How does one become an investment legend? Warren Buffett started a partnership with seven limited partners in 1956, when he was 25, with $105,000 in funds. He generated a 29% return over the next 13 years, developing his own brand of value investing during the period. One of his most successful investments during the period was an investment in American Express after the company’s stock price tumbled in the early 1960s. Buffett justified the investment by pointing out that the stock was trading at far less than what the American Express card generated in cash flows for the company for a couple of years. By 1965, the partnership was at $26 million and was widely viewed as successful.
In the wake of the subprime mortgage crisis of 2007-2008, I followed this method and entered the market to buy US stocks that justified the investment. April to June 2009, I bought American Express, Disney, Apple, Altria, Microsoft simply because, based on the cash they had in their books, the stock price was trading so low that I could get the value of the cash they had for less. Furthermore, they still generated healthy cashflows and clearly did not seem to be deviating from that. I exited all these positions steadily over the years with profits between 2 to 5 times my principle not including dividends. It would be silly to be ignorant about the qualities of each of these great companies and the business they are in. So imagine getting the business side of these securities for free!
The moment that made Buffett’s reputation was his disbanding of the partnership in 1969 because he could not find any stocks to buy with his value investing approach. At the time of the disbanding, he said, ‘On one point, I am clear. I will not abandon a previous approach whose logic I understand, although I might find it difficult to apply, even though it may mean foregoing large and apparently easy profits to embrace an approach which I don’t fully understand, have not practiced successfully and which possibly could lead to substantial permanent loss of capital.’ The fact that a money manager would actually put his investment philosophy above short-term profits, and the drop in stock prices in the years following this action, played a large role in creating the Buffett legend.
In my journey so far, there are many times I’ve come across or have been introduced extraordinary companies which look like winners. Recently I have been asked to seriously consider investing in iFAST Corporation (AIY.SI), an Internet-based investment products distribution platform. Its price have fallen lower than its IPO price $0.95 per share. The favorable qualities of this security were not lost to me as my friend was insistent that it is value. (Would add that my friend is a proven value investor with much financial success to demonstrate his strong ability to identify great stocks to buy). However, it did not reason with my logic, method or approach which I apply to selecting stocks. So I might one day see myself foregoing large profits in future, I will have to be calm and admit my limited ability to understand or see from my friend’s perspective how this is a winner.
Buffett then put his share of the partnership (about $25 million) into Berkshire Hathaway, a textile company whose best days seemed to be in the past. He used Berkshire Hathaway as a vehicle to acquire companies (GEICO in the insurance business and non-insurance companies such as See’s Candy, Blue Chip Stamps, and Buffalo News) and to make investments in other companies (Am Ex, The Washington Post, Coca-Cola, and Disney). His golden touch seemed to carry over, and Berkshire Hathaway’s stock price reflected his success.
An investment in Berkshire Hathaway in December 1988 would have outstripped the S&P 500 four-fold over the next 13 years.
As CEO of the company, Buffett broke with the established practices of other firms in many ways. He refused to fund the purchase of expensive corporate jets and chose to keep the company in spartan offices in Omaha, Nebraska. He also refused to split the stock as the price went ever higher to the point that relatively few individual investors could afford to buy a round lot in the company–recently trading around US$60,000 for a single share, making it by far the highest-priced stock in the United States. To discourage copy-cat funds that sprung up several years ago, Buffett launched Berkshire B shares that trade at 1/30th the value of the original. He insisted on releasing annual reports that were transparent and included his views on investing and the market, stated in terms that could be understood by all investors.
Roger Lowenstein, in his excellent book on Buffett, suggests that Buffett’s success can be traced to his adherence to the basic notion that when you buy a stock, you are buying an underlying business.
- The business the company is in should be simple and understandable. In fact, one of the few critiques of Buffett was his refusal to buy technology companies, whose business he said was difficult to understand.
- The firm should have a consistent operating history, manifested in operating earnings that are stable and predictable.
- The firm should be in a business with favorable long-term prospects.
- The managers of the company should be candid. As evidenced by the way he treated his own stockholders, Buffett put a premium on managers he trusted. Part of the reason he made an investment in The Washington Post was the high regard that he had for Katherine Graham, who inherited the paper from her husband.
- The managers of the company should be leaders and not followers. In practical terms, Buffett was looking for companies that mapped out their own long-term strategies rather than imitating other firms.
- The company should have a high return on equity, but rather than base the return on equity on accounting net income, Buffett used a modified version of what he called owner earnings.Owner Earnings = Net income + Depreciation and Amortization – Capital Expenditures
- The company should have high and stable profit margins and a history of creating value for its stockholders.
- In determining value, much has been made of Buffett’s use of a risk-free rate to discount cash flows. Because he is known to use conservative estimates of earnings and because the firms he invests in tends to be stable firms, it looks to us like he makes his risk adjustment in the cash flows rather than the discount rate.
- In keeping with Buffett’s views of Mr. Market as capricious and moods, even valuable companies can be bought at attractive prices when investors turn away from them.
Credits: Parts of this article is extracted from Aswath Damodaran’s Investment Philosophies: Successful Strategies and the Investors Who Made Them Work, 2003.