An Essential Buffett 2 Step Strategy (Part 1)

So we last discussed that it will be very difficult for an investor to replicate Warren Buffett’s success based on what he did. That is because those events in which he took those investing actions may never repeat itself. However, I would argue that investors looking to replicate his success to focus on the how and why rather than the what. Here in two parts, I will share in my view his 2-step strategy, which in general is essentially and in a nutshell how and why he makes his investing decisions. These are:

  • Step 1 – Determining the Value of the Business
  • Step 2 – Buy at Attractive Prices

It’s that simple…. but not so easy in a business. (Easy enough if you are just buying shoes, bags, fruits, etc…. ) So let’s dive a bit deeper.

Step #1… Determine the Value of the Business

Through the years, financial analysts have used many formulas for calculating the intrinsic value of a company. Some are fond of various shorthand methods: low price-to-earnings (PE) ratios, low price-to-book values, and high dividend yields. But the best system, according to Buffett, was determined more than 60 years ago by John Burr Williams in The Theory of Investment Value.

Paraphrasing William’s theory, Buffett tells us the value of a business is the total of the net cash flows (owner earnings) expected to occur over the life of the business, discounted by an appropriate interest rate. He considers it simply the most appropriate yardstick with which to measure a basket of all different investment types: government bonds, corporate bonds, common stocks, apartment buildings, oil wells, and farms.

The mathematical exercise, Buffett tells us, is very similar to valuing a bond. The bond market each day adds up the future coupons of a bond and discounts those coupons at the prevailing interest rate. That procedure determines the value of the bond. To determine the value of a business, an analyst estimates the future and then discounts all of these coupons back to the present. ‘So valued,’ Buffett says, ‘all businesses, from manufacturers of buggy whips to operators of cellular telephones, become economic equals.’

To summarize: Calculating the current value of a business means, first, estimating the total earnings that will likely occur over the life of the business, and then discounting that total backward to today. (Keep in mind that, for ‘earnings’, Buffett uses owner earnings–net cash flow adjusted for capital expenditures.) To estimate the total future earnings, we would apply all we had learned about the company’s business characteristics, its financial health, and the quality of its managers, using the analysis principles described by Buffett. For the second part of the formula, we need only decide what the discount rate should be.

Buffett is firm on one point: He looks for companies with future earnings that are as predictable, and as certain, as the earnings of a bond. If the company has operated with consistent earnings power and if the business is simple and understandable, Buffett believes he can determine its future earnings with a high degree of certainty. If he is unable to project with confidence what the future cash flows of a business will be, he will not attempt to value the company.

This is the distinction of Buffett’s approach. Although he admits that Microsoft is a dynamic company and he highly regards Bill Gates as a manager, Buffett confesses he hasn’t a clue how to estimate the future cash earnings of this company. This is what he means by ‘the circle of competence’; he does not know the technology industry well enough to project the long-term earnings potential of any company within it.

This brings us to the second element in the formula: What is the appropriate discount rate? Buffett’s answer is simple: The rate that would be considered risk-free. For many years, he used the current rate for long-term government bonds (30 years) then. Because the certainty that the U.S. government will pay its coupon over the next 30 years is virtually 100%, we can say that this is a risk-free rate. When interest rates are low, Buffett adjusts the discount rate upward. When bond yields dipped below 7%, Buffett upped his discount rate to 10%. If interest rates work themselves higher over time, he has successfully matched his discount rate to the long-term rate. If they do not, he has increased his margin of safety by three additional points.

Some academicians argue that no company, regardless of its strengths, can ensure future cash earnings with the same certainty as a bond. Therefore, they insist, a more appropriate discount factor would be the risk-free rate of return plus an equity risk premium, added to reflect the uncertainty of the company’s future cash flows. Buffett does not add a risk premium. Instead, he relies on the margin of safety that comes from buying at a substantial discount in the first place, and on his single-minded focus on companies with consistent and predictable earnings. ‘I put a heavy weight on certainty,’ Buffett says, ‘If you do that, the whole idea of a risk factor doesn’t make any sense to me.’

Stay tuned for Part 2…….

 

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