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In his experience, managers of high-cost operations tend to find ways to continually add to overhead, whereas managers of low-cost operations are always finding ways to cut expenses.
“The really good manager,” Buffett says, “does not wake up in the morning and say, ‘This is the day I’m going to cut costs,’ any more than he wakes up and decides to practice breathing.”25
“attack costs as vigorously when profits are at record levels as when they are under pressure.”26
Speaking broadly, the stock market answers the fundamental question: What is this particular company worth? Buffett proceeds in the belief that if he has selected a company with favorable long-term economic prospects, run by able and shareholder-oriented managers, the proof will be reflected in the increased market value of the company.
The same is true for how well the company reinvests its retained earnings
The increase in value should, at the very least, match the amount of retained earnings dollar for dollar. If the value goes up more than the retained earnings, so much the better.
“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.”27
Market Tenets
Theoretically, the actions of an investor are determined by the differences between price and value. If the price of a business is below its per-share value, a rational investor will purchase shares of the business.
As the company moves through its economic value life cycle, the analyst will periodically reassess the company’s value in relation to market price, and buy, sell, or hold shares accordingly.
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?
Determine the Value
Through the years, financial analysts have used many formulas for calculating the intrinsic value of a company.
the best system, according to Warren Buffett, was determined more than 70 years ago by John Burr Williams in his book The Theory of Investment Value.
Paraphrasing Williams, Buffett tells us that the value of a business is determined by the net cash flow expected to occur over the life of the business discounted at an appropriate interest rate.
For Buffett, determining a company’s value is easy as long as you plug in the right variables: the stream of cash flow and the proper discount rate.
In his mind, the predictability of a company’s future cash flow should take on a “coupon-like” certainty like that found in bonds. If the business is simple and understandable, and if it has operated with consistent earnings power, Buffett is able to determine the future cash flows with a high degree of certainty. If he cannot, he will not attempt to value a company. This is the distinction of his approach.
After he has determined the future cash flows of a business, Buffett applies what he considers the appropriate discount rate. Many people will be surprised to learn that the discount rate he uses is simply the rate of the long-term U.S. government bond, nothing else. That is as close as anyone can come to a risk-free rate.
Last, there are times when long-term interest rates are abnormally low. During these periods, we know that Buffett is more cautious and likely adds a couple of percentage points to the risk-free rate to reflect a more normalized interest rate environment.
“value investors”—use low price-to-earnings ratios, low price-to-book values, and high dividend yields. They have vigorously back-tested these ratios and concluded that success can be had by isolating and purchasing companies with exactly these accounting ratios.
Others claim to have identified value by selecting companies with above-average growth in earnings; they are customarily called “growth investors.”
Focusing on good businesses—those that are understandable, with enduring economics, run by shareholder-oriented managers—by itself is not enough to guarantee success, Buffett notes. First, he has to buy at sensible prices and then the company has to perform to his business expectations. If we make mistakes, he points out, it is either because of (1) the price we paid, (2) the management we joined, or (3) the future economics of the business. Miscalculations in the third instance are, he notes, the most common.
It is Buffett’s intention not only to identify businesses that earn above-average returns, but to purchase them at prices far below their indicated value. Graham taught the importance of buying a stock only when the difference between its price and its value represented a margin of safety.
The margin-of-safety principle assists Buffett in two ways. First, it protects him from downside price risk. If he calculates the value of a business to be only slightly higher than its per-share price, he will not buy the stock; he reasons that if the company’s intrinsic value were to dip even slightly because he misappraised future cash flow, eventually the stock price would drop, too, perhaps below what he paid for it. But if the margin between purchase price and intrinsic value is large enough, the risk of declining intrinsic value is less.
The margin of safety also provides opportunities for extraordinary stock returns.
if Buffett, by using the margin of safety, is able to buy this outstanding business at a significant discount to its intrinsic value, Berkshire will earn an extra bonus when the market corrects the price of the business.
Anatomy of a Long-Term Stock Price
A great business (center column), over time (the x-axis), will produce rising shareholder value (the y-axis) as long as it is bought at a good price (left-hand column), and managerial decisions (right-hand column) avoid extinction in the market, do better than simply matching market rate, and instead lead to increased value in the company.
The idea of buying stock without understanding the company’s operating functions—including its products and services, inventories, working capital needs, capital reinvestment needs (e.g., plant and equipment), raw material expenses, and labor relations—is unconscionable, says Buffett.
In the summation of The Intelligent Investor, Benjamin Graham wrote, “Investing is most intelligent when it is most businesslike.” These words are, Buffett often says, “the nine most important words ever written about investing.”
If management does its job, banks can generate a 20 percent return on equity. Although this is below what a Coca-Cola might earn, it is above the average return for most businesses.
Buffett says that he is “quite content to hold any security indefinitely, so long as the prospective return on equity capital of the underlying business is satisfactory, management is competent and honest, and the market does not overvalue the business.”
Chapter 5 Portfolio Management
We must also take into account three important portfolio management constructs that Buffett has developed: 1. His way of building a portfolio for long-term growth. 2. His alternative measuring stick for judging the progress of a portfolio. 3. His techniques for coping with the emotional roller coaster that inevitably accompanies portfolio management. (The psychological challenges of managing a Warren Buffett portfolio are fully discussed in Chapter 6.)
He refers to himself as a “focus investor”—“We just focus on a few outstanding companies.”1 This approach, called focus investing, greatly simplifies the task of portfolio management.
Remember Buffett’s advice to a “know-nothing” investor, to stay with index funds? What is more interesting is what he said next: “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.”
“Know-something” investors, applying the Buffett tenets, would do better to focus their attention on just a few companies—five to 10, Buffett suggests.
“With each investment you make, you should have the courage and conviction to place at least ten percent of your net worth in that stock.”5
Even though all the stocks in a focus portfolio are high-probability bets, some will inevitably be higher-probability than others, and they should be allowed a greater proportion of the investment.
The Kelly formula uses probability to calculate optimization—in this case, the optimal size bet one should make in the portfolio.
Focus investing is the antithesis of a broadly diversified high-turnover approach. Although focus investing stands the best chance, among all active strategies, of outperforming an index return over time, it does require investors to patiently hold their portfolios when it appears that other strategies are marching ahead.
In shorter periods, we realize that changes in interest rates, inflation, or near-term expectations for a company’s earnings can affect share prices. But as the time horizon lengthens, the trendline economics of the underlying business will increasingly dominate its share price.
How long is that ideal time? There is no hard-and-fast rule, although Buffett would probably say five years since this is the time period he is focusing on for Berkshire Hathaway’s results.
When it isn’t possible to do enough repetitions of a certain event to get an interpretation of probability based on frequency, we have to rely on our own good sense.
According to the textbooks on Bayesian analysis, if you believe that your assumptions are reasonable, it is “perfectly acceptable” to make your subjective probability of a certain event equal to a frequency probability.12 What you have to do is sift out the unreasonable and illogical and retain the reasonable. It is helpful to think about subjective probabilities as nothing more than extensions of the frequency probability method.
In fact, in many cases, subjective probabilities add value because this approach allows you to take operational issues into account rather than depend on long-run statistical regularity.
Buffett’s decision process is an exercise in subjective probability. He explains: “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
Exmple of how to calculate probaility with abott price going from 18 to 27 cause of chances of a merger at $30 per share
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 as 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
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Recommended for blackjack
The stock market, of course, is far more complex that the game of blackjack. In a card game, there are a finite number of cards and therefore a limited number of possible outcomes. The stock market, with many thousands of stocks and millions of investors, has an almost unlimited number of various outcomes. Using the Kelly approach requires constant recalculations and adjustments throughout the investment process.
