Legendary investor Warren Buffett has been in the stock market for over fifty years.
Serious mistakes cannot be avoided along such a long path, and Buffett could not have done without them.
But his tremendous success, which hardly anyone will be able to repeat, brought him and his investors billions.
Buffett has a lot to learn, and this, according to book author Robert Hagstrom, may be easier than you think.
The principles of investment activity, which, according to Hagstrom, Buffett adheres to, are quite simple. They do not have complex algorithms and formulas, as well as links to voluminous textbooks on investments.
It’s just that sometimes such simplicity is deceiving, besides, people are arranged in such a way that it’s more difficult for them to follow their own principles, albeit simple, than to repeat the actions of other market participants.
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An Investor Worth Considering
Warren Buffett began his investment career in 1956.
It was then that he invested $ 100 in his limited liability investment partnership.
A recent graduate of the Columbia University School of Business managed to attract seven partners who agreed to invest in the amount of 105 thousand dollars. Buffett’s success far exceeded all expectations.
By 1965, the total value of the assets of the partnership increased to $ 26 million. Four years later, the partnership was dissolved and the proceeds invested in Berkshire Hathaway. Buffett’s share (at that time 25 million) was enough to gain control of the new company.
By mid-2004, when the book was written, Buffett’s personal fortune reached $ 42.9 billion.
Apprentice Graham and Fisher
Among the people who had a great influence on Warren Buffett’s investment philosophy, there were two people with very different perspectives: Columbia University finance professor Benjamin Graham and the famous investor Philip Fisher. If at the beginning of his career, Buffett claimed that he was 15% Fisher and 85% Graham, then over time his philosophy shifted more and more towards Fisher, so now this ratio is about 50 to 50.
“Buffett focuses not on tracking stock prices, but on analyzing the economic performance of a company’s key business, as well as evaluating the quality of its management.”
Graham’s theory is based on just two simple rules.
The first of them urges the investor to avoid losses.
The second requires not to forget the first. Two methods of selecting objects for investment help to avoid losses: firstly, to acquire shares when the company’s price does not exceed two-thirds of the cost of equity, and secondly, to focus on companies with a low ratio “share price / net income per share” (P / E). In addition, to insure against unpleasant surprises, the company’s assets must exceed its obligations.
Markets are basically inefficient, Graham thought, which means that a prudent investor has a chance to capitalize on this inefficiency.
“Warren Buffett is characterized by ease of communication, straightforwardness, frankness and honesty. It is characterized by an attractive combination of refined, cold intellect and sentimental humor. He very much respects everything that lends itself to logical analysis, and has a strong dislike of human stupidity. “
Fisher, on the contrary, was sure that a reasonable investor uses all available sources of information to study the company’s business processes, knows its competitors and the industry well.
The maximum return on investment comes from companies with high potential, which are led by qualified managers. To select such companies, Fisher developed a system for evaluating the effectiveness of business management.
A good manager strives for sustainable profit-making in the long term (10–20 years), even if for this you have to sacrifice part of it in the short term.
Twelve Questions of Warren Buffett
Making investment decisions, Buffett seeks answers to twelve questions that are grouped into four categories: business, management, finance, company value.
I. What You Need to Know About the Business of the Company You Are Interested in
When choosing objects for investment, Buffett does not approach analysis as a supporter of particular market theory.
He does not take into account industry or macroeconomic trends. He studies the internal structure of the business, being primarily interested in three topics:
- How simple and understandable is the company’s business? If the investor is not able to understand the main aspects of the business (cash flow, labor relations, pricing features, principles of revenue and expenses, capital allocation), then he will not be able to correctly evaluate the events taking place in the company, and therefore make informed decisions. Buffett recommends limiting oneself to investments in companies that are part of the investor’s “circle of competence”. The boundaries of this circle may not be determined by one industry. Buffett himself invested in insurance companies, farming, textile, aluminum, cement, retail chains, advertising agencies, mining companies, cable TV channels.
- Does the company show stable results? Buffett has repeatedly convinced that significant changes in the organization’s work lead to serious errors with unpredictable consequences. Therefore, he tries to avoid investments in enterprises that change their direction after the previous strategy led to failure. Many investors, on the contrary, are attracted by companies that are in the process of reorganization. Buffett prefers facilities that can generate significant profits without the need for major reforms.
- What are the long-term prospects of the company? An investor should look for companies with a sustainable competitive advantage. Such companies satisfy three criteria: their goods are in great demand; there is nothing to replace it with; the state does not participate in pricing. The combination of factors that protect the company from competitors, Buffett calls the moat. The wider the “ditch”, the more difficult it is to overcome it, the more chances a company has of becoming Buffett’s attention.
II. What You Need to Know About the Management of the Company You Are Interested in
Assessing the quality of company management, Buffett seeks to find out the following:
- Does company management always act rationally? Rationalism is needed to make decisions about profit management, but this quality is rare in life. It was rationalism that became the hallmark of Buffett’s leadership style. The issue of profit distribution arises when the growth rate of business slows down and it begins to generate more money than necessary. Management can choose three options: 1) ignore problems and reinvest profits; 2) “buy growth” through the acquisition of other companies; 3) return the funds to shareholders. If the funds reinvested in the company cannot provide a return above the cost of capital, then, according to Buffett, only the last of them can be considered rational.
- Are leaders with investors sincere? The best managers are always open with shareholders, give them comprehensive financial information, and are ready to admit mistakes. When analyzing financial statements, specialists strive to answer three questions: what is the value of the company, whether it will be able to fulfill its obligations, and whether the management works well. The reports that Buffett himself provides to shareholders contain additional data that financial reporting standards do not require. But Buffett finds them useful in evaluating the cost-effectiveness of Berkshire. He expects the same honesty from the CEO of companies interested in him as an investor.
- Can management resist the trend of thoughtlessly copying the actions of other market participants?The most unexpected discovery for Buffett throughout his career turned out to be that even honest, qualified and experienced managers often act irrationally. This is due to the phenomenon that Buffett calls the institutional imperative. This invisible but powerful force encourages executives to imitate the actions of other market participants, no matter how reasonable they are. Its origins should be sought in human nature: it is much easier for us to follow the path laid by someone else. It is the “institutional imperative” that can explain the common features of the behavior of leaders: 1) resistance to any changes; 2) use of the maximum amount of funds for corporate projects and acquisitions; 3) the willingness of the team of top managers to justify any transaction, aggressively proposed by the CEO; 4) thoughtlessly copying the practice of other companies in such matters as business expansion or management compensation.
“Only rationally acting investors can survive in this stormy sea of irrational behavior.”
To understand the motives of the actions of any person, and even more so the leader is more difficult than to analyze the financial report.
Therefore, assessing the professional qualities of leadership is not a task for the lazy. But a “careful analysis of the intentions and actions of managers” pays off. Buffett advises first to get acquainted with several annual reports of the company, paying attention to the strategic plans announced by management and comparing them with the facts.
It is equally useful to compare the annual reports of the company and its competitors. Buffett recommends that investors use any means possible to develop intuition. If there are frauds or lies in the company’s statements, it is almost impossible to find them for an ordinary investor.
However, it does not hurt to take into account the following hazard signals: poor organization of accounting; unintelligible notes to the financial statements; guarantee of profit. A leader who claims to know the future does not deserve investor confidence.
III. What You Need to Know About Company Finance
No matter how impressive the company’s results are, you should not get carried away with their analysis. To understand the finances of the company, Buffett is looking for answers to the following questions:
- What is the return on equity? To assess the effectiveness of a company, many people analyze how the EPS ratio – net profit per share, has changed over the year. Buffett considers this approach erroneous. Much more useful information is contained in ROE, or return on equity. Buffett makes his own adjustments to this indicator: the company’s securities are taken into account at the purchase price; ignores changes in the market value of fixed capital. Buffett assesses a company’s ability to earn operating profit by using available capital.
- What is the “owners profit”? According to Buffett, cash flow cannot be considered an ideal way to determine the value of the company. This indicator does not take into account capital expenditures – funds that may be needed for modernization. Instead, Buffett uses what he calls the owners ’profit. They calculate the “owners’ profit ”as follows: depreciation and amortization are added to the net profit and the future capital costs, estimated approximately, are subtracted from it.
- What is the business profitability ratio? A well-managed company must always remain profitable. To do this, its leadership must be tough in relation to unnecessary costs. This is how Buffett himself rules Berkshire Hathaway. Headquarters staff is minimized. The company does not have a legal department, PR departments or strategic planning. While in many companies overhead costs reach 10% of operating profit (after tax), in Berkshire Hathaway they do not exceed 1%.
- Does every dollar of retained earnings give the same increase in the company’s market value? How to identify companies capable of successfully investing capital for a long time? Buffett uses a very simple test: every dollar of retained earnings should turn into at least a dollar of stock price growth. The logic here is transparent. With a successful investment, the market value will increase sooner or later. Otherwise, the stock price will inevitably decline.
IV. What You Need to Know About Company Value
Having figured out whether the company is interesting to him as an object of investment, Buffett goes on to analyze the ratio of price and actual value of shares.
- “What is the value of the company?” If the company’s business is simple and straightforward, and it has proven that it can bring a stable profit for a long time, then calculating future cash flows will not be difficult. So, it’s not so difficult to calculate the real value of the company. It is enough to discount the net cash flow (“owner’s profit”) for the entire life of the company, taking into account the corresponding interest rate. If it is not possible to make a cash flow forecast, then Buffett crosses out the company from the list of potential investment objects.
- “Is it possible to buy a company at a price significantly lower than its actual value?” Benjamin Graham Buffett learned the lessons of a lifetime. He is looking for companies with high profitability and is trying to buy their shares at a price lower than their fair price. Such opportunities may arise when a generally well-functioning company finds itself in unusual circumstances, forcing investors to sell or lower the valuation of its securities.
Most investment portfolio managers use either active or index strategies, which are fundamentally different from each other.
If in the first case, transactions of purchase and sale of a large number of securities are constantly being made, then in the second case, a widely diversified portfolio that is held for a long period is formed.
Buffett managed to find a third approach. His idea is to choose a relatively small number of companies (from 10 to 20) that can show high profitability, concentrate their capital in them and not sell them even during periods of adverse market behavior.
This approach is called a concentrated investment. The concentration of most of the capital in such stocks can give better results than any stock index.
Without exception, all investors need to remember the role that emotions play.
On the one hand, you need to control your own emotions, and on the other hand, do not miss the moment when the rash decisions of other investors will create the preconditions for conducting profitable deals.
Truly successful investors are distinguished by several features:
- Composure. Stock prices will inevitably rise and fall under the influence of various, both rational and irrational factors. The one who cannot calmly withstand a 50% drop in shares has no place in the stock market.
- Patience. The main advantage of the investor is the ability to say no, “do not succumb to the infectious enthusiasm of the crowd”, but patiently wait for a favorable chance.
- The rationality of thinking. The best investors are not characterized by either excessive pessimism or excessive optimism. Excessive optimism forces us to abandon a serious analysis and search for truly worthy objects for investment. Excessive pessimism encourages the sale of securities at an inappropriate time for this.
- Warren Buffett’s first investment was only $ 100, and by 2004 his fortune was estimated at almost $ 43 billion.
- Since 1965, Buffett has been managing Berkshire Hathaway.
- Buffett’s investment philosophy was greatly influenced by Columbia University professor Benjamin Graham and renowned investor Philip Fisher.
- Buffett’s creed: an investor makes informed decisions only if he analyzes the company’s economic performance and the quality of its management.
- Buffett recommends limiting oneself to investments in companies that are part of the investor’s “circle of competence”. This circle may include several industries.
- Before making a purchase decision, Buffett seeks answers to questions divided into four groups: business, leadership quality, finance, company value.
- Even experienced managers do not always act rationally. They are hindered by the “institutional imperative” – the tendency to imitate the actions of industry colleagues.
- There are two approaches to investing – active and index. Buffett uses a third approach – “concentrated investments” in a small number of companies.
- Buffett is looking for companies with high profitability and is trying to buy their shares at a price lower than their actual value.
- According to Buffett, a successful investor is distinguished by composure, patience, and rationality of thinking.
Why You Should Read “The Warren Buffett Way”
- To know what it takes to become a successful investor
- To open the world of investment knowledge
- To become more intelligent in the finance field