Buying businesses not picking stocks
“Warren Buffet does not buy stocks. He is, actually, buying a piece of the business of a company.”
These statements made by those who have personally interviewed him may be the best that could capture the core of Warren Buffet’s investment style.
With such a mindset, Warren Buffet did not only go one step higher in the practice of value investing but actually gave its philosophy a more sublime interpretation unseen—or probably ignored—by previous theoreticians, like his grand mentor, Benjamin Graham.
We’re on our last two investment celebrities on our study to better understand the principles and elements of value investing, and I’ll not make you wait any longer. We’ll take up Warren Buffet now and leave William J. O’Neil for last.
We will no longer go through the usual trivia on his supposedly interesting personal life, as well as his marvelous younger days, and we’ll go straight to his methods of investing that made him both the most influential investment thinker and the wealthiest investor of contemporary time.
Buying at bargain prices
An ardent student and reverend disciple of Benjamin Graham, Warren Buffet adheres faithfully to the primary principle of value investing. This means, he buys stocks at prices lower than what they are actually worth, thus, “buy stocks at bargain prices only.”
Unless he has recently changed his regimen, Warren Buffet does not have a quote machine on his desk. This is because, unlike most of us, he does not check stock prices regularly. According to him, “stock prices are unreliable indicators of a company’s worth,” another principle of value investing.
To him, daily stock quotes have no urgent value. He is often heard saying, “there are days when they’re up, others they’re down. Sometimes Wall Street thinks the market looks good, other times it thinks it looks bad. It’s willy nilly, unreasonable and unnecessary to know.”
This kind of thinking was formed by both his early foray in the stock market with technical analysis and his being a pupil of Graham who maintained that “nobody ever knows what the market will do.”
His father, after serving four terms as a Republican congressman, became a stockbroker. By then, Warren Buffet also became fascinated with technical analysis, and “developed his own market timing signals.” But after awhile, he concluded that “it made no real sense.” He discarded that approach.
It was by then that Buffet came up with his investment style of picking stocks. This is by, namely: searching for “quality companies” that are selling low but are not necessarily burdened by the direction of stock prices.
Sifting from reports, he adopted the said approach for two reasons: first, “quality companies are still good companies when times are bad” and second, “they are also far more vital than even buying at a discount.” Thus, when the stock prices of “quality companies” drop, Buffet is not perturbed and takes it as “nothing more than a signal for a chance to pick up additional shares at a discount.”
Attributes of a quality company
First and foremost in Buffet’s mind as to what makes a “quality company” is that its “management must be honest with shareholders and must always act in their interest.” To him, integrity precedes everything in business.
There is no point, according to him, in proceeding to evaluate a company whose people you do not trust. “It is important to see the explanations of a company’s successes and failures. You must have a continuing understanding on the businesses in which you invest in,” he says.
Second, “the company should earn more cash than is necessary to stay in business and direct that cash wisely.” This meant “investing more in financially rewarding activities” and, at the same time “returning the cash to shareholders in the form of increased dividends or stock buybacks.”
Third, a quality company is one that has a high net profit margin. A company’s profit margin is determined by dividing net profit (net income) by sales (revenues). It is ratio of profitability that “measures how much out of every peso of sales a company actually keeps in (the form of) earnings.”
To determine whether a quality company is at a bargain price, Buffet “makes a projection on future cash flows and discount them back to the present with the rate of long-term US government bonds.”
If you will notice, the use of the rate of long-term US government bonds is a reflection of Benjamin Graham’s margin of safety concept. Graham, though, was deliberately vague in describing a stock’s margin of safety. As he has always emphasized, investment analysis is not an exact science, “there are hard factors like book value, debt and other financial statement data, there are subjective factors like quality of management, nature of the business and the like.”
But in striving to be more concrete in the application of his concept, he cited the following general expression: “If you’re paying less for a company than it would sell piece by piece, there’s a good margin of safety there.”
After computing for the company’s intrinsic value, Buffet then looks at the company’s stock price. This is said to be one of the few occasions Buffet takes a look at stock prices. If its stock is “selling well under the company’s worth” (as one account reported it), Buffet buys it.
Next to the traditional concept of “buying at a bargain,” Buffet looks at the competitive advantage of a company or its “economic moat.”
In simple terms, this is about the capability of a company to maintain earnings and increase profits in the future despite strong and/or increasing competition. Economic moats could come in the form of unique or advanced products or services, marketing muscle, brand, franchise, pricing power and/or technology in combination with a host of other organizational attributes that allow the company to “generate solid returns on assets and on stockholders’ equity, keep competitors at bay or keep competitors from stealing profits.”
Such considerations brought Buffet to invest in Coca-Cola (“very valuable franchise and strong brand”), Walt Disney (“very strong franchise”), See’s Candy (“terrific pricing power”) and Gillette (“pricing power”), to mention a few.
Part of his success, too, is in the management of his investments. Buffet prefers to focus his portfolio on a few good companies. He believes that “concentrating on good stocks is safer than diversifying across mediocre ones.”
Also, Buffet invests more money in stocks that are performing well, “just as a business puts more money into its most successful ventures.”
Above all else, Buffet insists that you must “do your research, do it well and disregard the opinions of others.”
Bottom line spin
Geopolitical conditions may overshadow better-than-expected economic developments. They can also have further impact on the market’s general outlook beyond this week.