The Warren Buffett Way

These are my notes from Robert Hagstrom's The Warren Buffett Way.

Tl;dr

• Buffett’s investment principles were built on the ideas of great value investors, including Ben Graham, Philip Fisher and Charlie Munger

• Buffett looks for businesses that: (i) have great economics, (ii) are understandable, (iii) have a clear durable advantage, (iv) are run by great managers and (v) can be bought at a reasonable price

• Buffett seeks businesses that he can hold for long time horizons. This approach puts a premium on businesses that can consistently increase their earnings and are unlikely to be disrupted. He wants to be able to go away for 10 years and be confident he’ll come back to a better business.

• Investment mistakes come down to either: (1) price we paid, (2) management we joined with or (3) future economics of the business. #3 is most common mistake.

• Buffett uses the long-term US treasury rate to discount future cash flows and benchmarks new investment opportunities against his current portfolio.

• Businesses that sell a product that is needed and have no close substitute can raise their prices. Price is the biggest driver of earnings / above average returns on capital.

• Your goal should be to create a portfolio that will deliver the highest “look through earnings” a decade or so from now.

Solid Quotes (this book was chock full of them)

• “The difficulty lies not in the new ideas but in escaping the old ones” John Meynard Keynes

• “When management with a reputation for excellence meets an industry with a reputation for bad economics, it is usually the industry that maintains its reputation” Warren Buffett

• “Hire well, manage little.” Warren Buffett

• “The strongest of warriors are these two—time and patience” Leo Tolstoy

• “We shape our dwellings, and afterwards the dwellings shape us” Winston Churchill

• “Many shall be restored that have fallen, and many shall fall that now are in honor” Horace

Book Notes

• Your goal as an investor should be simply to purchase at a rational price a part interest in an easily understood business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time you will find only a few companies that meet those standards—so when you see one that qualifies you should buy a meaningful amount of stock

• Ben Graham

  • Focused on mispricings and profiting from the corrective forces of an inefficient market

  • Focused on finding securities trading below their intrinsic value. He looked at a company’s earnings, dividends, assets, and future definite prospects

  • “An investment operation is one which upon thorough analysis promises safety of principal and a satisfactory return.”

  • “As more investors become enamored with the promised return the price lifts free from underlying value and floats freely upward creating a bubble that expands beautifully until it must finally burst”

• Philip Fisher

  • Focused on investing in companies with above average potential and aligning oneself with the most capable management

  • Fischer developed a point system. He looked for (1) increasing sales and profits above industry average and (2) sufficient market potential to make possible sizable increases for years.

  • Distinguished between companies that were “fortunate and able and fortunate because they were able”

  • Emphasized the important of (1) R&D and (2) expertly merchandised i.e. translating R&D into revenue and monitoring changes in customer behavior, needs, and habits

  • Emphasized the importance of management including whether the CEO has a great team to whom he able to delegate

  • His analysis process involved what he called “scuttlebutt” to provide substantial clues about the business. He developed a scuttlebut network to learn about a business including customers, vendors, employees and competitors. Doing this was labor intensive leg work, so he reduced number of companies he’d look at and stick to his process

  • Emphasized the importance of concentration over diversification. Not knowing what you are investing in is riskier than limiting diversification but knowing what you are investing in extremely well

• Bufett’s Investing tenets

  • Invest in businesses that…

    • Are simple and understandable

    • Have a consistent operating history (“when a company demonstrates results with a product year after year it is not unlikely those results will continue”)

    • Have a clear durable competitive advantage (“future cash flows should take on coupon like certainty”)

    • Have favorable long-term prospects (“severe change and exceptional returns usually don't mix. Investors are infatuated with what tomorrow might bring and ignore today's business reality”)

  • Look for “franchises”. These are great businesses where…

    • (1) The product is needed / desired, (2) there is no close substitute, and (3) it is not regulated

    • If these three conditions are met the business can therefore hold its prices and even raise them without fear of losing volume

    • Pricing power allows for above average returns on capital

• The key to investing is determining competitive advantage and how enduring it is. The definition of a great company is that will still be great in 25 to 30 years

• Be skeptical of companies that need to buy growth, because buying growth usually comes at inflated prices. When the best prices are available the cost of money is usually at its highest thereby diminishing opportunity

• Having capital on hand: Investing in great business is rare so be ready. “If you want to shoot rare fast moving elephants, always carry a gun.”

• Even the best managers cannot make a difficult business thrive (“when management with a reputation for excellence meets an industry with a reputation for bad economics, it is usually the industry that maintains its reputation”).

• On leverage: great businesses will produce good results without the aid of leverage i.e. good ROE with little or no debt. Highly leveraged businesses are vulnerable.

• Buffet’s discount rate in long term US treasury rate

• Buffet puts a heavy weight on certainty and predictability of cash flow “if you do that whole idea of risk factor doesn’t make sense”

• Mistakes are either: (1) price we paid, (2) management we joined with or (3) future economics of the business. #3 is the most common mistake.

• By investing in good management, Buffett has been able to provide management with a proxy vote thereby engendering trust and goodwill and building his reputation as a good partner

• Low capital needs mean sales can be translated into profits more easily without being diverted into assets

• Case examples

  • Buffett’s investment in the Washington Post

    • WaPo had an $80m market cap and owners earnings of $10m.

    • If you capitalize owner’s earnings by the long term US treasuries (i.e. 6.81%) you’d get to a valuation of $150m

    • In addition CapEx was expected to decrease to equal depreciation, thereby increasing owner’s earning to $13.3 million, or a valuation of $200m

    • If you assume the company can raise prices by 3% and reach a 15% operating margin, you could justify a valuation of $485m.

    • In effect WaPo was trading at 20% of intrinsic value

  • Buffett’s investment in GEICO

    • $296 market value and $60m in owner’s earning on on $700m revenue

    • 30-year bonds were trading at 12%. If you capitalize earnings by that rate you’d get a valuation of $500m, nearly a $200m discount to intrinsic value assuming earnings stayed the same

• Tom Murphy set up a yearly budget review and quarterly performance review. Other than those two things managers were expected to run their business like they owned them.

• A company that produced more cash than can be profitably re-invested can be used to pay down debt or be returned to shareholders

• Long-time horizons

  • Pretend you make an investment and then have to go away for 10 years. What would you invest in? Be sure when I came back business was doing a lot better than today.

  • Buffet happy to hold forever so long as prospective ROE is good, management is good, market does not overvalue the business

• Commodity businesses

  • In a commodity-like business management is the most important factor. These businesses have to be managed extremely well.

• Focused investing

  • Focused investing is about choosing a few stocks that are likely to produce above average returns on the long term (i.e.“put eggs in one basket and watch it closely”)

• Going big

  • Great investment opportunities come around very infrequently

  • You need to be ready to take advantage of them and bet big

  • Blackjack players understand this intuitively

  • Kelly optimization model

  • Look at probability of loss * possible loss vs. probablility of gain * possible gain. It’s subjective but gives you a sense of how much to bet

  • Need to avoid gambler’s ruin by under-betting i.e. half Kelly or fractional Kelly

• Importance of low turnover

  • Not necessarily no turnover. If Mr. Market does something crazy you should have flexibility to take advantage of it

  • Probably 10% - 20% turnover is reasonable

• Charlie Munger

  • You need to be able to handle the bumps along the way because they are inevitable

  • The market is like the pari-mutuel system of horse betting

  • The horse most likely to win is always highly favored in the odds. You could risk $1 and stand to make less than $1. Your risk is more than your reward. It’s a sure thing but with a bad payoff. “Wait until the good horse comes to the post with inviting odds”

• Andrew Beyer on thoroughbred racing

  • Prime Bets - confidence in ability to win and payoff odds are greater than they should be. Put serious money here.

  • Action Bets - reserved for long shots and hunches…satisfy a psychological need to play. Small bets.

  • Do not blur the lines between which bet you are making

• Applying race betting to stocks

  • Calculate probabilities - what is the probability this stock will do better than average over the long-term?

  • Wait for the odds - wait for the company to sell for below intrinsic value. The less conviction you have the higher the margin of safety must be

  • Adjust for new information - you are likely to find a good opportunity and need to wait for some time for the odds to come to you. Watch and update your thesis

  • Decide how much to invest - Start with the kelly formula then adjust downward.

• John Maynard Keynes Principles

  • Focused on making a few investments in well understood companies, emphasizing cheapness relative to estimated intrinsic value, and comparing opportunities to next best alternatives

  • Emphasized the importance of “steadfast holding through thick and thin” until they met their potential or you realized you made an obvious mistake

  • He ran the Chest Fund for 18 years and underperformed ⅓ of the time.

• Let the economics of the business (ROE, earnings, margins) dictate if the business is more or less valuable—not the quoted price. The goal of building a portfolio is to create portfolio that will deliver highest look through earnings a decade or so from now.

• The threshold against which you should measure investment decisions is your current portfolio. If whatever you are evaluating isn’t better than what you are already holding then it hasn’t met your threshold. Your current portfolio is an economic benchmark.

• If you were limited to Omaha you would find the business with (1) best long-term economic characteristics, (2) high quality of the people in charge and (3) opportunity to buy at sensible prices. You wouldn’t buy every company in Omaha.

• Build a portfolio you can live with for a long time. Don’t pull your flowers and water your weeds.

• Mr. Market - sometimes he’s depressed and sometimes he elated. Take advantage of his emotions. Has anybody done anything foolish lately to let me buy great businesses at good prices?

• Modern portfolio theory

  • For the first time modern finance was coming from from academia not practitioners

  • Harry Markowitz - diversification to balance risk and reward

  • Eugeme Fama - efficient markets

  • Bill Sharpe - measure of risk

  • Buffett is dismissive of modern portfolio theory. “Observing correctly the market is frequently efficient, they went on to conclude incorrectly that it was always efficient.”

• Keith Stanovish - smart people can do dumb things “(dysrationalia”)

• Decentralization in the Berkshire model. Talented operators who require no help Buffett him to generate cash. Allows Buffett to focus 100% of his energy on his best talent. “Hire well, manage little.”

• Looking at businesses as if you have to hold it for ten years and rely on its profit to support yourself.

• “Our investment style fits our personalities and the way we want to live our lives”

• On partnering with great managers

  • “What can be more logical in whatever you want done than finding someone better equipped than you are to do it?”

Books Referenced

• John Burr Williams - Theory of Investment Value

• Richard Thaler - The Winner’s Curse

• Jack Treynor - Institutional Investing

• William Thorndike - The Outsiders