Warren Buffet: Greatest of All Time
April 10, 2017
What were you doing at age 11?
If you were Warren Buffet, you were already dabbling with investing in the stock market. That’s right, at just 11 years of age Buffet bought 3 shares of Cities Service (later becoming the multinational company Citgo).
Warren Buffet is one of the wealthiest people in the world, often playing billionaire-tag with Bill Gates over the top spot. Born in Omaha, Nebraska during the height of the Wall Street crash of 1929, Buffet would go on to create an incredible investing empire through his firm Berkshire Hathaway.
Buffet’s success cannot be overstated. Between 1964 and 2014 Berkshire Hathaway produced an incredible 1,826,163% return for shareholders. $1000 invested with Buffet in 1964 would be worth $10.5 million today.
The Early Years
Buffet was a bit of a hustler in his youth. His first business venture came in 1945, as a high school sophomore. He and a friend bought a used pinball machine for $25 and placed it in a barber shop. A few months later, they sold the machine and a few others they had bought over the months for $1200.
By 15, he was making $175 a month delivering newspapers in Washington, DC, where his family had moved to. By the way $175 in 1945 is about $2,400 in 2017. By the time he was 18, after investing in a business his father owned and having bought some farmland, Buffet had about $10,000 in savings (about $100,000 today).
It’s clear that Warren Buffet always had great drive and ambition, even from a very young age. He would go on to study at the Wharton School at the University of Pennsylvania, before being rejected from Harvard Business School.
This ended up being a blessing in disguise. Upon hearing that the great investor Benjamin Graham was a professor at Columbia University in New York City, Buffet applied and was admitted into the Columbia Business School.
Buffet and Benjamin Graham formed a deep friendship when Buffet attended Columbia, and the university professor heavily influenced Buffet. To understand Buffet then, we have to understand Ben Graham, the man who introduced the idea of intrinsic value to the world.
Intrinsic value is a calculation that value investors try to apply to companies, in an attempt to understand how much a company is actually worth. This value can be different from the market value, i.e. the price that investors in the market are willing to pay for it.
Ideally, a value investor leaning on intrinsic value looks to snap up companies that are trading for below their intrinsic value. Intuitively that makes sense. If you buy shares in a company at a discount, then by definition you will make a profit as the market wakes up to the intrinsic value.
Bufffet has said that his philosophy can be described as “85% Ben Graham, and 15% Phil Fisher”. While that might have been true early on in his career, today’s Buffet is probably the inverse of that.
You see, early Buffet followed a style of investing called cigar butt investing, championed by Benjamin Graham. This style of investing focuses on investing in mediocre companies at bargain basement prices.
As Buffet became more experienced he was persuaded to leave cigar butt investing behind – favoring more established companies and holding them for the long term. This is a very Phil Fisher-esque strategy; Fisher once held stock in Motorola from 1955 to 2004, the year he passed away.
A few of Buffet’s favorite investing metrics and principles, used to grow his impressive investing empire, are outlined below.
High Return on Equity
We can get clues about Buffet’s investment style from the annual letters he writes to Berkshire Hathway’s shareholders. In his 1987 letter, he stressed the importance of return on invested capital, or return on equity. That year Buffet mentioned how Berkshire’s 7 largest non-financial subsidiaries had earned $100 million after taxes. He then went on to stress that the $100 million figure on its own meant nothing, without understanding how much capital was needed to create it.
ROE, or Return on Equity shows the rate at which shareholders are earning income on their shares. It is a great way to evaluate a company’s performance and is one of Warren Buffet’s favorite metrics. Buffet looks at ROE is to see whether a company has outperformed other companies within the same industry. He looks at the historical performance of a company’s ROE, not just the past 1 or 2 years.
Finding companies within the same industry is easy on Buycel. Simple click the insert tab and then scrolling down to List insert will bring up a list of sectors and industries that Buycel can pull companies from.
Once you have your list you can evaluate an entire industry on their ROE.
ROE = Net Income / Shareholder’s Equity.
We can find Net Income and Shareholder’s Equity, which is made up of Total Liabilities and Total Assets, directly on Buycel.
Here’s what the list looks like once everything is filled in. Malvern Bancorp stands out, having the highest ROE of the bunch.
Buffet is always looking at company’s debt/equity ratio. The higher this ratio, the more debt is financing the company, rather than equity. A high ratio of debt can result in the company having volatile earnings and big interest expenses. Buffet would certainly rather see a small debt/equity ratio.
Debt/Equity = Total Liabilities/Shareholders’ Equity
Increasing Profit Margins
Buffet looks at whether profit margins are increasing over time. Again, he’ll look at the company’s long-term history rather than just the past couple years when determining whether the company has a healthy profit margin history. Generally, a healthy profit margin is around 25%, but it can vary greatly from industry to industry. A healthy profit margin in the energy industry, with its high amounts of capital expenditure, might be a pitiful one in the financial industry.
A healthy profit margin shows that the company is executing its business plan well and steady increases in profit margin over a few years shows the company has been very good at controlling expenses and adapting to the changing economic climate.
Profit Margin = Net Income/ Net Sales
Invest in What You Know
Buffet only invests in companies he fully understands and has admitted he doesn’t fully understand these new technology companies. As a result he doesn’t stock in companies like Facebook or Twitter. Buffet claims he’s only sent 1 email in his life. He’s basically an investing Luddite.
Buffet evolved the cigar butt approach into investing in established, well-run companies with genuine economic moats.
An economic moat is when a business has a competitive advantage over other companies within the same industry. Imagine the moat of a medieval castle; it’s a method of defending the castle from invaders. If threated, all you have to do is bring up the drawbridge and weather the storm. It’s a similar idea, a business’ economic moat keeps other businesses in the same industry from encroaching on their profits.
Big pharmaceutical companies are good examples. These types of companies often control patents on drugs they produce, which gives them exclusive rights to produce and market these goods.
Buffet doesn’t like to invest in companies that are built around commodities. This means, for example, he wouldn’t invest in an oil company because it would be hard to find a competitive advantage between companies within the same industry because the prices of commodities tend to be fixed and decline over long periods of time. In other words, they don’t have strong economic moats.
Let People Do Their Job
As Berkshire grew larger, incorporating different companies under its corporate umbrella, Buffet realized that he couldn’t micro-manage the whole affair. Instead, he understood that he needed to make sure that any company he acquired already had a rock star management team in place.
Buffet preferred to buy these businesses and let the existing management continue to do what made them a success in the first place, rather than attempting to clean house or exert his influence over them. His door is always open, but he leaves the day-to-day to people best suited for it.
Buy At a Discount
Buying at a discount is a staple principle of every value investor. Buying a company at a price below its intrinsic value is so important because of the margin of safety it provides you.
Imagine Exxon Mobil is selling for $150 and you’ve surmised that its intrinsic value, the price the shares should be trading at, is $100. If for some reason Exxon’s shares go to $60 – you can buy with confidence as the stock is trading far below its intrinsic value.
You’re just taking precaution. If you had to build a bridge to support 10,000 lb trucks traveling across it, you would probably want to make sure the bridge could support that truck, and then some. What you might do is build the bridge to withstand 20,000 lbs. You’re building in a margin for error.
Hold Forever, Cut Your Losers
Warren Buffet doesn’t watch the price movements of shares he owns. Instead, when he makes the decision to buy a company, he does so with the intention of holding that ownership stake for 10, 20, or even 30 years.
As Buffet has said before, his favorite holding period is forever.
While this is what he says in public, the truth is a little different. A study analyzing Berkshire’s trades between 1980 and 2006 found that Warren’s median holding period is merely a year long. 20% of stocks were held longer than 2 years and about 30% of stocks were sold within 6 months.
What that tells us is that when the buying decision is being made, you need to have conviction that this decision is right for the very long-term, but there’s no reason to hold an underperforming stock and punish yourself forever.
Buy for the long run, hang on to the winners and ditch the losers.
Warren Buffet is the ultimate bargain hunter, parlaying his successes into a net worth of approximately 80 billion. Luckily for the world, Buffet’s philanthropic reach is widespread and he plans to donate at least half of his wealth to charity.
Thanks for the $40 billion Warren!
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