The Warren Buffett Way

by Robert G. Hagstrom

Prices are never so low or so high that they can be taken advantage of, and thus no investors can be capable of consistently identifying opportunities to benefit.

Warren Buffett has established a high standard for the future performance of Berkshire by setting an objective of growing intrinsic value by 15 percent a year over the long term,

He thinks about the business, the people who run the business, the economics of the business, and then the value of the business, and in each case he lays what he learns against his own benchmarks. I labeled them investment tenets and divided them into four categories: business tenets, management tenets, financial tenets, and market tenets.

“Your goal as an investor should be simply to purchase, at a rational price, a part interest in an easily understood business whose earnings are virtually certain to be materially higher, five, ten, and twenty years from now. Over time, you will find only a few companies that meet those standards—so when you see one that qualifies, you should buy a meaningful amount of stock.”

“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”

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.

“margin of safety.” In this approach, investors who are optimistic about a company’s future growth have two techniques for adding the stock to their portfolios: (1) purchase shares when the overall market is trading at low prices (generally, this occurs during a bear market or a similar type of correction), or (2) purchase the stock when it trades below its intrinsic value even though the overall market is not substantially cheap.

intrinsic value is “that value which is determined by the facts.” These facts include a company’s assets, its earnings and dividends, and any future definite prospects.

margin of safety could work successfully in three areas: (1) in stable securities such as bonds and preferred stocks; (2) in comparative analysis; and (3) in selecting stocks, provided the spread between price and intrinsic value is large enough.

(1) buy a company for less than two-thirds of its net asset value, and (2) focus on stocks with low price-to-earnings ratios.

the current assets. If the stock price was below this per-share value, Graham considered this to be a foolproof method of investing.

the results were based on the probable outcome of a group of stocks (diversification), not on the basis of individual results.

ability to grow sales and profits over the years, at rates greater than the industry average.

“products or services with sufficient market potential to make possible a sizable increase in sales for several years.”

his investment approach is a combination of a qualitative understanding of the business and its management (as taught by Fisher) and a quantitative understanding of price and value (as taught by Graham).

He looks for companies he understands, with favorable long-term prospects, that are operated by honest and competent people, and, importantly, are available at attractive prices.

Review annual reports from a few years back, paying special attention to what management said then about the strategies for the future. Then compare those plans to today’s results; how fully were the plans realized? Also compare the strategies of a few years ago to this year’s strategies and ideas; how has the thinking changed? Buffett also suggests it can be very valuable to compare annual reports of the company in which you are interested with reports of similar companies in the same industry. It is not always easy to find exact duplicates, but even relative performance comparisons can yield insights.

1. Focus on return on equity, not earnings per share. 2. Calculate “owner earnings” to get a true reflection of value. 3. Look for companies with high profit margins. 4. For every dollar retained, make sure the company has created at least one dollar of market value.

To measure a company’s annual performance, Buffett prefers return on equity—the ratio of operating earnings to shareholders’ equity.

business should achieve good returns on equity while employing little or no debt.

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.

Instead of cash flow, Buffett prefers to use what he calls “owner earnings”—a company’s net income plus depreciation, depletion, and amortization, less the amount of capital expenditures and any additional working capital that might be needed.

the one-dollar rule. The increase in value should, at the very least, match the amount of retained earnings dollar for dollar.

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.

Active portfolio managers are constantly at work buying and selling a great number of common stocks.

Index investing, in contrast, is a buy-and-hold approach. It involves assembling and then holding a broadly diversified portfolio of common stocks deliberately designed to mimic the behavior of a specific benchmark index, such as the Standard & Poor’s 500.

From an investor’s point of view, the underlying attraction of both strategies is the same: to minimize risk through diversification. By holding a large number of stocks representing many industries and many sectors of the market, investors hope to build in a warm blanket of protection against horrific loss that could occur if they had all their money in one arena and that arena suffered some disaster.

focus investing means this: Choose a few stocks that are likely to produce above-average returns over the long haul, concentrate the bulk of your investments in those stocks, and have the fortitude to hold steady during any short-term market gyrations.

That is the heart of focus investing: concentrating your investments in companies with the highest probability of above-average performance.

“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.”

The Kelly formula uses probability to calculate optimization—in this case, the optimal size bet one should make in the portfolio.

Thorp’s strategy was based on a simple concept. When the deck is rich with 10s, face cards, and aces, the player—let’s say it’s you—has a statistical advantage over the dealer. If you assign a −1 for the high cards and a +1 for the low cards, it’s quite easy to keep track of the cards dealt; just keep a running tally in your head, adding and subtracting as each card shows. When the count turns positive, you know there are more high cards yet to be played. Smart players save their biggest bets for when the card count reaches a high relative number.

“If the new thing you are considering purchasing is not better than what you already know is available,” says Charlie, “then it hasn’t met your threshold. This screens out 99 percent of what you see.”

You already have at your disposal, with what you now own, an economic benchmark—a measuring stick. You can define your own personal economic benchmark in several different ways: look-through earnings, return on equity, or margin of safety, for example. When you buy or sell stock of a company in your portfolio, you have either raised or lowered your economic benchmark.

The first is simply looking at stocks as businesses, which “gives you an entirely different view than most people who are in the market.” The second is the margin-of-safety concept, which “gives you the competitive edge.” And the third is having a true investor’s attitude toward the stock market.

“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.

“So why do smart people do things that interfere with getting the output they’re entitled to?” Buffett continued. “It gets into the habits and character and temperament, and behaving in a rational manner. Not getting in your own way. As I have said, everybody here has the ability absolutely to do anything I do and much beyond. Some of you will, and some of you won’t. For those who won’t, it will be because you get in your own way, not because the world doesn’t allow you.”6

Business Tenets