Thursday, October 9, 2014

Book Review #15: The Warren Buffet Way: Author: Robert G Hagstrom

Concepts: Circle of Competence, Moat, Owner's earnings

Quick Review

If you are a savvy and knowledgeable investor who want to augment your investing skills by learning from the expert practitioners, then this book is for you. If you are not, and still want to invest, then I will suggest index investing.

The operative part of the book 'The Warren Buffet Way' consists of three themes. The first theme deals with the various tenets followed by Mr.Buffet for identifying potential investment opportunities. Mr.Buffet follows 12 tenets grouped into four parts vis. Business Tenets, Management Tenets, Financial Tenets and Value Tenets. These tenets act as guiding non-negotiable principles that he uses to evaluate companies and businesses. He focuses on business that are simple and easy to understand, with high level of operational consistency and managed by exceptional talents with high level of integrity. Unlike other analysts who focus on Earnings Per Share as a measure of business valuation, Buffet focus on 'Owner's Earnings'. The key difference between these is that while the former focuses entirely on the Profit and Loss Statement, the latter also looks at the impact of Capital Expenditures (Balance Sheet Item) on the Overall Earnings. And finally, the objective is to buy businesses that are trading at a discount to the intrinsic value giving him a margin of safety.

The second theme looks at how an investor should build one's portfolio. Traditionally one of the two approaches is followed. First one is the Value Approach. A follower of this approach will will identify companies that are trading at deep discount to their intrinsic value expecting that the market will ultimately find the true value of the company. Growth Investing, on the other hand will try to identify companies that are in Growth Sectors and invest in companies in those sectors hoping to run with the growth. 

Both these approaches have their advantages. However the problem with both the approaches is that they place excessive focus on the current market price of the company and less focus on the future business potential. Even when you are investing in a potential growth opportunity, you have to pay attention to the market price. There is no point in paying excessively high price for a growth opportunity. In the same way, there is no point in buying a company simply because it is trading at very low valuations. 

Buffet follows a new approach called Focus Investing. The first step in focus investing is to create a concentrated portfolio of about 5-10 Stocks that are trading at substantial discount to intrinsic value. Once you identify such a stock, next step is to invest significant amount in that stock. Once you have completed the above steps, wait for market to discover the fair value. The holding period is long-term, 10 years to forever, and the daily price fluctuations are ignored. Since the initial research was thorough the portfolio risk is minimal.

The final theme in this book relates to behavioral aspects of investing. The chapter describes a few habits, also known as Heuristics, that can impact the portfolio returns of an investor. These have been extensively covered in the book by Mr.Parag Parekh.

That this book is a bestseller is a testament to its value and the interest that Mr.Buffet elicits among informed readers. The clarity and lucidity in this book is an added bonus. 

Chapter Summary

Chapter 1 discusses the initial years of Warren Buffets career as an investor. In the years from 1955 to 1969, Mr.Buffet converted a $100 of initial capital into 25 Million Dollars. On the way he purchased Berkshire Hathaway, a textile company, and converted that as his holding company for his market investments. From 1970 till today, he has outperformed the Dow Jones index for most of the years. Mr.Buffet invests within his 'Circle of Competence', list of business that he can understand. He is on the lookout for stocks that are trading at significant discount to intrinsic value and when he finds such company, he invests significant amount.

In his investment journey  Buffet has been influenced by experts like  Benjamin Graham, Charlie Munger,Philip Fisher and John Burr Williams. Chapter 2 covers the lessons that Buffet learned from the masters. From Graham he learned the concept of Value Investing. This involves buying companies that are trading at deep discount to the intrinsic value and wait for the market to realize the value. Graham also taught him to manage his emotions while investing in Stock Market. From John Burr Williams, he learnt the conceptual approach to identifying the intrinsic value. The approach called 'Discounted Cash Flow Model' consist of discounting the future cash flows at a risk adjusted discounted factor (Buffet used 10% as the discount factor). Charlie Munger taught Buffet how to identify businesses with significant growth potential and not to lay excessive focus on current valuation. Philip Fisher taught him the importance of keeping a tight portfolio and deeply understanding each stock in the portfolio.

Chapter 3 details the evolution of Berkshire Hathaway. This was a textile company that Buffet purchased in 1965. Over the years this has become a holding company for Buffet's investments. He closed down the textile business in 1985. Starting in 1967 with the purchase of GEICO Buffet has added many other insurance companies to his business portfolio. The attraction for insurance companies is the steady cash flow that they produce, a cash flow that Buffet uses to finance his investment activities. Cumulatively these companies produced about 44 Billion in cash in 2003. Buffet buys both businesses as well as invests in stocks of companies.

Over the course of his career, Buffet has purchased numerous business. He has also purchased the stocks of many companies that he has held for long-term. Chapter 4 deals with the approach that Buffet takes to his investment decisions. Buffet's approach to buying a business or investing in stocks of a company is the same. Look from the perspective of the owner of the business. He does the same due diligence to stock purchases as he would do for buying a business. He looks for businesses with consistent operating performance history, with sound management and which are trading at discount to fair value. Due diligence also involves considering the operational functions of the company - its products and services, raw material expenses, plant and equipment, capital expenditure requirements, inventories, receivables and need for working capital.

Chapter 5 details the first of the four tenets, vis. Business Tenets which looks at the basic characteristics of the business itself.. Buffet only invests in companies within his area of financial and intellectual understanding. He calls it his  'circle of competence'. The business should be simple and easy to understand. Since Technology stocks are outside his circle of competence, he avoided the sector altogether. He looks for businesses with consistent operating history. Not for him are those companies that do well in one quarter and badly in others. Same is the reason for avoiding turnarounds. He would rather wait for business to turnaround and produce consistent performance before investing in them. Finally he looks for companies with favorable long-term prospects. Buffet looks for companies with has a product or service that is widely needed, whose products do not have close substitutes, in an industry which is not regulated and an industry that has a strong barrier to entry. Buffet calls it the 'Moat'. The larger the Moat, the better the long-term prospects are of the company.

Buffet realizes that an exceptional company is led by an exceptional management. Chapter 6 considers the tenets that he considers while evaluating the management of the company. He looks for rationality in the way management makes capital allocation decisions. Faced with excess cash, a rational management makes either of the two decisions. One, invests in opportunities that can produce returns in excess of cost of capital. This will increase the shareholder value.Two, if such opportunities are not available, return the cash to shareholders in the form of dividends or share buyback (which is the preferred option). Buffet places a high premium on managements that are candid with the shareholders in terms of the financial performance of the company as well as in sharing the failures as well as successes and in admitting the mistakes committed.  When it comes to business decisions, many managers tend to 'follow the herd' or as Buffet calls it 'Institutional Imperative'. For example, the company makes risky investments because competitors are doing that and are getting away with it. Management's ability to resist the institutional imperative is the third tenet that Buffet follows along with test for rationality and evaluation of the candor. The chapter ends with a discussion on how one can identify a great management. One of the suggestions is to go back to the financial report of the past and look for effective implementation of strategies laid out in the past. Another check is to look for strategic consistency. Current strategies should seamlessly dovetail with the past strategies.

Chapter 7 looks at the Financial Tenets. Unlike other analysts Buffet do not give a lot of importance to Earnings Per Share calculations.His focus is on consistent growth in Return on Equity. To do this calculation, Buffet removes all the abnormal and one off items from the returns and considers the impact of asset base and inflation while calculating the equity base. Unlike traditional approaches that follow Cash Flow as a proxy to company's earnings, Buffet uses 'Owner's Earnings' which is calculated by reducing Capital Expenditures and Working Capital Requirements from the Cash Flow calculations. Consistent or increasing profit margins is another important parameter to be considered. Buffet looks for companies where cost reduction is a habit rather than a project. It is very clear that companies cannot increase profit margin on a regular basis without focusing on cost cutting. Finally, Buffet looks for companies that create at least one dollar of market value for one dollar of earnings retained. A company can achieve this only by generating returns at least equal to the cost of capital on every additional dollar of retained earnings.

Quote: "A manager forced to make the numbers will at some point make 'up' the numbers"

Chapter 8 covers the last of the four tenets, the Value Tenet. To calculate the value, Buffet uses the Discounted Cash Flow Approach. In this approach the value of a business is calculated by discounting all the future cash flows ('Owner's Earnings') by an appropriate discount factor. Buffet normally uses the interest rate on 30 Year Government bonds as the discount rate. Since he looks for companies with consistent operating history and high visibility of cash flows, he do not use risk premium in the discount rate. The second aspect to the value tenet is the price that you pay to buy the stock. Buffet looks for companies trading at significant discount to the intrinsic value so that a margin of safety is established. More about Buffet's Valuation Methodology is discussed in THIS BOOK

Chapter 9 focuses on Warren Buffet's investments in Fixed Income Securities. Three types of securities are covered. They are Bonds, Arbitrage and Convertible Preferred Stocks. By 2003, about 30 percent of Berkshire's portfolio comprised of Fixed Income Securities. Buffets devotes the same attention and follows the same principles to buying Fixed Income Securities as he does to stocks. While buying Fixed Income Securities, Buffet looks for Margin of Safety, discount to intrinsic value and uninterrupted cash flow. Buffet buys Fixed Income Securities at a discount to market value and then waits for market to discover the value.

Chapter 10 discusses Portfolio Management. The two traditional styles are Active Investing and Index Investing. Active Investing try to buy stocks that will perform better than the index. The objective is to get what are known as 'Alpha' returns. Active investors will need to be financially savvy. If you are not a savvy investor, and still want to invest in stock market, you can invest in the respective indexes. This involves identifying an index ( like Sensex or Nifty) and invest in the stocks in the index in the same proportion of their value in the index. Index investing, also called 'Passive Investing' is found to perform better than 90 percent of the Actively managed mutual funds. Buffet follows neither of the methods. He follows what is known as Focus Investing. There are four elements to Focus Investing. One, identify Outstanding companies run by efficient management. Two, Limit your portfolio to about 15 companies you can truly understand. Three, invest significant amounts in the companies that you identified in element one above. And four, ignore market volatility. If you have done your analysis thoroughly, you are not going to be significantly impacted by day to day price changes.

Chapter 11 covers the behavioral aspects of money. Making money is a mental activity. There are some behavioral trait that an investor need to cultivate if she wants to be successful. A true investor is calm, patient and rational. Some of the behavioral traits that can hamper successful investing include Overconfidence, Overreaction (especially to bad news), Loss aversion -  people feel twice as bad about loss as they do about gain and this makes them overly conservative investors, mental accounting - where people put money into different 'mental buckets' and treat these buckets differently and risk tolerance - Women are more risk averse than men and older people are more risk averse than younger people. Since he has done thorough due diligence before investing, Warren Buffet is immune from the psychological aspects of investing. He look for buying opportunities when market is down and people are selling and he is very cautious when the markets start going up uncontrollably.

Chapter 12, the final chapter, rounds off by summarizing simple investment style that an investor should follow. First step is to do the due diligence before investing in a stock and then turn off the stock market. The prices in the market keeps fluctuating, however if the fundamental analysis is correct then one should not react to the stock price movements. Like Buffet does, do an annual analysis to see if your assumptions are getting validated. Second step is to stop worrying about the economy. Buffet invests in companies that will do well in any economic scenario. Third aspect is to buy a business and not a stock. Invest in stocks as if you are buying a part of the business. Look at key operational functions, look at the business prospects, looks at the cash flow pattern...In short follow the tenets described in this book and invest for long term. Don't look at your portfolio as comprising stocks, look at it as comprising businesses. When you follow this approach, you are less likely to sell your business when it is making profit, you are likely to do thorough due diligence before investing in a new company and you are likely to maintain a tight portfolio. After all it is not the number of stocks in your portfolio that matters, it is the quality of the stocks that matter.

This book is for the informed investor, not a beginner. For an informed investor, this book is one heck of a value add.

Highly recommended. Will give 4/5.

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