More on this book
Community
Kindle Notes & Highlights
Sidney talked about financial issues of the day,
Someone who conducts a thorough financial analysis based on sound logic and makes a choice for a reasonable rate of return without compromising safety of principal would be, by Graham’s definition, an investor, not a speculator.
buy a company for less than two-thirds of its net asset value, and (2) focus on stocks with low price-to-earnings ratios.
Successful investing involves purchasing stocks when their market price is at a significant discount to their underlying business value.
Business tenets—three basic characteristics of the business itself. 2. Management tenets—three important qualities that senior managers must display. 3. Financial tenets—four critical financial decisions that the company must maintain. 4. Market tenets—two interrelated cost guidelines.
Tenets of the Warren Buffett Way Business Tenets Is the business simple and understandable?
Does the business have a consistent operating history? Does the business have favorable long-term prospects? Management Tenets Is management rational? Is management candid with its shareholders? Does management resist the institutional imperative? Financial Tenets
Focus on return on equity, not earnings per share. Calculate “owner earnings.” Look for companies with high profit margins. For every dollar retained, make sure the company has created at least one dollar of market value. Market Tenets What is the value of the business?
Can the business be purchased at a significant discount to its value?
What Buffett does say is that a good business should be able to earn a good return on equity without the aid of leverage. Companies that depend on debt for good returns on equity should be viewed suspiciously.
“Within this gigantic auction arena, it is our job to select a business with economic characteristics allowing each dollar of retained earnings to be translated eventually into at least a dollar of market value.”
In sum, then, rational investing has two components. 1. What is the value of the business? 2. Can the business be purchased at a significant discount to its value?
the investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase.”30
“Investing is most intelligent when it is most businesslike.”
playing cards. Buffett considers this the height
By 1992, the market value had grown to $2.630 billion. Over those 20 years, for every $1.00 the company retained, it created $1.81 in market value for shareholders.
reputation for being candid with its shareholders. Tenet: Rationality
Thus, for every dollar retained, GEICO created $3.12 in market value for its shareholders. This financial accomplishment demonstrates not only GEICO’s superior management and niche marketing, but its ability to reinvest shareholder money at optimal rates.
in 1984. Tenet: Consistent Operating History Both Capital Cities and American Broadcasting Companies had profitable operating histories dating back more than 30 years. ABC averaged 17 percent return on equity and 21 percent debt to equity from 1975 through 1984. Capital Cities, during the 10 years before its offer to purchase ABC, averaged 19 percent return on equity
Both active and index funds do offer diversification, but, in general, neither strategy will give you exceptional returns.
“If you are a know-something investor, able to understand business economics, and can locate five to ten sensibly priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you.”4
A 10 percent turnover rate suggests that an investor holds the stock for 10 years; a 20 percent rate implies a five-year period.
“Take the probability of loss times the amount of possible loss
“If I think there is a 90 percent chance of occurring and there is 3 points on the upside and there is a 10 percent chance that it will fall through and there is 9 points on the downside, then that’s $0.90 off of $2.70, leaving $1.80 mathematical expectation.”15
Next, said Buffett, you have to figure in the time span involved and then relate the return of the investment to other investments available to you. If you bought one share of Abbott Company at $27, there is, according to Buffett’s mathematics, a potential 6.6 percent return ($1.80/$27). If the deal is expected to close in six months, the annualized return on the investment would be 13.2 percent. Buffett would then compare the return from this risk arbitrage with other returns available to him.
The Kelly optimization model, often called the optimal growth strategy, is based on the concept that if you know the probability of success, you bet the fraction of your bankroll that maximizes the growth rate. It is expressed
a formula: 2p − 1 = x where 2 times the probability of winning (p) minus 1 equals the percentage of your total bankroll that you should bet (x). For example, if the probability of beating the house is 55 percent, you should bet 10 percent of your bankroll to achieve maximum growth of your winnings. If the probability is 70 percent, bet 40 percent. And if you know the odds of winning are 100 percent, the model would say: Bet it all.
“In the short run the market is a voting machine but in the long run it is a weighing machine.”51
“The goal of each investor,” says Buffett, “should be to create a portfolio (in effect, a company), that will deliver him or her the highest possible look-through earnings a decade or so from now.”53
It should be noted that in order to generate substantial returns from short-term arbitrage, the strategy must be employed frequently, over and over again. Shleifer and Vishny also explain that, to increase your investment return beyond what a speculator would likely receive, you must be willing to increase the cost of the investment (the amount of time your money is invested) as well as
take on more risk (uncertainty as to when the outcome will be resolved). The controlling variable for both speculators and investors is the time horizon. Speculators work in short-horizon periods and accept smaller returns. Investors operate over long-horizon periods and expect larger returns.
What mindware would you need to activate System 2 thinking? At a minimum, you would read a company’s annual report and the annual reports of competitors. If
it appears the company has a strong competitive position with a favorable long-term outlook, you would next run several dividend discount models that include different growth rates of the company’s owner earnings over different time periods to get a sense of approximate valuation. Then you would study and understand management’s long-term capital allocation strategy. Last, you might call a few friends, colleagues, or financial advisers to see if they have an opinion about your company or, better yet, your company’s competitors. Take note: None of this requires a high IQ, but it is more
...more
“How I got here is pretty simple in my case. It is not IQ, I’m sure you will be glad to hear. The big thing is rationality. I always look at IQ and talent as representing the horsepower of the motor, but that the output—the efficiency with which the motor works—depends on rationality. A lot of people start out with 400 horsepower
motors but only get 100 horsepower of output. It’s way better to have a 200 horsepower motor and get it all into output.
You know you have approached Buffett’s level when your attention turns to the stock market and the only question on your mind is: “Has anybody done anything foolish lately that will allow me an opportunity to buy a good business at a great price?”
