Stock selection is more than quantitative

The recent article I wrote on Warren Buffet elicited favorable reactions, but it was far too simple and short.  Thus it drew requests for an additional commentary to more clearly appreciate his investment style and success.

Truly, Warren Buffett’s record of success deserves more than just a cursory review.

As some have commented, there are those who may “have made money faster” and others who “have made it in flashier ways,” but none seems to fit better the title of “world’s greatest investor” than Warren Buffett given his long-running record of success.

A plain narrative on his story is not sufficient to capture the essence of his investment success.

Indeed, there is a need for a closer look at how Buffett exactly applied, and thus brought to a higher level, the philosophy of value investing beyond what Benjamin Graham had conceived.

Graham observed that “nobody ever knows what the market will do.” But he also believed that one can still profit from the market, withstanding that fact, by reacting intelligently to what it will do.

But Graham also felt that the general investing public has an inherent weakness that makes people guess the market wrong. Emotions often interfere.  He then recognized the need to automate to remove the influence of emotion.

Graham insisted on the quantitative approach because he “found it difficult to trust an analysis which is fundamentally subjective and judgment based.”  To do this, he formulated the “margin of safety” concept.  Added to it was Graham’s main basis of intrinsic value.   He relied on tangible assets.

He reasoned that “firms with high net assets would eventually produce high earnings and the stock price would rise to reflect this.”

Evolution of his philosophy

Buffett accepted Graham’s viewpoint, at first.  But he soon found out that with Graham’s purely quantitative approach, it was difficult to find real bargain stocks.  In many cases, too, Graham’s bargain stocks simply did not perform (to rise and exceed intrinsic value) in the face of the changing complexion of the market.

In cases where Graham’s “bargain stocks” rose, they rose too slowly to give a good compound return.

To cite a given account, “Buffett buys a textile company stock at $20 with a calculated (Grahamite) intrinsic value of $27 per share.  The margin of safety is reasonably comfortable as the stock is 26 percent undervalued.  If the stock rises to $27 in one year, the investor achieves a more than satisfactory rate of return.”

“The problem is that many of these investments fail to rise to their intrinsic value in the first, or even the second or third year. So, if it takes three years for the stock to reach intrinsic value, the annual rate of return falls to 10.5 percent.  After four years the rate falls to less than 7.8 percent.  If the stock continues to languish at $20 the return, of course, is zero.”

This is the classic problem of Graham’s method.  When intrinsic values are not quickly reflected in the market, the investor ends up with a return that can be zero or, at best, “less than that available on a savings account.”

Buffett, thus, concluded that “Graham’s quantitative bargains only work well when the stock market is going through an exceptional phase” of uptrend and activity.

He also concluded that this peculiar consequence on Graham’s stock picks happen because all must comply with quantitative rules; also, his choices are to be confined to high net asset firms only.  Thus, Graham’s approach excluded a majority of stocks in the market that are potentially good “bargain” stocks.

Qualitative factors

These observations made Buffett gradually move away from Graham’s purely quantitative approach.

He took into account qualitative factors that in his mind are important and contributory to the earnings potential of a business.

To his amazement, this made him find his most successful investees, many of which were companies whose values did not depend on tangible assets as Graham had imagined but rather on “economic goodwill” that generated as much or more earnings.

For example, he found out that insurance companies—businesses that do not rely on large tangible assets to produce high earnings—have a special feature to produce high cash flows and earnings.

As he explains it, insurance companies “have a float of money which can be used to generate astonishingly large amounts of money (investment returns).” So, he used them to acquire similar businesses along with other profitable enterprises.

As reported in 1967, Buffett’s “Bershire Hathaway, through its insurance subsidiaries, had a float of $17.3 million.  This was to grow, by organic growth and acquisition, to $58.7 billion by the end of 2007.”

Another terrific investment was the Washington Post.  It was another type of business that has low capital needs.  Yet, it produced high returns on equity capital invested.

For one, Washington Post “not only did it own the newspaper, it published Newsweek magazine and controlled a number of television stations;” two, because Washington Post “has a very strong brand, it is able to increase prices relatively easily.”

Similar to insurance companies, Washington Post proved to be another bargain company that “has excellent potential for producing high and rising cash flows long into the future.”

Another key element in his new philosophy and success was the purchase of non-quoted (unlisted) companies “possessing extraordinarily strong franchises with excellent management.”

Buffett’s value investing style evolved from the purely classical quantitative method of looking for stocks that were available at very attractive prices to a process that included qualitative considerations, such as the following: The competitive advantage or economic moat of a company (as further discussed in the foregoing investment illustrations), the company’s operation by honest and competent persons, the confinement of your investments to businesses you understand, and the confinement of your investment portfolio to a few but better performing investments as (Buffett would stress) “it’s better than diversifying into a number of mediocre ones.”

Bottom line spin

Improved geopolitical conditions allowed unfolding positive economic developments to influence the market’s gains last week.  But as can be observed, the market was not that strong.  The market’s net gain came from advances made early in the week.  In the last two days of the week, it was actually on the fall.  This retreating-more-than-advancing character of the market may continue in the near-term.

(The writer is a licensed stockbroker of Eagle Equities, Inc..  You may reach the Market Rider at [email protected] , [email protected] or at www.kapitaltek.com)