessthat
areundertheircontrolandthathaveanimpactonprofitability.Buffett
writes,“AtGEICO,thebonusesreceivedbydozensoftopexecutives
arebasedupontwokeyvariables:(1)growthin
voluntaryautopolicies;
and(2)underwritingprofitabilityonseasonedautobusiness.EveryoneatGEICOknowswhatcounts.”1
Whenacompensationplanisthatsimpleandfocused,dramatic
resultsensue.ThefollowingreflectionbyBuffettprovidesuswithaset
ofprinciplesinthisregard:
Berkshire’sincentivecompensationprinciples:Goalsshouldbe(1)tai-
loredtotheeconomiesofthespecificoperatingsystem;(2)simplein
charactersothatthedegreetowhichtheyarebeingrealizedcanbe
easilymeasured;and(3)directlyrelatedtothedailyactivitiesofplan
participants.2
Buffettalsoarguesthatcompensationplansshouldencourageahigh
returnoncapitalemployed,notjustahighlevelofprofits,becauseit
maybeeasytoincreasethelevelofprofitsbysimplyincreasingthe
amountofcapitalemployed.Inaddition,thecostofcapitalmustbetakenintoaccount.RecallBerkshire’shighlysuccessfulsubsidiaryScottFetzerCompany(discussedinChapter13)withRalphScheyasitsmanager.
BuffettexplainshowSchey’sbonusplangiveshimincentivestoincrease
theprofitabilityofcapitalemployed.
WritesBuffett:
IfRalphcanemployincrementalfundsatgoodreturns,itpayshimto
doso:Hisbonusincreases
whenearningsonadditionalcapitalexceed
ameaningfulhurdlecharge.Butourbonuscalculationissymmetrical:
Ifincrementalinvestmentyieldssubstandardreturns,theshortfallis
costlytoRalphaswellastoBerkshire.Theconsequenceofthistwo-
wayarrangementisthatitpaysRalph—andpayshimwell—tosend
toOmahaanycashhecan’tadvantageouslyuseinhisbusiness.3
Notethatitisnotsufficienttorewardmanagersonlyifperformance
isbetterthanexpected;managersshouldalsoreceive
incentivestoavoid
losses.Thisconceptofsymmetricalincentivesisrareinpractice.One
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consequenceoftherarityofsymmetricalincentivesystemsisthat,when
possible,managersmanipulateaccountingnumberstoreporthigher
numbers,inordertoearnhigherbonuses.However,
thesemanagers
alsoattempttoreportlargerlossesinyearswhentheydonotexpectto
earnbonuses.4Whenyoustudyacompany’sincentivecontracts,look
forsymmetricalincentiveplans.
Buffettsummarizeshis
overallmanagementphilosophy:
AtBerkshire,ourmanagerswillcontinuetoearnextraordinaryreturns
fromwhatappeartobeordinarybusinesses.Asafirststep,theseman-
agerswilllookforwaystodeploytheirearningsadvantageouslyintheir
businesses.Whatisleft,theywillsendtoCharlieandme.Wethenwill
trytousethosefundsinwaysthatbuildper-shareintrinsicvalue.Our
goalwillbetoacquireeitherpartorallofbusinessesthatwebelieve
weunderstand,thathavegood,sustainableunderlying
economics,and
thatarerunbymanagerswhomwelike,admireandtrust.5
Buffett’sphilosophysuggeststhatpeople,ratherthanthetypeof
industry,arebehindextraordinaryresults.Berkshiregetsextraordi-
naryresultsfromitssubsidiaries,whichrangefromautoinsurance
tohonest-to-goodnesstraditionalbusinesses,becauseBerkshirecreates
compensationplanstailoredtothosespecificbusinesses.Unlikeprac-
ticesinmostlargecorporations,compensation
plansatBerkshirearenotlinkedtoBerkshire’soverallperformance.
CompensationforDirectorsandExecutiveOfficers
Berkshire’sprogramforcompensatingitsdirectorsalsodiffersfromcom-
pensationprogramsatmostpubliccompanies.Berkshirepaysnominal
amountstothedirectorstoattendboardmeetings.Adirectorwhois
notanemployeeoraspouseofanemployeereceivesafeeofonly$900
foreachmeetingattendedinperson,and$300forparticipatinginany
meetingconductedbytelephone.Incomparison,
directorsinlargecor-
porationsarefrequentlypaidmorethan$100,000incashcompensation
and$200,000intotalcompensation.Furthermore,theBerkshireCom-
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ofBerkshireHathawaynorthemarketvalueofitsstockisconsideredin
thecompensationofany
executiveofficer.Underthecommittee’scom-
pensationpolicy,Berkshiredoesnotgrantstockoptionstoexecutive
officers.
HowdoesBerkshireattractoutstandingdirectors?Thekeyseems
tobethat,inidentifying
potentialdirectors,Buffettlooksforindi-
vidualswhoare“owner-oriented,businesssavvy,interested,andtruly
independent.”6Thelastcriterion,“trulyindependent,”requiressome
elaboration.Itiseasyforaboardmembertomeettheindependence
criteriasetupbytheNationalAssociationofSecuritiesDealersorotherinstitutions.ButforBuffett,whatmattersis“trueindependence.”For
example,supposeauniversityprofessorisappointedasadirectorofa
publiclytradedcompanyandreceivescompensationof$100,000.Since
theincomederivedfromhisboardmembershipislikelytobeasub-
stantialportionofhisorhertotalincome,thecompanyCEOcanexert
significantinfluenceonthatboardmember.AccordingtoBuffett,this
boardmembercannotbeconsideredtrulyindependent.
MostBerkshire
boardmembersareaccomplished,wealthybusinessleaderswhoarelikely
tobe“trulyindependent,”byBuffett’sstandards.Theyarealsoowner-
oriented,asBuffettexplains,“Mostofourdirectorshaveamajorportionoftheirnet
worthinvestedinthecompany.Weeatourowncooking.”7
Thereisonecaveat:Whenalldirectorsthinksimilarly,theymay
ignorenewideasthatoftencomefromoutsiders,suchasprofessorsor
entrepreneurs.Inotherwords,acorporateboardin
whichmostmembers
havesimilarbackgroundsmayfallvictimtowhatisknownasgroupthink;theymaytrytominimizeconflictandreachconsensuswithoutcritically
analyzingandevaluatingideas.
WhatIsWrongwithCompensation
throughStockOptions?
Tomotivateseniorexecutives,manycompaniesawardstockoptions
totopmanagersandCEOs.Aboutstockoptions,Buffetthaswrit-
ten,“Thoughoptions,ifproperlystructured,canbeanappropriate,
andevenideal,waytocompensateandmotivatetopmanagers,theyare
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asmotivators,andinordinatelyexpensiveforshareholders.”8Ifthestockpriceincreasesafterstockoptionsareawarded,thevalueofstockoptionsalsoincreases.Inmostcases,thepotentialbenefitstotheexecutivesarehuge.ItisnotuncommonforsomeCEOsto
reapmillionsorevenhundredsofmillionsofdollarsthroughstockoptions.However,whenthe
stockpricedeclines,theexecutivesdonotsuffermuchbywayofdirect
monetarylosses.Fromtheshareholders’pointofview,thisisjustnot
fair.Buffettbelievesthat
executivesshouldparticipateinboththeupsideandthedownsideofstockpricemovements,justastheshareholdersdo.9
Forthisreason,executivesshouldbeencouragedtoownsharesinthe
company.
WhenGeneralRe,alargereinsurancecompany,was
acquiredby
BerkshireHathaway,BuffettchangedGeneralRe’scompensationplan.
Inaspecialmeetingofshareholdersheldtovoteonthemerger,which
Iattended,Buffettstatedthathepreferredtochangethecurrentplan
atGeneralRe,eventhoughitwouldcostaboutabilliondollarsto
immediatelyvestthesubstantialbenefitsunderexistingplans.
Inevaluatingacompany’sprospects,aninvestorshouldlookinto
executivecompensationplans.Greedyexecutives
preferstockoptions
overotherformsofpayments.Giventheincentivestructurearisingfrom
theexistenceofstockoptions,managersaremorelikelytocarefortheirowninterests,potentiallyatsubstantialcosttotheshareholders.They
alsotendtocaremoreabouttheshortrunratherthanthelongrun;as
stockoptionsgenerallyhavealimitedtimetomaturity.
CEOsoftenabusethestock-optioncompensationsystem.David
Yermack,aprofessoroffinanceatNewYorkUniversity,findsthatthe
timingofstockoptionsfrequentlycoincideswithmovementsinacom-
pany’sstockprices.10Attheendof2007,165companieswereunder
investigationinawide-rangingfederalprobeofstock-optiongrantsand
practices.ItappearsthatCEOsfrequentlyreceive
stock-optionawards
shortlybeforefavorablecorporatenews.Thus,CEOsbenefit,butatthe
expenseofshareholders.Evidencealsosuggeststhatmanagers,generally
speaking,announcebadnewspriortooptiongrantdatesandgoodnews
after.11
Forexample,CendantCorporation’sstockpricedeclineddramat-
icallyduring1998formanyreasons,includinganaccountingscandal.
WhenCendant’sstockpricedropped,alargeportionofCEOHenry
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corporategovernance
Silverman’s25.8millionstockoptions,originallypricedbetween$17
and$31ashare,wererepricedto$9.81—wellunderthethen-current
Cendantstockpriceof$15pershare.Silvermanearned$63.9millionin
1998andhadabout$400millioninthepipeline.Itdidnotmattertohim
thatthestockpricedeclined.And,ofcourse,hewould
haveearneda
largesumifthestockpricehadgoneup.Wow!HeadsIwin,tailsyoulose.
Notonlydidshareholderssufferbecauseofthepricedecline;theysuf-
feredevenmorewhenthecompany’sexecutiveswerehandsomelypaid.
HowtoIdentifyGoodCEOsorOther
SeniorManagers
AtBerkshireannualmeetings,WarrenBuffettsometimesmentionsthat
hewouldforgoaprofitableopportunityifpursuingitmeantforginga
partnershipwithsomeone
whomhedidnottrust.Inotherwords,ifyou
aresuspiciousoftheCEO,youshouldnotinvestinthatcompany’sstock.
Wheninvestingforthelongrun,thequalityofmanagement—including
integrity—ismoreimportantthancurrentprofitability,becauseprof-
itabilitycan’tbesustainedifmanagementqualityispoor.HereareafewsignsofagoodCEO,basedonBuffett’sthoughts.
Firstandforemost,trackrecordmattersalot.Tothebestofmy
knowledge,allBerkshiresubsidiaryCEOshaveaproventrackrecordin
theirrespectivecompaniesorinthesameindustry.Buffettisunlikelytohireapersonfromoneindustrytorunacompanyinanotherindustry.
Thiscoincideswithhisprincipleofstayinginyourcircleofcompetence.
MaybethiswasonereasonwhyRobertNardelliwasnotsuccessfulat
HomeDepot.In2000,hebecameCEOofHomeDepotaftersuc-
cessfullyrunningGeneralElectric’sminesandlocomotivebusinesses,
butNardellilackedretailexperience.In2007,hewasaskedtoresign
fromHomeDepot—onlytobeappointedastheChrysler
CEOseveral
monthslater!In2009,whenChryslerfiledforbankruptcy,heagreedto
resignfromhispositionbytheendofthebankruptcycase.
Second,CEOcompensationshouldbeexaminedforabuse.Noth-
ingiswrongwithpayingCEOswell,buttopaythemexorbitantlymay
indicatealaxcorporategovernanceculture.AtHomeDepot,Nardelli’s
problemsprobablystartedwiththefactthathewasfromadifferent
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industrybutthathehadalsonegotiatedagenerouscompensationcon-
tract.Hehadaccesstoseveralcorporatejetsandotherexpensivebenefits,forwhichhewascriticized.Nardelli’scompensationwassowelldesigned
thatwhenheleftHomeDepot,hereceiveda$210millionseverance
package,despitepresidingovera40percentdeclineinthecompany’s
stockprice.HighlypaidCEOsalsocreateamoney-mindedculturein
theorganization.SuchCEOsdonotcommandrespectfromemploy-
ees,andwhencompaniesfallonhardtimes,theycannotpossiblylead
effectively.Suchorganizationsarenotlikely
todowellforshareholdersinthelongrun.
Third,aCEOshouldhaveaconceptualframeworkthatheorshecan
articulatewell.YoushouldlistencarefullytoaCEO’sanswersatpublic
meetingsorconferencecalls(allanalystconferencecallsarenowopen
tothepublic).Forexample,ifaCEOexpandsthecompanyintoanew
businessinwhichheorshelacksexpertise,howdoesheorsheexplain
thisdecision?Youshouldexaminetheexplanationcarefully.Buffettalso
paysattentionwhenCEOsforecastearnings:“Weare
suspiciousofthose
CEOswhoregularlyclaimtheydoknowthefuture—andwebecome
downrightincredulousiftheyconsistentlyreachtheirdeclaredtargets.
Managersthatalwayspromiseto‘makethenumbers’willatsomepoint
betemptedtomakeupthenumbers.”12Itmaynotbepossibletoavoid
allcompaniesthatmakeforecasts,becausemostdo.Butavoidinvesting
incompaniesforwhichCEOsclaimtoregularlyaccomplishseemingly
impossibletargets.
Fourth,youshouldreadthecompanychairman’sannualletters(fre-
quentlyco-signedbytheCEO)totheshareholdersfromseveralyears.
Iflettersgenerallyofferexcusesforweakresults,youshouldcertainly
besuspiciousofthequalityofthemanagement.Inmany
oftheselet-
ters,successisoftenattributedtomanagementefforts,butfailuresare
attributedtoexogenousreasons,suchastheweatherorChina’sproduct
dumping.Doyouwanttopartnerwithcompanymanagerswhohavea
habitofmakingexcusesandavoidingresponsibility?
Fifth,youshouldattendannualshareholdermeetings.Itgivesyoua
uniqueopportunitytoevaluatethecompany’smanagersbyexamining
theirresponsestoshareholderquestions.13Youmaynotlearnmoreabout
companyfinancialsastheyarealreadyreflectedincompanyfinancials.
However,yourobjectiveshouldbetolearnmoreaboutmanagement
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corporategovernance
attitudetowardshareholders,whichyoucertainlydointhesemeetings.
Youcandevelopasenseofwhetheryoutrustthemanagementornot.
BuffettandMungerhave
oftenemphasizedtheimportanceoftrustand
havementionedthattheywouldnotinvestinacompanyiftheydidnot
trustitsmanagement.Toshowhistrustinvariouscompanymanage-
ments,BuffetttransferredhisvotingrightsatdifferentpointsintimeinAmerican
Express,WashingtonPost,andSalomonInc.totheirrespectivemanagement.
Lastandprobablyoverarching,averyhighlevelofintegrityamong
companyemployeesandtheCEOisimportant.WhenBillGateswas
askedwhatheadmiredmostaboutWarrenBuffett,he
replied,“With
Warren,therearealotofthingsyoucouldpick,...hisintegrityis
anexamplefortheworld.”14AtvariousBerkshireannualshareholder
meetings,avideoclipofBuffett’s1991testimonytoCongressisshown
totheshareholderstoexplainthecompanyphilosophy.Atthetime,
BuffettwaschairmanoftheinvestmentbankingfirmSalomon,Inc.He
toldCongressthataletterwassenttoallSalomonemployeestoobey
alllawsandtobehaveasiftheywereneverashamedof
theiractions.
Buffettwrotetotheemployees,“LosemoneyforthefirmandIwill
beunderstanding;LoseashredofreputationforthefirmandIwillbe
ruthless.”15Clearly,moneyisimportantbutmoneyalonemustnotbe
themaindrivingforceforaCEO.Integrityismoreimportantforthe
long-termsurvivalofacompany.
Withsomethought,youshouldbeabletojudgethequalityand
integrityofacompany’sCEO.Thesesixpointsdonotbyanymeans
constituteanexhaustivelisttostudycompanymanagement.Forexam-
ple,IwouldratherinvestwithCEOswhodonotleadanextravagant
lifestyle.Iamnotclaimingthatidentifyingshareowner-orientedCEOs,
likeWarrenBuffett,iseasy.However,aninvestorshould
makesincere
effortsinthatdirection.Afterall,youonlyneedtofindafewoutstandingCEOstobesuccessfulinvestor.Itisindeedworththetrouble.
Conclusions
Asaninvestor,youshouldlookforcompaniesinwhichCEOsowna
significantinterestinthecompany’sstockanddonotreceiveexcessive
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compensationfromthecompany,especiallythroughstockoptions.If
thetopmanagementisowner-oriented,fairlycompensated,andhas
well-thought-outincentiveplans,theconsequencesarelikelytobetrans-
mitteddowntheranks.Allemployeesarethenmotivatedtoworkhard,
andthecompanywillprobablyproduceextraordinaryresults,justas
Berkshiredoes.
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Chapter30
LargeShareholders:
TheyAreYourFriends
WarrenBuffettowns26.91%
ofthesharesinBerkshireHathaway.
—BerkshireHathawayProxyStatement,2009
WarrenBuffettisthelargestBerkshireHathawayshareholder
andeffectivelycontrolsthecompany.Similarly,Wal-Mart
iscontrolledbytheWaltonfamily,CharlesSchwabInc.
is
controlledbyCharlesSchwab,AmericaOnline(AOL)wascontrolledby
SteveCaseforalongtime,StarbucksiscontrolledbyHowardSchultz,
Amazon.comiscontrolledbyJeffreyBezos,OracleiscontrolledbyLarry
Ellison,andDelliscontrolledbyMichaelDell.Allthesecompanies
performedverywellfor10to20yearsorlonger.
FounderControlMatters
Whileyoumayhavemissedjoiningthesuccessfulentrepreneursjust
listed,plentyofothersare
likelytocometoyourattentionifyoukeep
lookingforthem.Asaninvestor,youshouldinvestigatefamily-controlledorindividuallycontrolledcompaniesforpotentialinvestment—theyare
usuallywell-managedandfriendlytoshareholders,especiallywhenthe
foundingCEOisstillincharge.Inawell-knownstudy,RonAnderson
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corporategovernance
ofAmericanUniversityandDavidReebofTempleUniversityshow
that,amongallfirmsintheS&P500,familyfirmsperformbetterthannonfamilyfirms.1AdditionalresearchshowsthatwhenthefounderCEO
isincharge,performanceisevenbetter.Whymightthisbethecase?
AlthoughBuffettdidnotestablishBerkshireHathaway,hehasbeen
adirectorsince1965anditschairmanoftheboardsince1970,andso,
forallpracticalpurposes,heisthefounder.AsCEO,he
hasworkedhard
andmadealotofmoneyforBerkshire’sshareholders.Foraninvestor,
itisclearlyimportanttoconsiderwhetherthefirmwillcontinueto
dowellaftertheinitialsuccessunderafoundingCEO.Sincelong-term
successfulentrepreneursorfoundersareproudoftheiraccomplishments,
theyhaveastrongdesireforthefirmtocontinuetoperformwell.Itis
personalforthem.Justasmostpeoplewouldliketheirfamiliestobe
successful,theiruniversitiestobecomeprominent,and
theirchildrento
bethebesttheycanbe,thefounderofacompanywouldlikealongand
successfullifeforthefirm.
Apassionatemanagerorbusinessownerdoesnotbecomesatisfied
simplybecauseagoalisreached.Eachsuccesspaves
thewayforachievingbiggergoals.Asuccessfulhighschoolfootballcoachwantstobecomea
collegecoach,andsoon.Thus,youaretypicallyingoodhandswhen
youinvestwithsuccessfulentrepreneurs,evenifyouinvestwiththem
aftersomesuccesshas
alreadybeenreflectedinthestockprice.Ifyou
hadinvestedinWal-Martin1982,bywhichtimeithadbeenlistedfor
10yearsontheNewYorkStockExchange,youwouldhaveearned
phenomenalreturns—morethan1,000percentoverthenext10years.
Ofcourse,youshoulddoyourcompany-specificanalysisnomatterwhen
youinvest.
Duringthesecond,third,orfourthgeneration,afamily-controlled
companymaynotbeassuccessfulasitwasundertheoriginal
entrepreneur.MotorolaandHewlett-Packard,nowmorethantwo
generationsold,havefacedintermittenttroubles.Whilebotharestill
world-classcompanies,theirrecentperformanceshavenotequaledtheir
earlyperformances.Similarly,HenryFord’sand
E.I.DuPont’slegacies
ofentrepreneurshiphavenotbeenduplicated,eventhoughthefamilies
continuetomaintainsubstantialinterestinthesecompanies.Thus,asan
investor,youshouldinvestigatethecompanymorethoroughlywhenthe
foundingCEOisnolongerinfluential.
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IntheS&P500universe,manycompaniesarerunbytheirfounders.
AndersonandReebfoundthatfoundingfamiliesareinvolvedinabout
one-thirdoftheS&P500firmsandownabout18percentoftheout-
standingequityofthesecompanies.Keepinmind
thatthestockprices
ofthesecompaniesfluctuategreatly;theyarebidupveryhighinsome
yearsandpusheddownsubstantiallyinotheryears.Inpart,thishap-
pensbecauseowner-managersdonotpayasmuchattentiontothestock
pricesashiredmanagersdo.Butbythesamelogic,owner-managersare
alsonotlikelytoengageinearningsmanagementtomanipulatestock
prices.Overall,withotherfactorsheldconstant,youareunlikelytogo
wrongifyouinvestincompaniesrunbytheir
founders.
Acontrollinginterestisimportanttoanowner-orientedmanager
becauseheorshecannotbeinfluencedbycorporateraidersincasethe
stockpricegoesdown.Instead,heorshecanremainfocusedonthe
longrun.Ifso,acontrollinginterestinthehandsofoneorafewis
beneficialtoallshareholders.2Acontrollinginterestisoftenmaintainedbyadual-classstockstructureinwhichoneclassofshareshasahigher
votingpowerperunitofeconomicorcashflowrights.InBerkshire’s
case,classAstockhas30timestheeconomicinterestpershareofclass
Bstockbuthas200timesthevotingpower.Berkshirehasannounceda
50:1stocksplitforitsclassBshareseffectivefromayet-to-be-announceddatein2010.ClassAshareswillnotbesplit.BecauseWarrenBuffett
andCharlieMungertogethereffectivelyhaveacontrollinginterestin
thecompany,theydonotworryaboutanunfriendlytakeover.
GoogleInc.alsohasadual-classcommonstockstructure.CEOEric
Schmidt,SergeyBrin,andLarryPagetogetherhold
about22percent
oftheshares,buttheycontrolabout66percentofthevotingpower.
In2004,whenGooglewentpublicwithadual-classstructure,several
articlesinthepopularpresscriticizedthecompany.Investorswouldhaveearnedseveralhundredpercent
returnsinafewyearsiftheyhadignored
thecriticismandinvestedinGoogle’sstock.
Conclusions
Largeshareholdersinacompanyarelikelytomonitorthecompany’s
managementinawaythatisnotpossiblewhenthe
shareholdingis
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moredispersed.Similarly,
CEOswithlargeshareholdingsarelikelytobe
shareholderfriendly.UnlessWarrenBuffettdecidestorunforapoliticaloffice,yourmoneyisgenerallysaferinhishands,orinthehandsofotherentrepreneur-owner-managers,thanwiththehiredmanagerswhorun
thevastmajorityofothercompanies.
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Conclusion
B=Baseball=Buffett
WarrenBuffettfrequentlyusessportsanalogiestoexplain
thegameofinvesting.Inthisconclusion,IfollowBuffett’s
refreshingsimilebetweensportsandinvestingtoexplain
thekeyfeaturesforsuccessininvesting.Intheappendixthatfollowsthischapter,Ipresentashortsummaryofthebook.
Whenweplaybaseball—or,really,anysport—whatmotivatesus?
Whataboutwhenweplaybridge?Whatmotivatesusthen?Istherea
singlemostimportantprinciplethatmakesusbetteratanygame,includ-
ingthegameofinvesting?IfIhavetopointtoasinglecharacteristic,Iwouldsaythatthesurvivalinstinct,whichhasbeenthoroughlyexplained
inTheSelfishGeneandearlierinTheOriginofSpecies,leadsplayerstovictorymorethananythingelse.1Thesurvivalinstinctcanbethoughtof
asthemind-settowin.Onceweseeagamewiththiswinningmind-set,
therestofourbehaviorfollowsnaturallytoputusinthebestpossible
positiontoemergevictorious.
Don’tLoseMoney
Themind-settowinistheoverarchingprinciplethatappliestolife,
sports,andinvesting.Otherrulesaregenerallyderivativesofthisfundamentalnotion.Let’sstartwithbaseball.Everyone
hasbeentold,“Keep
youreyesontheball.”Ifyourobjectiveistowinthegameandyouhave
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conclusion
completelyinternalizedtheideathatyouwanttowin,thenyourmind
shutsoutotherthoughts,andyouseetheballasclearlyaspossible.Youautomaticallykeepyoureyesontheball.Yourbodynaturallyreactsin
acoordinatedmotionthatmaysurpriseyou.Thisisbecauseyouhave
developedamind-settowin.Furthermore,supposeyouloseagameby
hittingaflyballthatiscaughtjustshortofthefence,andyourealizethatyoulostbecauseyoulackedthephysicalstrengthtodrivetheballoutofthepark.Ifyou
haveinternalizedthefundamentalprinciple,youwillbe
motivatedtogotothegymandaddthenecessarymuscle.
Let’sapplythesameideastowinninginthestockmarket.Sincethe
stockmarketisallaboutmoney,youwinbyearning
goodreturnson
yourinvestments.Attheveryleast,youdon’twanttolosethemoney
youoriginallyinvested,theprincipal.Buffettputsitslightlydifferently,butthephilosophyisthesame.Hesays,“Rulenumber1:Don’tlose
money.”2
Thinkingintermsofnotlosingandwinningatthesametimegivesrisetomostoftheideasthathavebeendiscussedinthisbook.Whenyouplan
toinvest,youshouldlookatBuffett’sruleonnotlosingmoneyandask
thequestion,“WhatarethechancesthatIwilllosemoney?”Bytryingto
decidetheprobabilityoflosing,youareautomaticallybeginningtothinkintermsofvalueinvesting,ataverybasiclevel.Ifyoufindthatyouarestilllosingbecauseyoudon’tknowenoughaboutvalueinvesting,youwill
bemotivatedtolearnmore.Later,towinbigorearnveryhighreturns,
youwillstarttotakeaharder
lookatthegrowthpotentialofcompanies
andeventuallygrasptheprinciplesofgrowthinvesting.Atthispoint,byfollowingthetwoprinciplesofbeingcarefulnottoloseandtryingto
win,youwilllearntocombinevalueinvestingwithgrowthinvestingas
Ihavediscussedinthisbook.ThisiswhatIcallBuffettinvesting.
Onceyoudevelopthemind-settowin,yoursubconsciouswillguide
youtootherrulesforyoursuccess.Youmayindeedproducesuper-
sizereturnsjustasWarrenBuffetthas.Buffettdoesnot
simplypractice
valueplusgrowthinvestingbuthasalargerepertoire.Heparticipatesinthemarketthroughjudicioususeoffinancialproductssuchasoptions,
futures,andswaps.Healsomanagesoneofthelargestcompaniesin
theworldwithoperationsin
theinsurance,retail,manufacturing,util-
ities,andfinancialservicessectors.Hehasdevelopedapsychological
bentthatallowshimtolookatmarketmovementsobjectively.Forall
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thesereasons,Icallhimarenaissanceinvestor.Perhapsthatshouldbe
yourfinalgoal:tobecomearenaissanceinvestor.Thegoodthingisthat
winninginthegameofinvestingdoesnotrequireahighIQormagical
mantras.Overall,onceyoudecideyouwanttosucceed,youwill.
StayinYourCircleofCompetence
Inthecontextofmind-settowin,onequestionhasalwaysappealedto
me:“HowdoyoubeatworldchesschampionBobbyFischer?”3Yes,it
isabitofatrickquestion.IfyouwanttobeatBobbyFischer,youdon’tplaychesswithhim.Youfindagamethatyoucanwin.Pickingupthe
baseballanalogy,assumethatdespiteallyourefforts,youstillcan’thit.
Thenyouareplayingthewronggame.Youshouldfindanewgame,a
gamethatyoucanwin.Ifyouaretall,maybeyoushouldtrybasketball;
ifyouhavegoodendurance,maybeyoushouldrunamarathon.
Findingtherightgameisextremelyrelevantto
investing.Ifthehigh-
techindustryisnotwhereyoucanwin,thendon’tinvestinit.Buffett
doesnotinvestinhigh-tech.Findanindustrywhereyoucanwin,and
investthere.Ifyoucan’tfigureouthowacompanywillprobablyshape
upin10years,don’tinvestinit;findacompanythatyouunderstandso
youcanprojectitslikelyfuture.Youdon’thavetoplayeverysport,andyoudon’thavetohaveanopiniononeverystock.Inotherwords,the
fundamentalprinciplewillkeepyouinsideyourcircleofcompetence,an
investingrulethatBuffetthasoftendiscussed.InthebookletBatting,BabeRuthwroteasimpleruleforwinninginbaseball:“Learnnottoswing
atbadballs.”Similarly,youshouldinvestonlywhenyouunderstandthe
companyandonlywhenthemarketpriceisfavorableinrelationtothe
stock’sintrinsicvalue.Itisimportanttobepatient.Youwaitandwaitandwaitforafatpitchoragoodstock,andwhenitcomes,youswingaway.
FindGoodPeople
Insports,managersmakekeydecisions,suchaswhichprospectstodraft
andwhichcoachestohire.
Effectively,high-qualitymanagementisa
prerequisitetosuccess—asMichaelLewisshowsinhisstoryofthegen-
eralmanagerBillyBeaneandhishighlysuccessfulbaseballteamOakland
E1BOTH
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280
conclusion
A’s,despitelimitedfinancialresourcesinMoneyball.4Thesameistrueininvesting.Buffetthasemphasizedtheimportanceofmanagementcompetenceandintegrityaboveothermetricsinexplaininghissuccess.If
youwanttowininthegameofinvesting,youshouldlookformanagers
whohaveproventobeoutstandingatrunningcompanies.Berkshire
HathawayisonesuchcompanyIfound.Whenyoufindoutstanding
peoplelikeBuffett,buysharesintheircompanies.If
theyheadupmoney
managementfirms,investwiththem.Goodluck!
E1BAPP
Date:Jan19,2010
Time:9:36am
Appendix
ASummaryoftheBook
WarrenBuffettisageniusinthesameleagueasBenjamin
Franklin,ErnestHemingway,andHenryFord.Theirideas
aresimpletounderstand,buttheirsuccessesaredifficult
toduplicate.However,geniusesabidebycertainprinciplesthatwecan
learnfrom.Inthisbook,IhavetriedtoexplaintheprinciplesthatI
believeBuffettfollows.Thisappendixprovidesasuccinctsummary.
TableA.1
SummaryofWarrenBuffett’sInvestmentPrinciples
Principle
Explanation
(i)DevelopaMind-SettoWin
Youplayagamebecauseit’s
funandeven
exhilaratingwhenyouwin.Youwillwin
oftenwhenyouplaytoyourstrengths.In
thestockmarketgame,thismeansstaying
withinyourcircleofcompetence.
(ii)StickwithValueInvesting
Examinehistoricalrecords,price-to-
earningsratios(P/E),andotherfinancial
measures.
(iii)CombineGrowthInvesting
Managementwithintegrityand
withValueInvesting
competenceisthekeytogrowth.Make
surethequalityofacompany’s
managementisoutstanding.
(continued)
281
E1BAPP
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282
appendix
TableA.1
Continued
Principle
Explanation
(iv)MaintainLowRisk
Lowdebtlevel.Reread(ii).Learnsome
accountingtolookforpossiblehidden
risks.
(v)ActRationally
Knowledgeisthebestantidoteto
irrationality.Knowthecompany’s
business,andprojectwhatthecompany
willlooklikein10years.
(vi)DoNotPayaHighPrice
Estimateacompany’sintrinsicvalueby
learningaboutthecompany’sbusiness.
Investonlywhenthepriceislow
comparedwiththeintrinsicvalue.
(vii)FindGoodPeople
Trytofindandinvestwithoutstanding
peoplelikeWarrenBuffett;theytreatthe
shareholders’interestsastheirown.
E1BNOTES
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Notes
Preface
1.WarrenE.Buffett,“UptheInefficientMarket,”Barron’s(February25,1985),11.
2.“Billionaires2008,”Forbes(March24,2008),80.
3.BerkshireHathawayAnnualReport1996,16.
4.ThereareatleasttwoexcellentBuffettbiographies:RogerLowenstein,Buffett:TheMakingofanAmericanCapitalist(NewYork:RandomHouseTradePaperbacks,2008),andAliceSchroeder,TheSnowball:WarrenBuffettandtheBusinessofLife(NewYork:BantamBooks,2008).
Chapter1TheThrillof
InvestinginCommonStocks
1.RogerLowenstein,Buffett:TheMakingofanAmericanCapitalist,20.
2.“Mr.Market”isafictitiouscharactercreatedbyBenjaminGrahamtorepresentmarketindicesandhasoftenbeendiscussedbyWarrenBuffett.SeeBenjaminGraham,The
IntelligentInvestor(NewYork:HarperCollinsPublishers,1996,originallypublishedbyHarper&Rowin1973),108.
3.PeterLynchwithJohnRothchild,BeatingtheStreet(NewYork:SimonandSchuster,1993),20.
4.WarrenE.Buffett,“BuyAmerican,Iam.”NewYorkTimes(October17,2008,Op-
ed).
5.LaurenC.TempletonandScottPhilips,InvestingtheTempletonWay(NewYork:McGraw-Hill,2008),x.
283
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284
notes
Chapter21965–2009:LessonsfromSignificantEventsinBerkshire
History
1.BerkshireHathawayAnnualReport1980,7.
2.BerkshireHathaway
AnnualReport1984,12.
3.BerkshireHathawayAnnualReport1985,8.
4.Ibid.,9.
5.BerkshireHathawayAnnualReport1986,18.
6.BenjaminFranklin,AutobiographyofBenjaminFranklin(NewYork:SimonandSchuster,1993),28.
7.BerkshireHathawayAnnualReport1988,13.
8.Ibid.
9.BerkshireHathawayAnnualReport1989,16.
10.Ibid.,14.
11.Ibid.
12.BerkshireHathawayAnnualReport1990,17.
13.Ibid.
14.BerkshireHathawayAnnualReport2008,5.
15.BerkshireHathawayAnnualReport1991,17.
16.Ibid.
17.BerkshireHathawayAnnualReport1992,20.
18.BerkshireHathaway
AnnualReport1993,19.
19.BerkshireHathawayAnnualReport1994,8.
20.Ibid.
21.BerkshireHathawayAnnualReport1995,7.
22.Ibid.,6.
23.Ibid.,10.
24.Ibid.,6.
25.Ibid.
26.BerkshireHathawayAnnualReport1997,5.
27.Ibid.
28.BerkshireHathawayAnnualReport1999,3.
29.BerkshireHathawayAnnualReport2000,3.
30.BerkshireHathawayAnnualReport2001,61.
31.BerkshireHathawayAnnualReport2002,15.
32.BerkshireHathawayAnnualReport2008,3.
Chapter3ValueInvesting—It’sLikeBuyingChristmasCardsinJanuary
1.BerkshireHathawayAnnualReport1985,19.
2.BenjaminGraham,TheIntelligentInvestor(4thed.)(NewYork:HarperCollins,originallypublishedbyHarper&Rowin1973),54.
3.Ibid.
E1BNOTES
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Notes
285
4.DataareobtainedfromProfessorRobertShiller’sWebsiteatYaleUniversity.
Thesedataareupdatedfrequently.
5.JohnNeff,JohnNeffon
Investing,withS.L.Mintz(NewYork:JohnWiley&Sons,1999),122.
6.BerkshireHathawayAnnualReport1985,19.
7.BerkshireHathawayAnnualReport2008,5.
8.Ibid.,280.
9.WarrenBuffett,“TheSuperinvestorsofGraham-
and-Doddsville,”inGraham,1973,appendix.
10.Graham,82.
11.JosefLakonishok,AndreiShleifer,andRobertW.Vishny,“Contrarian
Investment,Extrapolation,andRisk,”JournalofFinance(1994):1541–
1578.
12.BenjaminGrahamdiscussesglamour-typestocksinTheIntelligentInvestoronpage182.Hepointsoutthatintheshortrun,glamourstocksmaydowellandcommon-stockinvestmentpolicymustdependontheindividualinvestor.
13.EugeneFamaandKennethFrench,“TheCross-sectionofExpectedStock
Returns,”JournalofFinance(1992):427–466.
14.DavidDreman,ContrarianInvestmentStrategies:TheNextGeneration(NewYork:SimonandSchuster,1998).
15.Ibid.,61.
16.Forthisanalysis,thevalueportfolioiscomposedofthestocksinthetwo
deciles(i.e.,about20percentofthetotalnumberofstocks)withthesmallestmarket-to-bookratio,whiletheglamourportfolioiscomposedofthecorrespondinglargestmarket-to-bookratiostocks.
17.LouisK.C.ChanandJosefLakonishok,“ValueandGrowthInvesting:ReviewandUpdate,”FinancialAnalystsJournal(2004):71-86.
Chapter4GrowthInvesting
1.PhilipA.Fisher,CommonStocksandUncommonProfits(NewYork:JohnWiley
&Sons,1996),15.
2.BenjaminGraham,TheIntelligentInvestor(4thed.)(NewYork:HarperCollins,originallypublishedby
Harper&Rowin1973),57.
3.Wal-Mart’sWebsite,www.walmart.com.
4.JayR.RitterandIvoWelch,“AReviewofIPOActivity,Pricing,andAllocations,”JournalofFinance(2002):1795–1828.Forresultsonrecentyears,seeupdatesbyJayRitterattheUniversityofFloridaWebsite.
5.SamWalton,MadeinAmerica,withJohnHuey(NewYork:BantamBooks,1993).
6.MichaelDell,DirectfromDell:StrategiesThatRevolutionalizedanIndustry,withCatherineFreidman(NewYork:HarperCollins,1999).
E1BNOTES
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286
notes
7.ClaytonM.Christensen,TheInnovator’sDilemma:WhenNewTechnologiesCauseGreatFirmstoFail(Boston:HarvardBusinessSchoolPress,1997).
8.Fisher,35.
Chapter5IntrinsicValue
1.BenjaminGrahamandDavidDodd,SecurityAnalysis(NewYork:McGraw-Hill,1934),17.
2.BerkshireHathawayAnnualReport1999,60.
3.WescoFinancialCorporationAnnualReport
2008,7.
4.MyronJ.Gordon,TheInvestmentFinancingandValuationoftheCorporation(Homewood,IL:RichardD.Irwin,1962).
5.BerkshireHathawayAnnualReport2008,5.
6.Theassumptionofagrowthratesmallerthanthediscountrateimpliesthat
Berkshiremaysellsomesharestoinvestinwhollyownedsubsidiariesthatgenerateearningsorthatthestockmarketgrowthrateinthecoming10yearswillbeabout5.5percentplusdividends.
Chapter6BuffettInvesting=Value+Growth
1.BerkshireHathawayAnnualReport1992,13.
2.GeraldS.MartinandJohnPuthenpurackal,“ImitationIstheSincerestFormofFlattery:WarrenBuffettandBerkshireHathaway,”AmericanUniversity
workingpaper,April2009.
3.Buffett’slettertohispartnersinBuffettPartnership,October9,1967.
4.BerkshireHathaway
AnnualReport2008,7.
5.ColumbiaUniversity,“WarrenEdwardBuffett,”http://c250.columbia.edu/
c250celebrates/remarkablecolumbians/warrenedwardbuffett.html.
6.BerkshireHathawayAnnualReport1996,6.
7.BerkshireHathaway
AnnualReport1998,49.
8.BerkshireHathawayAnnualReport1999,9.
9.BerkshireHathawayAnnualReport2007,14.
10.BerkshireHathawayAnnualReport1999,5.
11.In1999,thepretaxoperatingprofitsof$225milliononrevenuesrepresent
a12percentmarginonrevenuesanda12.5percentreturnonidentifiableassets.
Thiscertainlyseemssatisfactory.
12.FortunepublishedacoverstoryonBYD,“Buffett’sElectricCar,”April27,2009,pp.44–60.
13.CharlieMungerhashadaconsiderableinfluenceon
Buffett,especiallyinthinkingaboutgrowthinvesting.Mungerwasalsothemainpersoninconvincing
BuffetttoinvestinBYD.Thus,thisstyleofcombiningvalueinvestingwithgrowthinvestingmayalsobecalledBuffett-Mungerinvesting.
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Notes
287
Chapter7Insurance:OtherPeople’sMoney
1.BerkshireHathawayAnnualReport1999,6.
2.BerkshireHathawayAnnualReport1995,9.
3.BerkshireHathawayAnnualReport2008,8.
4.BerkshireHathawayAnnualReport1998,6.
5.BerkshireHathawayAnnualReport1967,2.
6.CharlieMunger,“LetterfromtheChairmanandthe
PresidentofBlueChipStamps,1981,”inBerkshireHathawayAnnualReport1981,47.
7.CharlieMunger,“LetterfromtheChairmanandthePresidentofBlueChipStamps,1982,”inBerkshireHathawayAnnualReport1982,59.
Chapter8Reinsurance:MoreofOtherPeople’s
Money
1.BerkshireHathawayAnnualReport1998,9.
2.Ibid.,10.
3.BerkshireHathawayAnnualReport2008,8.
4.Ibid.,9.
5.BerkshireHathawayAnnualReport1996,8.
6.BerkshireHathawayAnnualReport2002,8.
Chapter9TaxDeferment:Interest-FreeLoansfromtheGovernment
1.WescoFinancialCorporationAnnualReport2000,6.
2.BerkshireHathawayAnnualReport1989,6.
Chapter10IfYouDon’tKnowJewelry,KnowYourJeweler
1.BerkshireHathawayAnnualReport1989,6.
2.BerkshireHathawayAnnualReport1990,8.
3.BerkshireHathawayAnnualReport1989,9.
4.BerkshireHathaway
AnnualReport1995,7.
5.BarnettC.Helzberg,WhatILearnedbeforeISoldtoWarrenBuffett(Hoboken,NJ:JohnWiley&Sons,1993),xx.
6.Ibid.,xvii.
Chapter11CompeteLikeMrs.B
1.BerkshireHathaway
AnnualReport2000,11.
2.BerkshireHathawayAnnualReport1983,3.
3.ThisMrs.BquoteisfromNebraskaFurnitureMart’swebsite,www.nfm.com/
ourstoryhistory.aspx?ID=1a.
4.BerkshireHathawayAnnualReport1996,20.
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notes
5.PeterLynchwithJohnRothchild,OneUponWallStreet(NewYork:PenguinBooks,1989),123.
6.BerkshireHathawayAnnualReport1995,8.
7.Ibid.,9.
8.BerkshireHathawayAnnualReport1997,13.
9.BerkshireHathawayAnnualReport1999,11.
10.WescoFinancialCorporationAnnualReport2008,14.
Chapter12WhyInvestinUtilityCompanies?
1.BerkshireHathawayAnnualReport1989,6.
2.MidAmericanEnergypressrelease,October25,1999.
3.Ibid.
4.BerkshireHathawayAnnualReport1999,11.
5.AMidAmericansubsidiary,HomeServices(previouslyHomeServices.com),isacollectionofmanysmalllocalrealestatefirmsandhasgrownsteadily.Interestingly,itsphilosophyofkeepingtheindividualunitsindependentissimilartoBerkshire’smodelforitssubsidiaries.IownedsharesinHomeServices.combeforeitwasacquired.
6.Imadesomeadjustmentstothereportedaccountingnumbersforthemtobecomparableacrossyears.Forexample,IdonotincludegainsfrominvestmentinConstellationEnergyandthebreak-upfeeasexplainedintheBerkshireHathaway2008annualreport.
Chapter13HighProfitsinHonest-to-Goodness
ManufacturingCompanies
1.BerkshireHathawayAnnualReport1994,8.
2.SinceShawIndustrieswasacquiredafterthebeginningof2001,someofthenumbersfortheyear2001inthetablehavebeenadjustedslightlytomakethemcomparablefortheotherfull-yearnumbers.
3.TribuneBusinessNews,
July21,2006.
4.LorraineD.Miller,“ScoringtheBoardCompanyProfile,”Flooring(August1,1977).
Chapter14RiskandVolatility:HowtoThinkProfitably
aboutThem
1.BerkshireHathaway
AnnualReport1993,14.
2.SeethepreviouslymentionedarticleinChapter3byEugeneFamaand
KennethFrench(1992)andadditionalinsightbyS.P.Kothari,JayShanken,andRichardSloan,“AnotherLookattheCross-SectionofExpectedReturns,”
JournalofFinance(1995):
185–224.
E1BNOTES
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Notes
289
3.TheOrangeCountyexampleisnotunique.In
March2008,JeffersonCounty,Alabama,failedtoproduce$200millionincollateralforitsswaps.SeeWallStreetJournalonlineedition,March22,2008.
4.BerkshireHathawayAnnualReport(10-K)1999,18.
5.BerkshireHathawayAnnualReport1993,15.
6.RobertJ.Shiller,MarketVolatility(Cambridge,MA:TheMITPress,1999).
7.Forbes,“TheMoneyMen,”November1,1974,pp.41-42.
8.BerkshireHathawayAnnualReport1985,19.
9.BerkshireHathawayAnnualReport1993,15.
10.Ibid.
Chapter15WhyHoldCash:LiquidityBringsOpportunities
1.BerkshireHathawayAnnualReport1990,19.
2.MorganStanleyEquityResearchReportonInsurance-PropertyandCasualty,NewYork,WorldTradeCenterSpecialIssue,
September17,2001.
3.AsreportedinapressreleasebyWrigleyonApril28,2008,availableonWrigley.com.
Chapter16Diversification:HowManyBasketsShouldYouHold?
1.SeeChapter13inStephenA.Ross,RandolphW.Westerfield,andBradfordD.
Jordan,FundamentalsofCorporateFinance(NewYork:McGraw-HillIrwin,2006).Foradetailedacademicdiscussionofthistopic,seeEugeneFama,
FoundationsofFinance(NewYork:BasicBooks,1976).
2.ForthispurposeIassumedatypicalstocktohaveacovarianceof0.18withother
stocks.Thisistypicalofanexchangetradedstock.
3.BenjaminGraham,TheIntelligentInvestor(4thed.)(NewYork:HarperCollins,originallypublishedbyHarper&Rowin1973),54.
4.PhilipA.Fisher,CommonStocksandUncommonProfits(NewYork:JohnWiley
&Sons,1996),108.
5.PeterLynchwithJohnRothchild,OneUponWallStreet(NewYork:PenguinBooks,1989),242.
6.Ibid.
7.Ibid.,150.
Chapter17WhentoSell
1.BerkshireHathaway
AnnualReport1996,16.
2.BerkshireHathawayAnnualReport1988,13.
3.BerkshireHathawayAnnualReport1997,15.
4.BerkshireHathawayAnnualReport1998,12.
5.See,forexample,WashingtonPost,October31,2007.
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notes
Chapter18HowEfficientIstheStockMarket?
1.BerkshireHathaway
AnnualReport1988,18.
2.SeeHemangDesaiandPremC.Jain,“AnAnalysisoftheRecommendations
ofthe‘Superstar’MoneyManagersatBarron’sAnnualRoundtable,”JournalofFinance(1995):1257–1273.Inthisarticle,weshowthateventhestockrecommendationspublishedinBarron’sbytheso-called
superstarmoneymanagersdonotproduceexcessreturns.
3.Forasummaryofthisresearch,seeAndreiShleifer,InefficientMarkets(OxfordUniversityPress,2000).
4.AndrewW.LoandA.CraigMacKinlay,“ANon-RandomWalkDownWall
Street”(Princeton,NJ:PrincetonUniversityPress,
2001).
5.Severalpapersinrecentyearstrytoexplaindeviationofpricesfromfundamentals.Forarecentpaper,seeHenkBerkman,ValentinDimitrov,PremC.Jain,PaulKoch,andSheriTice,“SellontheNews:DifferencesofOpinion,Short-SalesConstraints,andReturnsAroundEarningsAnnouncements,”Journalof
FinancialEconomics92(June2009):376–399.
6.See,forexample,HemangDesaiandPremC.Jain,“FirmPerformanceand
Focus:Long-runStockMarketPerformanceFollowingSpinoffs,”JournalofFinancialEconomics(October1999):75–101.AlsoseeHemangDesaiandPremC.Jain,“Long-Run
CommonStockReturnsfollowingStockSplits
andReverseSplits,”JournalofBusiness(1977):409-433.
7.NarasimhanJegadeeshandSheridanTitman,“Cross-SectionalandTime-
SeriesDeterminantsofMomentumReturns,”ReviewofFinancialStudies15
(2002):143–157.
8.WernerDeBondtandRichardThaler,“FurtherEvidenceonInvestorOverreactionandStockMarketSeasonality,”JournalofFinance42(July1987):557–581.
SeveralothersimilarpapersareexplainedinRichardThaler,AdvancesinBehavioralFinance,Volume
II(Princeton,NJ:PrincetonUniversityPress,2005).
9.LouisChan,NarasimhanJegadeesh,andJosefLakonishok,“MomentumStrategies,”JournalofFinance51(December1996):1681-1713.
10.BerkshireHathawayAnnualReport1988,18.
Chapter19Arbitrageand
HedgeFunds
1.BerkshireHathawayAnnualReport1989,16.
2.BerkshireHathawayAnnualReport1988,15.
3.Foradetailedaccount,seeRogerLowenstein,WhenGeniusFailed:TheRiseandFallofLong-TermCapitalManagement(NewYork:RandomHouseTrade
Paperbacks,2001).
4.BurtonG.MalkielandAtanuSaha,“HedgeFunds:RiskandReturn,”FinancialAnalystsJournal(2005):80–88.
5.AndrewW.Lo,HedgeFunds:AnAnalyticPerspective(Princeton,NJ:PrincetonUniversityPress,2008).
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291
6.LudovicPhalippouandOliverGottschalg,“ThePerformanceofPrivateEquityFunds,”Reviewof
FinancialStudies22(2009):1747-1776.
7.SteveKaplanandAntoinetteSchoar,“PrivateEquityPerformance:Returns,PersistenceandCapital,”JournalofFinance60(August2005):1791–1823.
Chapter20:M=Monopoly=Money
1.BerkshireHathaway
AnnualReport2001,61.
2.Whileitistemptingtocomparethetwocompaniesusingreturnonequity(ROE),IdonotdosobecausebothMicrosoftandIBMrepurchasedsignificantamountsofcommonstockinrecentyears.ThesetransactionsmadebookvaluesofequityverysmallandROEcomparisonsmeaningless.Thisalsoshows
thatmindlesscomparisonoffinancialratiosmaynotyieldusefulresults.
3.AninsightfulhistoryofBuffaloNewsispresentedbyMurrayB.LightinFromButlertoBuffett:TheStoryBehindtheBuffaloNews(PrometheusBooks,2004).
Intheforewordtothebook,BuffettdescribesMurrayLighttobeabril-
liantandtirelesseditorwhosuccessfullypulledoffaSundayeditionofthenewspaper.
4.BerkshireHathawayAnnualReport1981,46.
5.PeterLynchwithJohnRothchild,OneUponWallStreet(NewYork:PenguinBooks,1989),266.
Chapter21WhoWinsin
HighlyCompetitiveIndustries?
1.BerkshireHathawayAnnualReport1999,8.
2.Buffettexplainedthispointinaquestion–answersessionatColumbiaUniversityonNovember12,2009.Hesaid,“TheBurlingtonNorthernlastyear
moved...atonoffreight
470milesononegallonofdiesel.Thatisfar,farmoreefficientthanwhattakesplaceoverthehighways.I’mwillingtobet...
onthefactthat10yearsfromnow,20yearsfromnow,50yearsfromnow,therewillbemoregoodsbeingmovedbyrailanditwillbebetterforthecountryandfortheshareholders.”Thetranscriptisavailableon
www.cnbc.com.
3.BerkshireHathawayAnnualReport2008,6.
Chapter22Property,Plant,andEquipment:GoodorBad?
1.WescoFinancialCorporationannualmeeting,May9,2007.
2.NetPPEandtotalassetsas
ofSeptember28,1963,were$12.8millionand$39.5million,respectively.
3.BerkshireHathawayAnnualReport1989,21.
Chapter23KeytoSuccess:ROEandOtherRatios
1.SeeBenjaminGraham,DavidL.Dodd,andSidneyCottle(4thed.),SecurityAnalysis(NewYork:
McGraw-Hill,1962),231.
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notes
2.Ibid.,464.
3.Probablythemostwell-
knownaccountingresearchpaperthatinfluencedthewayhedgefundsinvestinlong-shortstrategiesisRichardG.Sloan’s“DoStockPricesFullyReflectInformationinAccrualsandCashFlowsaboutFuture
Earnings?”AccountingReview(1996):289–315.
4.BerkshireHathawayAnnualReport1992,17.
5.WorldCom8-K,SecuritiesandExchangeCommission,Washington,DC,August8,2002.
Chapter24AccountingGoodwill:IsItAnyGood?
1.BerkshireHathawayAnnualReport1983,4.
2.BerkshireHathawayAnnualReport1996,66.
Chapter25HowMuchPsychologyShouldYouKnow?
1.L.J.Davis,“BuffettTakesStock,”NewYorkTimes,April1,1990.
2.PeterLynchwithJohnRothchild,OneUponWallStreet(NewYork:PenguinBooks,1989),155.
3.BenjaminGraham,
IntelligentInvestor(4thed.)(NewYork:HarperCollins,originallypublishedbyHarper&Rowin1973),94.
4.GeorgeSoros,TheAlchemyofFinance(NewYork:JohnWiley&Sons,1987).
5.GeorgeA.AkerlofandRobertJ.Shiller,AnimalSpirits(Princeton,NJ:PrincetonUniversityPress,
2009).AlsoseeHershShefrin,BeyondGreedandFear(NewYork:OxfordUniversityPress,2002).
6.TerranceOdean,“AreInvestorsReluctanttoRealizeTheirLosses?”JournalofFinance53,no.5(October1998):1775–1798.
7.BradBarberandTerranceOdean,“TradingIsHazardoustoYourWealth:
TheCommonStockInvestmentPerformanceofIndividualInvestors,”JournalofFinance55,no.2(April2000):773–806.
8.PremC.JainandJoannaShuangWu,“TruthinMutualFundAdvertising:
EvidenceonFuturePerformanceandFundFlows,”JournalofFinance66,no.2
(April2000):937–958.
9.Forfurtherreadings,seeMichaelJ.Mauboussin,MoreThanYouKnow:FindingFinancialWisdominUnconventionalPlaces(NewYork,NY:ColumbiaBusinessSchoolPublishing,2008).CharlieMungerhasoftenconvincinglyarguedtheimportanceofpsychologyinhisdialoguesattheBerkshireandWescoannual
meetings.HehasalsorecommendedbooksbyRobertB.Cialdini.Ihave
benefitedfromhisrecommendationsandhistalks.SeveralofMunger’sverywell-articulatedtalksandthoughtsarepublishedinPoorCharlie’sAlmanack:TheWitandWisdomofCharlesT.Munger,editedbyPeterD.Kaufman(Marceline,MO:Walsworth
PublishingCompany,2008).
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293
Chapter26HowtoLearnfromMistakes
1.BerkshireHathawayShareholders’annualmeeting,2005.
2.TomDowdell,SureshGovindaraj,andPremJain,“TheTylenolIncident,EnsuingRegulations,andStockPrices,”JournalofFinancialandQuantitativeAnalysis(1992):283–301.
3.MichaelJ.Mauboussin,ThinkTwice:Harnessingthe
PowerofCounterintuition(Boston,MA:HarvardBusinessPress,2009).
4.RichardH.ThalerandCassR.Sustein,Nudge:ImprovingDecisionsAboutHealth,WealthandHappiness(NewHaven,CT:YaleUniversityPress,2008).Theauthorsarguethatitissometimeshelpfultomakemistakes,sincethatishowwelearn.
Chapter27Dividends:DoTheyMakeSenseinThisDayandAge?
1.MertonMillerandFrancoModigliani,“DividendPolicy,Growth,andthe
ValuationofShares,”JournalofBusiness(1961):411–433.
2.FischerBlack,“TheDividendPuzzle,”Journalof
PortfolioManagement2(Winter1976):72–77.
Chapter28ShouldYouInvestinCompaniesThatRepurchaseTheir
OwnShares?
1.BerkshireHathawayAnnualReport1984,5.
2.AmyK.Dittmar,“WhyDoFirmsRepurchaseStock?”
JournalofBusiness(2000):331–355.Forlong-runperformancefollowingrepurchases,seeDavidIkenberry,JosephLakonishok,andTheoVermaelen,“MarketUnderreaction
toOpenMarketShareRepurchases,”JournalofFinancialEconomics39(1995):181–208.
3.BerkshireHathawayAnnualReport1984,5.
4.Ibid.,6.
5.Ibid.
6.BerkshireHathawayAnnualReport1999,16.
7.Ibid.,17.
Chapter29CorporateGovernance:Employees,
Directors,andCEOs
1.BerkshireHathawayAnnualReport1996,10.
2.Ibid.
3.BerkshireHathawayAnnualReport1994,10.
4.PaulM.Healy,“TheEffectofBonusSchemesonAccountingDecisions,”
JournalofAccountingandEconomics(1985):85–107.
5.Ibid.
6.BerkshireHathawayAnnualReport2006,18.
7.BerkshireHathawayAnnualReport2008,89.
E1BNOTES
Date:Jan20,2010
Time:3:35pm
294
notes
8.BerkshireHathawayAnnualReport1998,14.
9.Academicresearchevidencealsodoesnotsuggestthatstockoptionsimprovecompanyprofitssignificantly.SeeDavid
Larcker,“DiscussionofAreExecutiveStockOptionsAssociatedwithFutureEarnings?”JournalofAccountingandEconomics36(2003):91–103.
10.DavidYermack,“GoodTiming:CEOOptionAwardsandCompanyNews
Announcements,”JournalofFinance(1977):449–476.
11.DavidAboodyandRonKasznik,“CEOStockOptionAwardsandtheTiming
ofCorporateVoluntaryDisclosures,”JournalofAccountingandEconomics29
(2000):73–100.
12.BerkshireHathawayAnnualReport2002,21.
13.RandyCepuchdescribeshisexperiencesfromattendingalargenumberofannualshareholdermeetingsintheUnitedStates,Europe,andAustralia.SeeRandyCepuch,AWeekendwithWarrenBuffett:AndOtherShareholderMeetingAdventures(NewYork:BasicBooks,2007).Youshouldalsobeawarethatmanagersoftenannouncegoodnewspriortoorduringtheannual
shareholdermeetings.SeeValentinDimitrovandPremC.Jain,“It’sShowtime.DoManagersManipulateStockPricesbeforeAnnualShareholderMeetings?”
Workingpaper,McDonoughSchoolofBusiness,GeorgetownUniversity,
2009.
14.Aquestionandanswer
sessionwithstudentsatColumbiaUniversityon
November12,2009.
15.RogerLowenstein,Buffett:TheMakingofanAmericanCapitalist(NewYork:RandomHouseTradePaperbacks,2008),395.
Chapter30LargeShareholders:TheyAreYourFriends
1.RonaldC.AndersonandDavidM.Reeb,“Founding-FamilyOwnershipand
FirmPerformance:EvidencefromtheS&P500,”JournalofFinance(June2003):1301–1328.
2.ValentinDimitrovandPremC.Jain,“RecapitalizationofOneClassofCommonStockintoDual-Class:Growthand
Long-runStockReturns,”JournalofCorporateFinance(2006):342–366.
ConclusionB=Baseball=Buffett
1.SeeRichardDawkins,TheSelfishGene(NewYork:OxfordUniversityPress,1990);andCharlesDarwin,TheOriginofSpecies(NewYork:GramercyBooks,1979,originallypublishedin
1859).
2.JanetLowe,WarrenBuffettSpeaks(NewYork:JohnWiley&Sons,1997),85.
3.JohnTrain,MoneyMastersofOurTime(NewYork:HarperPaperbacks,2003),47.
4.MichaelLewis,Moneyball:TheArtof
WinninganUnfairGame(NewYork:W.W.NortonandCompany,2004).
E1BABOUT
Date:Jan19,2010
Time:10:25am
AbouttheAuthor
PremC.Jain,Ph.D.,C.P.A.,beganhisacademiccareerin1984at
theWhartonSchooloftheUniversityofPennsylvania,followed
byamovein1991totheFreemanSchoolofBusinessatTulane
UniversityinNewOrleans.In2002heacceptedhiscurrentpositionas
theMcDonoughProfessorofAccountingandFinanceat
Georgetown
University’sMcDonoughSchoolofBusiness.
JainhasalsotaughtatMonterreyTechinMexicoandtheChina
EuropeInternationalBusinessSchool(CEIBS)inShanghai,andwasa
visitingscholarfortwo
summersatINSEADinFrance.Hehastaught
graduate-levelcoursesincorporatefinance,investments,international
finance,andfinancialstatementanalysis.HehasalsoworkedasafinancialeconomistfortheCommodityFuturesTradingCommission(CFTC)in
Washington,D.C.
Overhis25-yearacademiccareer,Jainhastraveledacrosstheglobe
topresenthisresearchatvariousconferencesanduniversities.Hehas
publishedextensivelyinthemostprestigiousfinanceandaccounting
journals,includingtheJournalofFinance,JournalofFinancialEconomics,andJournalofAccountingResearch.Hisworkincludesseveralscholarlyarticlesanalyzingstockmarketandstockfuturesdata.HehasalsobeenreferencedintheWallStreetJournalandothernewsmedia.Hisresearchsubjectsincludestocksplits,spin-offs,mutualfundadvertising,performanceof
WallStreetsuperstars,andmarketefficiency.
295
E1BABOUT
Date:Jan19,2010
Time:10:25am
296
abouttheauthor
AtTulane,JaindevelopedacourseforMBAstudentstostudytra-
ditionalvalueandgrowthinvestmentstrategies,initiallydevelopedby
BenjaminGraham,DavidDodd,andPhilipFisher.Thestudentsalso
studyWarrenBuffett’swritingsanddecisionsalong
withcontemporary
financeresearchandmanageatwo-million-dollarportfolioaspartofthe
Universityendowment.Hefrequentlytakesstudentsandotherfaculty
memberswithhimtoBerkshire’sannualshareholders’meetings.
Jainreceivedabachelor’sdegreeinengineeringfromBirlaInstitute
ofTechnologyandScienceinIndiaandworkedasanengineerfortwo
yearsatHindustanMotors,anIndiancarmanufacturingcompany.He
receivedanMBAfromtheIndianInstituteof
Management,Calcuttaand
workedfortwoyearsasafinancialanalystforNovartis.Hereceiveda
Master’sdegreeinAppliedEconomicsfromtheUniversityofRochester,
aPh.D.fromtheUniversityofFlorida,andhisC.P.A.licensefromthe
StateofFlorida.
E1BINDEX
Date:Feb4,2010
Time:2:56pm
Index
AbuDhabiInvestmentAuthority,252
Bankruptcy,189
AccountingGoodwill,133,134,223–228
BarnesandNoble,208
andearnings,225–226
BearStearns,151
andprofitabilityofacquiredbusinesses,
Bel-OroInternational,119
226–228
BenBridgeJeweler,118
Accountingskills,valueof,221–222
BerkshireHathaway,3,29–30,31,32
Acquisitions,corporate,17–18,258
acquisitioncriteria,75–76
criteria,75–76,131–135,136
annualizedreturn,6
reasonsfor,226
BerkshireHathawayReinsuranceGroup,
AdvancedMicroDevices,53
103–105,107–108
Advertising,116
capitalallocation,140
Agediscrimination,19
andcapitalintensity,212–213
Airlineindustry,15–16
Coca-Cola,44
Akerlof,George,237
compensationofdirectors
andexecutive
Amazon.com,273
officers,265–266
AmericaOnline(AOL),237,273
diversification,163
AmericanBankersInsuranceGroup,
dividendpolicy,251–252
186–187
GEICO,89–97
AmericanExpress,11–12,32,163,190,
GeneralReCorporation,99–103,
203,208,212,259,270
267
AmericanInternationalGroup(AIG),
asgrowthstock,70–71
106–107,188
historyof,9–22
Anderson,Ron,273–274
holdings,examplesof,77–
83,115–121,
Anheuser-Busch,259
140–142,151
Appearanceversusreality,14
intrinsicvalue,63–67
Arbitrage,185–188
andmanagementquality,52
Assets,58
MidAmericanEnergy(MEC),129
AuraLLC,119
andrepurchasesofitsown
stock,260
Balancesheets,58–59
ScottFetzer,17,137–140
Bankingindustry,15
versusS&P500,70
297
E1BINDEX
Date:Feb4,2010
Time:2:56pm
298
index
BerkshireHathaway(Continued)
BurlingtonNorthernSantaFe,16,67,
valueplusgrowth,73–74
77–80,151,173,207,211,212,215,
WashingtonPostCompany,150
259
WescoFinancialCorporation,58–61
Buyingandsellingpatterns,234–235
Beta,145,180
BYD(or“BuildYourDreams”),83–85
BethlehemSteel,35
Byrne,Mark,189
Bezos,Jeffrey,273
Black,Fischer,252
CapitalCities/ABC,173
BlueChipStamps,95–96
Capitalexpenditure,12–13
Blumkin,Irv,125,126
Capitalintensity
Blumkin,Rose,123–124,132
andmanagementquality,214–216
Bookvalue,36–37
Capital-intensivecompanies,211
Borsheim’s(jewelrystore),115–117,119,
Carefour,206
130
CarnivalCruiseLines,201
BostonCeltics,202
Case,Steve,273
Bridge,Ed,118–119
Cash,liquidityandopportunity,
Bridge,Jon,118
155–159
Brin,Sergey,275
Cashflow,96
BuffaloNews,198–199,200
anddividends,253,255
Buffett,Warren,3,6–7,25,29,31,34,43,
asking,10–11
54,69,72–73,74–75,84,89,137,
andrepurchasing,258
243,275
cash-flow-toprice,37–38
andacquisitionsphilosophy,75–76
Cendant,186–187,267–268
andarbitrage,185,187–188
Chace,MalcolmG.,95
Berkshire,transformationof,into
Challenges,companyresponseto,51
insurancegiant,95
ChampionInternational,73–74,157
Berkshirehistory,significanteventsin,
Chan,Louis,181
9–22
CharlesSchwabInc.,273
andcatastrophes,106
Child,Bill,125,126
circlesofcompetence,52
Chipotle,54
andefficiencyofthemarket,177
Chrysler,268
onfurnitureretailingbusiness,123
“Cigarbutt”approachtoinvesting,
GEICO,205
133
andGeneralReCorporation,102
Circleofcompetence,10,16,52,74,96,
geniusof,281–282
219,279
andGoodwill,223
Cisco,43,50,201,202
independence,respectfor,125
Citicorp,30
integrityof,270
Citigroup,252
jewelrybusiness,115
Coca-Cola,13–14,29–30,43,59,60,77,
aslargestBerkshireHathaway
149,163,201,203,233,237,246,
shareholder,273
258,259
andliquidity,155
asagrowthstock,44–45
andlong-terminvesting,169–170
intrinsicvalue,exampleofimportance
managementphilosophy,265
of,61–63
reinsurance,99
Comment,Jeff,116,118
andrisk,145,146
Commonstocks
andstockrepurchases,257,259,
evaluationof,examples,58–66
260
versusmutualfunds,4–5
andtheutilityindustry,129
Compac,232–233
Buffettinvesting,85
Companyprominence,29–30
valueplusgrowth,69–85
Compaq,50
E1BINDEX
Date:Feb4,2010
Time:2:56pm
Index
299
Compensationissues,124,139,173
DowChemical,151,158,159
BerkshireHathaway,263–266
DowJonesIndustrialAverage(DJIA),164,
stockoptions,266–268
213
Competition,123–124
DowJonesTransportationIndex,213
Compounding,112
Downsiderisk,72,73,74,77,83,151–153
CompuAdd,50
Dreman,David,40
ConocoPhillips,163,212,223,224,244,
Drucker,Peter,18
246
Duopolies,201
Conservativefinancing,29–30,34,41
DuPont,E.I.,274
ConstellationEnergy,156
Convertiblebondsand
preferredstocks,
Earnings
157–158
growthin,asdriverofstockprice,47
Corporateacquisitions,17–18,258
manipulationof,12
Corporategovernance,249,263–271
andsales,importanceoftrackrecord,
Corporatejets,13
47–54
CORTBusinessServices,126–127
volatility,asbenefit,93
Costadvantage,115,116–117,209
Earningsforecasts,74
Costco,206,217–218,220,252
EatonVance,54
Costs,waystoreduce,209–210
Efficiencyofthemarket
Counterparties,increditdefaultswaps,107
andacademics,179–181
CourierNews(Buffalo,N.Y.),198
Eisner,Michael,173
Creditdefaultswaps,106
Ellison,Larry,273
CSFB/TremontHedgeFundIndex,190
Enron,21,133,134,151
Customerservice,208
Euphoria,32
asinvestor’senemy,15,19
DairyQueen,225
sellingin,20–21
Danaher,54
Eventstudies,180
Davidson,Lorimer,90
ExecutiveJetAviation,225
deBeers,197
Executiveofficers,compensationof,
Debt,133
265–266
Debt-to-equityratio,29
Extreme-valueportfolios,37,40
Dell,Michael,50,273
Exxon,186
DellComputer,50,232–233,273
Demandandsupply,180
Fama,Eugene,37
Derivatives,21–22,146
Familyfirms,274–275
DinersClub,208
FannieMae,244
Directors
Fast-growingindustries,74
compensationof,265
FedEx,201
groupthink,266
Financialresults,269
Disaster,maintainingfocus,21
reportedversustrue,12
Discountrate,67
FirstEmpireState,74
Disney,171,173,201
Fisher,Philip,43,53,165
Dittmar,Amy,257
FlightSafetyInternational,18–19,80–81,
Diversification,161–167
132,214
avoidingexcessive,164–165
Float,60
international,165–166
GEICO,90,92–93
Dividends,58,251–255
andinsurancebusiness,100,101–102
anddoubletaxation,252
asinterest-freeloan,92,94,97
monitoringroleof,253
andtradingstampservice,95–96
Do-it-yourselfstores,207
Float-to-revenuesratio,101
Dollar,declineinvalueof,152
Ford,Henry,274,281
E1BINDEX
Date:Feb4,2010
Time:2:56pm
300
index
Foundercontrol,273–275
researchanddevelopment,49–51
Franklin,Benjamin,13,96,281
responsetochallenges,51
FreddieMac,171,174
Growthpotential,131,133,134,225
French,Kenneth,37
Growthrate,58,225
Friedman,Ike,116,117
Growthstocks
Fundamentals,25,180
examplesofprospects,77,81,83
Futureearnings,58
identificationof,46–47
non-high-tech,54–55,130
Gannett,199
Gates,Bill,244,270
Hedgefunds,185,188–192
GEICO,11–12,18,71–72,81,89–97,
indicesandsurvivorshipbias,
190
104–105,205,206–207,208,210,
managementfeestructure,191
225
Helzberg,Barnett,117,118,119
compensationplan,263–264
Helzberg,Gilbert,117
versusGeneralRestrategies,103
Helzberg,Morris,117
intrinsicvalue,calculationof,94
HelzbergDiamonds,115–119
marketing,90,93
Herdinginstinct,232–233
valuationandreturnstoBerkshire
HewlettPackard,232,274
Hathaway,94
High-profit-margincompanies,52–53,
GeneralElectric,30,74,151,156,158,
199,201
159,165,172,268
High-techcompanies,50,74
GeneralMills,166
BYD,83–85
GeneralMotors(GM),171,199,207
Hiringpractices,18–19
GeneralRe,99–103,107,186,225
Holdingperiods,13–14,146–147
compensationplan,267
sellingtooearly,18
andfloat,101–102
HomeDepot,46,49,50,54,268
versusGEICO,103
history,1998-2008,101–102
IBM,50,51,165,199,207–208,219–220,
Gillette,74,157,158
233
Glamourstocks,35,36,41
profitabilitycomparisonwith
Microsoft,
GlobalMarine,48
196–197
GoldmanSachs,30,74,151,156,158,159,
Incentiveplans,271
172,188
symmetrical,264–265
“Goodcompany,”131,132–133
Indexfunds,4–5,112
Google,46,51,52,275
Inefficiencyofthemarket,181–183
Gordon,Myron,62
Inflationrisk,151–152
Gottschalg,Oliver,191
Initialpublicofferings(IPOs),47
Governance,corporate,249,263–271
Insurancebusiness,14,89–97,205–206
Graham,Benjamin,26–27,29,33,34,36,
and9/11terroristattacks,101,156–157
40,89,164
BerkshireHathawayReinsuranceGroup,
growthinvesting,45–46
103–105
Groupthink,266
Berkshire’sexperiencepriortoGEICO,
Growthinsales/assets,37–38,73
95
Growthinvesting,23,43–56,72–73,
float,90,92–93,94
281
GEICO,89–97
defined,43,44
GeneralRe,99–102
long-termperspective,51
operatingprofits,90–92
andone-timeevents,48
sizeandrisk,99–100,156–157
profitmargins,53–54
Integrity,270,281
qualityofmanagement,52–53
Intel,43,50,53,201,202
relationshipwithemployees,49
Interest-freeloans,109–112
E1BINDEX
Date:Feb4,2010
Time:2:56pm
Index
301
Internet,48,51
Luxuries,13
effectof,onthebook
industry,208
Lynch,Peter,47–48,124,166,179,202,
Intrinsicvalue,56,57–68,74,172,202,
233
203,282
BerkshireHathaway,62–67
MacKinlay,A.Craig,179
Coca-Cola,61–63
Malkiel,Burton,190
computing,57–66
Management
GEICO,94
compensationfordirectorsandexecutive
Wesco,61
officers,265–266,268–269
Inventoryturnover,209
andgrowthinvesting,52–53
Investingasgame,3–4
identifyinghighquality,25,68,75,94,
mind-settowin,277–279,
281
108,131–132,268–270,282
Investingonmargin,151
incentives,124,139
Investmentstrategy,7
qualityandcapitalintensity,214
basisprinciples,281–282
Managers
valueinvesting,25,35
andBerkshirejewelrybusinesses,121
Iscar,156,214,225
examplesofoutstanding,14,80,81–82,
84,116
Jain,Ajit,103
identificationoftop,importanceof,11,
J.C.Penney,206
16–17,130,142,279–280
Jegadeesh,Narasimhan,181
andindependence,125
Jewelrybusiness,115–121
integrity,270
Johnson&Johnson,172,243
NebraskaFurnitureMart,124
Jordan’sFurniture,126
nomandatoryretirementage,132
J.P.Morgan,151
self-perpetuationofhigh
quality,52
Manufacturingcompanies,137–142
Kaplan,Steve,191
Marginofsafety,67,73,74–75,202
Kaypro,50
Marketcrashes,2008-2009,22,70
Kelleher,Herb,210,214
Marketefficiency,175,177–183,179–181
KernRiver,134,208
Marketinefficiency,181–183
Kmart,33,35,53,205,206,207,209,
Marketshare,81,209
245
Borsheim’s,115
KraftFoods,59,60,259
GEICO,91
Market-to-bookratios,23,26,29,38,69,
Lakonishok,Joseph,35,37,38,41,181
73
Leadercompanies,characteristicsof,
MidAmericanEnergy(MEC),130
206–209
performanceofhighversuslowM/B
LeggMason,244
stocks,36–37
Lenovo,51
Markettrends,237
Leverage,152,188–189
Marketvalue,36–37,58,59
Liquidity,152
Wesco,60
andopportunity,155–159
MarketingGEICO,90,93
problems,189
MarmonHoldings,140,141,214
Lo,Andrew,179,191
Martin,Gerald,71
Long-TermCapitalManagement,153,
Mauboussin,Michael,244
188–190
Maximizationofshareholdervalue,75
Long-termdebt,29
McDonald’s,49,54–55,171,172–173,
andCoca-Cola,30
206
Long-termfocus,89,93,170,233
McLaneCompany,140,141–142,226
Long-termreturns,72,111–112,133
Mergerdeals,arbitragein,186–187
Low-qualitystocks,33
MerrillLynch,32
E1BINDEX
Date:Feb4,2010
Time:2:56pm
302
index
Microsoft,43,46,48–49,50,
51,52,165,
andstockmarketcrash,6
201,202,203,225
andvolatility,147–148
dividendpolicy,253–255
Oracle,273
asnear-monopoly,195–196
Overconfidencebias,238
profitabilitycomparisonwithIBM,
Ovitz,Michael,173
196–197
Owner-managers,273–275
MidAmericanEnergy(MEC),129–135
criteriaforacquisition,131–135
PacifiCorp,134
Miller,Merton,251
Page,Larry,275
Mind-settowin,277–279,281
Papergains,asinterest-freeloan,109
Mistakes,learningfrom,243–247
Pastperformance,58
MiTek,226
Patience,19–20,26,31,131,133,134,
Mobil,186
159,279
Modigliani,Franco,251
andNetJets,82
Momentuminstockprices,181
andvalueinvesting,38,40,41–42
Monitoringroleofdividends,253
Pepsi,201
Monitoringyourportfolio,39
Performance,returnonequity,217
Monopolies,195–203
Pessimism,asinvestor’sfriend,15,32
profitabilityof,196–199
PetroChina,171,172,211
Moody’s,259
Phalippou,Ludovic,191
MorganStanley,157
PhilipMorris,202
Mortgages,payingoff,152
Portfolioformation,38–39
Motivationofemployees,263
Portfolioinsuranceeffect,148–149,
Motorola,274
181
Munger,Charlie,58,84,96,109,127,132,
POSCO,211
198,211,214,226,275
Preferredstock,157–159
Murphy,Tom,173
Preservationofcapital,26
Mutualfunds,4–5
Pricediscrimination,209
Price-to-earningratios(P/E),23,26,
Nardelli,Robert,268–269
27–29,38,58,73,202,203,281
Naturaldisasters,14,21
averageearningsovertime,27–29
Near-monopolies,196,201
andexcellentmanagement,132
NebraskaFurnitureMart,16–
17,123–124,
MidAmericanEnergy(MEC),130
125,130,132
performanceofhighversuslowP/E
Neff,John,28–29,165
stocks,35–36
NetJets,81–82,210,226
andvalueinvesting,69
NewYorkTimesCompany,199
Prince,Charles,252
Nicely,Tony,207
Principlesforinvesting,26–30,281–282
NorthernNaturalGas,134,156,208
examplesforhistoryofBerkshire
Hathaway,10–22
Odean,Terrance,239
Privateequityfunds,191
Operatinglosses,93
Procter&Gamble,59,60,74,158,163,
Operatingprofits,GEICO,90–92
172,203,223,224,225
Opportunity,25
Profitmargins,53–54
andgrowthinvesting,55
Profitability,119–121,193,196–199
industrythatleadsthedecline,32
ofhigh-capital-intensitycompanies,
andliquidity,155–159
215–216
sharpdeclineinthestock
market,30–32
andmonopolies,195,196,199,201
andsharpdeclineof1987,148–149
sustainabilityof,202
andslowdeclinein1973-1974and
versustotalprofits,139
2008-2009,149–151
Prominenceofcompany,29
E1BINDEX
Date:Feb4,2010
Time:2:56pm
Index
303
Property,plant,and
equipment(PPE),
Ritter,Jay,47
212–213
Russiandefaultcrisis,32,153
Psychology,229,231–242
biases,238–240
Safety,155–157
herdinginstinct,232–233
Saha,Atanu,190
Puthenpurackal,John,71
Salesandearnings,importanceoftrack
record,47–54
Qualitativeapproach,72–73
SalomonInc.,74,157,158,
243–244,270
Quantitativeapproach,72–73
Sam’sClub,51
Santulli,Richard,81–82
Rateofreturn,4–5
Schey,RalphE.,137–138,140,264
andutilities,131,134
Schmidt,Eric,275
Rationality,282
Schoar,Antoinette,191
R.C.WilleyHomeFurnishings,125
Schulz,Howard,273
Realestate,152
Scott,Walter,129,130
Reeb,David,274
ScottFetzer,17,137–140,264
Reinsurance,99–112
Sears,206
defined,99
See’sCandies,226
risks,103–105
Shareholders
ReinsuranceGroup,103–105,107–108
large,asfriends,273–276
RelianceGroupHoldingsInc.,105–106
unfairnessofstockoptions,266–268
Reportedearnings,58
Sharpe,Lintner,andBlack(SLB)model,41
Reportedversustruefinancialresults,12
Shaw,RobertE.,140
Repurchasesofstock,253,254,257–261
ShawIndustries,140–141,142,226
Reputation,116,118,119,127
Shiller,Robert,148,237
andsaleofstock,173
Shleifer,Andrei,35
Researchanddevelopment(R&D),
“Shoppertainment,”126
49–51
Short-termdebt,29
inhigh-techcompanies,50
Short-termvolatility,146
Responsibility,taking,20
Silverman,Henry,267–268
Results,extraordinaryinordinarybusiness,
Sizeofcompany,29–30
17
insurancebusiness,99–100
Retailsector,113,115–121
Sloan,AlfredP.,207
Retirementage,132
Smallinvestor,advantagesof,6
Returnonassets(ROA),218,220–221,
Sokol,David,81,84
222
Soros,George,236
Returnonequity(ROE),217–221,
SouthwestAirlines,210,214
222
S&P500index,31,164,172,190,191,
Risk,15–16,143,180
274,275
arbitrageandhedgefunds,185–192
annualizedreturn,comparisons,6
andcapitalintensity,213,216
StandardOil,195,203
defined,145–146
StarFurniture,125–126
downside,151–153
Starbucks,43,48,54,273
andhedgefunds,190–191
Stock
andholdingperiod,146–147
managementinterestin,267,270
lowdebtlevel,282
pricemomentum,181
tolerance,31,57
reasonstosell,171–172
andutilitysector,129,130
repurchasing,253,254,257–260
andvalueinvestmentstrategies,
selection,182–183
40–41
whentobuy,67
Risk-takingbehavior,107
whentosell,169–174
E1BINDEX
Date:Feb4,2010
Time:2:56pm
304
index
Stockoptions,266–268
BenjaminGraham,26–27
unfaircosttoshareholders,267–268
andconservativefinancing,29–30
Stockprice,growthinearnings,47
evaluationof,34–38
Stocksplits,16
examples,77,80,81,83
Subaru,202
andGEICO,71–72
Sunk-costfallacy,172
andmonitoringtheportfolio,39
Survivalinstinct,277
otherhelpfulguidelines,30–34
Survivorshipbias,190
preservationofcapital,26
Sustainabilityofprofitability,202
andprice-to-earningsratios,26–29
SwissRe,151,158,159
ValueLine,29
Valueplusgrowthconcept
Target,206
implementationof,73–75
Tatelmanbrothers,126
Valuestocksversusgrowthstocks,46
Taxdeferment,109–112
VanguardWindsorFund,28
Technology,effectiveuseof,209–210
Venturecapitalfunds,191
Templeton,John,178–179
Vishny,Robert,35
Tesco,206,212
Volatility,146,147–148,183
Timeframes,38–39,42
andhedgefunds,191,192
TimeWarner,237
Timingthemarket,32,39
Wal-Mart,33,43,49,50,51,53,54,81,
difficultyof,150
90,115,124,165,203,205,
206,207,
TIPs,152
208,209,210,246,273,274
Trading,frequencyof,andmutualfunds,
asgrowthstock,46
110,112
andMcLaneCompany,141–
142
Travelers,171
Walton,Sam,46,47,49,54,116,118,207
Treasurybonds,long-termzero-coupon,19
WashingtonPost,31,150,199,201,203,
“Turnaround”companies,
11–12,33
258–259,270
Welch,Ivo,47
Uelstchi,A.L.,80,132
WellsFargo,59,60,77,163,203,212,
Undervaluation,andcompanyrepurchases,
258
257,261
WescoFinancialCorporation,58–61,126,
Underwritinglosses,101
127
Underwritingprofits,90–92
float,60
UPS,201
WestEndCapital,189
U.S.Airways,74,157,158,211,214
Whitman,Bruce,80
U.S.Bancorp,212
WholeFoods,203
U.S.Steel,214
Wolff,Melvyn,126
Utilitycompanies,129–136
WorldCom,151,222
andregulation,129,130
Wrigley,74,151,156,158–159,172
W.T.Grant,206
Valuation,GEICO,94
Valueinvesting,23,25–42,69,281
Yahoo!,54
academicresearchevidencefor,34–35
Yermack,David,267
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DocumentOutline
BuffettBeyondValue:WhyWarrenBuffettLookstoGrowthandManagementWhenInvesting
ContentsPrefaceAcknowledgments
PartOne:INTRODUCTIONANDBACKGROUND
Chapter1:TheThrillofInvestinginCommonStocks
Howa1PercentAdvantageBecomesa100
PercentGainHowMuchWouldYouHaveEarnedIfYouHadInvestedwithBuffett?Conclusions
Chapter2:1965–2009:
LessonsfromSignificantEventsinBerkshireHistory
1965:NotThrowingGoodMoneyafterBad1967:InvestinYourCircleof
Competence1973:CashFlowIsKing1977:SuccessfulGrowth1980:BuyingSharesafterPricesFall
1984:ReportedVersusTrueFinancialResults1985:CapitalExpenditures1986:CorporateJetsandOtherLuxuries
1988:HoldingPeriodofanInvestment1989:LookingFoolishVersusActingFoolish1990:PessimismIsYour
Friend1991:Risk1992:StockSplits1993:IdentifyingExcellentCEOs1994:ExtraordinaryResultsinOrdinary
Businesses1995:CorporateAcquisitions1996:SellingTooEarly1996:HiringPractices1997:Patience1999:Taking
Responsibility2000:SellinginEuphoria2001:NotLosingFocusWhenDisasterStrikes2002:FinancialWeaponsofMass
Destruction2008-2009:MarketCrashesConclusions
PartTwo:BUFFETTINVESTING=VALUE+GROWTH
Chapter3:ValueInvesting—
It’sLikeBuyingChristmasCardsinJanuary
ValueInvestingandTwoEssentialPrinciplesOtherHelpfulGuidelinesforValue
InvestingDoesValueInvestingReallyWork?FrequentlyAskedQuestionsConclusions
Chapter4:GrowthInvesting
Coca-
ColaasaGrowthStockHowtoIdentifyGrowthStocksImportanceofTrackRecord:SalesandEarningsOneExample
ofaNon-TechnologyGrowthStockConclusions
Chapter5:IntrinsicValue
ComputingIntrinsicValueWhentoBuyAnyStock:Consider
MarginofSafetyConclusions
Chapter6:BuffettInvesting=Value+Growth
BerkshireHathawayIsaGrowthStockValue
PlusGrowthExamplesfromBerkshireInvestmentsConclusions
PartThree:OTHERPEOPLE’SMONEY
Chapter7:Insurance:OtherPeople’sMoney
InsuranceCompaniesasOtherPeople’sMoneyConclusions
Chapter8:Reinsurance:MoreofOtherPeople’sMoney
SizeMatters:Berkshire’s
AcquisitionofGeneralReFailureofRelianceInsuranceCompanyConclusions
Chapter9:TaxDeferment:Interest-FreeLoansfromthe
GovernmentValueofBerkshire’s$10BillionInterest-FreeLoanfromtheGovernmentReturnsona$10,000Investmentin25
YearswithandwithoutTaxDefermentConclusions
PartFour:SUCCESSINRETAILING,MANUFACTURING,ANDUTILITIES
Chapter10:IfYouDon’tKnowJewelry,
KnowYourJeweler
ComparisonwithWal-Mart:CostAdvantageHelzbergDiamonds,BenBridgeJeweler,andOthers
Profitability:Berkshire’sJewelryBusinessesversusTiffany&Co.Conclusions
Chapter11:CompeteLikeMrs.B
KnowWhenNotto
Compete:NebraskaFurnitureMartR.C.WilleyHomeFurnishingsStarFurnitureandJordan’sFurnitureCORT
BusinessServicesConclusions
Chapter12:WhyInvestinUtilityCompanies?
SimilaritybetweentheMECandOtherAcquisitionsFourNonprice
AcquisitionCriteriaConclusions
Chapter13:HighProfitsinHonest-to-GoodnessManufacturingCompanies
ScottFetzer’sSuccessShawIndustries,
Marmon,andMcLaneConclusions
PartFive:RISK,DIVERSIFICATION,ANDWHENTOSELL
Chapter14:RiskandVolatility:HowtoThinkProfitablyaboutThem
RiskandReturn:HoldingPeriodVolatilityOffersOpportunitiesOpportunitiesfromtheSharpDeclineof1987ASlowDecline
in1973–1974and2008–2009MoreonDownsideRiskConclusions
Chapter15:WhyHoldCash:LiquidityBringsOpportunities
LiquidityandOpportunitiesBerkshire’sInvestmentsinConvertiblesRecentBerkshireInvestments:Wrigley,GoldmanSachs,General
Electric,SwissRe,andDowChemicalConclusions
Chapter16:Diversification:HowManyBasketsShouldYouHold?
DiversificationHowDiversified
IsBerkshireHathaway?HowManyStocksShouldYouHold?PhilipFisherWarnsagainstToo
MuchDiversificationDiversificationand“Diworsification”Conclusions
Chapter17:WhentoSell
TurnoverofBerkshire’sEquityPortfolio:Why
BuffettHoldsAlmostForeverTwoMainReasonstoSellConclusions
PartSix:MARKETEFFICIENCY
Chapter18:HowEfficientIstheStock
Market?CanIMakeMoneyintheStockMarket?MostAcademicsFavorMarketEfficiencyRecentEvidenceon
MarketConclusions
Chapter19:ArbitrageandHedgeFunds
ArbitrageinMergerDealsAnExampleofaSuccessfulArbitrageDealby
BuffettLong-TermCapitalManagement:TheStoryofaHedgeFundandBerkshireHathawayShouldYouInvestin
HedgeFundsorPrivateEquityFunds?Conclusions
PartSeven:PROFITABILITYANDACCOUNTING
Chapter20:M=Monopoly=Money
Widen
theMoatProfitabilityofMonopoliesDominanceDoesNotMeanHighProfitsHowtoLookforMonopoliesDoNotSella
MonopolyinaHurryConclusions
Chapter21:WhoWinsinHighlyCompetitiveIndustries?
InsuranceIsaCommodityBusinessLike
RetailingTwoMainCharacteristicsofaLeader:LowCostandCustomerSatisfactionHowDoCompaniesKeepCosts
Low?Conclusions
Chapter22:Property,Plant,andEquipment:GoodorBad?
CapitalIntensityCapitalIntensityandManagementQuality
ConclusionsChapter23:KeytoSuccess:ROEandOtherRatios
ROE:UnderlyingPerformanceofaBusinessROA:ReturnonAssets
BuffettandAccountingConclusions
Chapter24:AccountingGoodwill:IsItAnyGood?
AccountingGoodwillandItsEconomicValueGoodwill
andEarningsGoodwillandProfitabilityofAcquiredBusinessesConclusions
PartEight:PSYCHOLOGY
Chapter25:HowMuchPsychology
ShouldYouKnow?
HerdingandYouExamineYourBuyingandSellingPatternsCanYouChangeYourself?How
PsychologyMayHelpYouHowtoThinkaboutPsychologicalBiasesSomeImportantQuestionsforYoutoConsider
ConclusionsChapter26:HowtoLearnfromMistakes
MistakesversusBadLuckLearningfromMistakesMistakesofCommissionand
MistakesofOmissionConclusions
PartNine:CORPORATEGOVERNANCE
Chapter27:Dividends:DoTheyMakeSenseinThisDayandAge?
BerkshireDoesNot
PayDividendsMicrosoftandaSpecialDividendConclusions
Chapter28:ShouldYouInvestinCompaniesThatRepurchaseTheirOwn
Shares?ShareRepurchasingIsGoodNewsShareRepurchasesbyCompaniesinWhichBerkshireHasInvestedWhy
Doesn’tBerkshireRepurchaseItsOwnShares?Conclusions
Chapter29:CorporateGovernance:Employees,Directors,andCEOs
EmployeeCompensation
atBerkshireCompensationforDirectorsandExecutiveOfficersWhatIsWrongwithCompensationthroughStock
Options?HowtoIdentifyGoodCEOsorOtherSeniorManagersConclusions
Chapter30:LargeShareholders:TheyAreYourFriends
FounderControlMattersConclusions
Conclusion:B=Baseball=Buffett
Don’tLoseMoneyStayinYourCircleofCompetence
FindGoodPeople
Appendix:ASummaryoftheBook
NotesAbouttheAuthorIndex