Wall Street Cosmos
Fundamental Analysis
Part II: Warren Buffett
Part II: Warren Buffett
Fundamental Analysis (Part II)
by James A. Maccaro
Warren Buffett amassed his fortune far from Wall Street, from his base in Omaha,
Nebraska, where he returned after his relatively brief stint working for Graham.
Sticking to basic principles and ignoring the conventional wisdom of other
professional investors are the pillars of Buffett’s fortune. His basic investment
philosophy is to “be fearful when others are greedy and greedy when others are
fearful.”
It should not be forgotten that although Buffett absorbed Graham's ideas, he moved
beyond them to develop his own investment philosophy. A particularly important
example of this is the recognition that a company can have great value, beyond its
tangible assets, in the form of widely recognized brand names, trademarks and
other attributes that add value to an enterprise.
Buffett was born in 1930 in Omaha, Nebraska, the son of a U.S. Congressman,
and attended the University of Pennsylvania for two years. He then transferred to
Columbia University, in order to become a student of Graham.
In addition to working for Graham as a security analyst after graduation in 1951,
Buffett also invested his own funds and was able to turn $9,800 into $140,000 by
1956. In that year, he returned to his hometown and began Buffett Associates, an
investment partnership that he funded with his family and friends. This partnership
would eventually evolve into Berkshire Hathaway, Inc., a corporation traded on the
New York Stock Exchange.
Berkshire Hathaway, Inc., was formed by the merger of two New England textile
companies with long histories. The company, however, was in steep decline when
Buffett gained control of it in the 1960’s.
By purchasing Berkshire Hathaway, Buffett gained a company traded on the New
York Stock Exchange. This company had declining market share and earnings
potential but still produced sizable cash flow that could be invested in other
businesses and in the stock market.
Cash flow consists of a company’s earnings before deductions are made for
depreciation and amortization and any other “non-cash” items. Depreciation is
a percentage of the book value of tangible assets owned by the firm (such as real
estate and equipment) and is reflective of the fact that the value of many assets
depreciate over time. Of course, it ignores the fact that many assets, particularly
real estate, can increase in value also.
Amortization is a charge for capital expenditures, the cost of which are deducted
over many years rather than in just the year in which the money was spent. The
rationale behind spreading out the deductions is that capital expenditures have the
potential to benefit the company over a long period of time, not just in the year
during which the expenditure is made. Furthermore, capital expenditures (such as
the purchase of a new factory) can be very large. Therefore, a single deduction of
the whole amount could present a distorted picture of the financial performance of
the firm in that year.
Due to depreciation and amortization, a company can have low reported earnings
or even losses, while also generating significant amounts of cash. This was the
case with old-line textile firms such as Berkshire Hathaway, which had very high
depreciation and amortization charges because of large capital expenditures made
years earlier.
Eventually, Berkshire Hathaway left the textile industry, with only the corporate
name as a reminder of its New England roots. Buffett used the cash flow from
Berkshire Hathaway’s declining textile interests to buy control of a wide array of
companies, including furniture and jewelry retailers, a newspaper publisher, home
improvement products companies, natural gas pipelines and firms involved in the
aviation industry. Most famously, he used Berkshire Hathaway’s cash flow to
invest in the stock market, with dazzling results.
Buffett also bought several insurance companies, most notably the GEICO
company. Buffett realized that control of the premiums paid by the policy holders
would provide a huge pool of capital that could be invested. Even if the insurance
operations were only marginally profitable, large profits could be made because
Berkshire Hathaway could pocket any profits from the investments. This pool of
money is known in the insurance business as “float” and as Buffett stated in the
Berkshire Hathaway annual report of 2004, “float is wonderful.”
Berkshire Hathaway stock has the distinction of having the highest price per share
of any company traded on a major exchange. In the 1960’s, a share cost less than
ten dollars; by the 1980’s, it cost over $2,000, which was thought to be
remarkable at that time; but by the 1990’s, the stock was worth over $50,000 per
share. Today, a single share costs more than $100,000.
Most companies follow the policy of having a “stock split” once the price per share
reaches a high point. Through this action, shareholders receive additional shares,
most often on a two for one basis, with a corresponding drop in price per share.
For example, in a two for one stock split, if a shareholder owns 100 shares, he or
she will be sent an additional 100 shares. However, the value per share, all other
things being equal, should drop a corresponding amount so that the total value of
the investment is unchanged. This begs the question: if a stock split causes no
change in the underlying investment’s value, why bother? The explanation is that it
is a vote of confidence by management in the future prospects of the company,
which attracts attention and might cause the stock’s P/E ratio to rise. In addition,
there is a tendency for some shareholders to gravitate towards stocks selling in the
range of roughly $25 to $60 per share.
Psychologically, many people are under the impression that a stock that sells for a
lower price per share is a bargain when compared to one that has a higher price.
They pick stocks the same way that they would purchase linens or appliances at a
store: they look for the lowest price. But there is no inherent difference between an
investment of $1,000 in a stock that sells for $10 per share, and an investment of
the same amount in a stock that sells for $100 per share. In both cases, the same
amount is put at risk; the fact that ten shares is owned in one and 100 shares in the
other is irrelevant.
To a logical mind, which Warren Buffett has in abundance, a stock split can seem
to be an irrational gimmick. Yet their appeal is strong: most people simply enjoy
receiving them. Buffett, however, rejects them because he feels that they attracts
too many speculators interested in only a quick gain.
Of course, the fact that Berkshire Hathaway’s share price is astronomical means
that many people cannot to afford to purchase even a single share. To meet this
demand, Buffett agreed (after decades of resistance) to the creation of a second
class of stock, Berkshire Hathaway class B, which has an ownership interest of
1/30th of a share of the original (class A) stock and has 1/200th the voting rights.
Due to the high price of the class A stock, the cost of class B is also much more
expense than virtually all other shares.
Another distinction of Berkshire Hathaway is the popularity of its chief executive.
To the investing public, Warren Buffett is the closest we will come to a corporate
folk hero. For this reason, Berkshire Hathaway annual meetings attract over 25,000
shareholders, all eager to see and hear the “Sage of Omaha” in person.
Article Continues After Sponsor's Message
Buffett wrote to his early investors: "I cannot promise results to partners. What I
can and do promise is that: (a) Our investments will be chosen on the basis of
value, not popularity; (b) Our patterns of operation will attempt to reduce the risk
of permanent capital loss (not short-term quotational loss) to a minimum, and, (c)
My wife, children and I will have virtually our entire net worth in one partnership."
Many years latter, when explaining his investments to shareholders, he added, “if
we fail, we will have no excuses.”
Those who had confidence in him have been amply rewarded. An investment of
$1,000 made with Buffet in 1956 would be worth over $30 million today (even
after taking into account the three-year bear market declines that began in 2000).
Buffett has always said that he has two rules for successful investing: Rule No. 1 is
"Never lose money"; Rule No. 2 is "Never forget Rule No. 1."
A careful approach to the stock market can minimize the chances for failure. “In
stocks,” Buffett asserted, “we expect every commitment to work out well because
we concentrate on conservatively financed businesses with strong competitive
strengths, run by able and honest people. If we buy into these companies at
sensible prices, loses should be rare.”
Many corporations fail to perform because of what Buffett refers to as the
"institutional imperative." This causes corporate managers to resist change and to
desire to increase their prestige and power by expanding market share or buying
other companies, even if doing so does not make economic sense. Furthermore, it
leads management to mindlessly imitate other companies in the industry for fear of
looking foolish by being out-of-step, even if the rest of the industry is acting like
"lemmings heading into the sea."
Buffett asserts that companies that are well-managed, i.e., that resist the
institutional imperative, only spend money when the expenditure will result in
earnings that exceed the cost of capital; every dollar of retained earnings should
increase the stock price by more than one dollar. If this is not possible, according
to Buffett, a rational company will transfer all excess earnings to shareholders in
the form of dividends or through a buy back of stock. Unfortunately, not all
companies are rational.
Like Graham, Buffett is a contrarian, that is, at heart, he believes in being
independent and going against the crowd. His approach rests on five core
principles of investing, derived from Graham’s teachings.
First, think independently. Buffett is unconcerned with conventional wisdom.
Secondly, invest in high-return businesses run for the benefit of shareholders.
Third, pay only a reasonable price, even for an excellent business. Buffett once
quoted Samuel Johnson, who said that “ a horse that can count to ten is a
remarkable horse – not a remarkable mathematician.” Likewise, a company with
earnings growth of 20 percent, but with a P/E ratio of 80, is a remarkable company
but not a great investment. When there is a “shortage of attractively priced stocks,”
Buffett is willing to remain on the sidelines. He explained that he would rather hold
cash then do “something stupid” by buying overpriced shares. Like Graham,
Buffett looks for a “margin of safety.”
Fourth, invest for the long term. Buffett stated that a stock portfolio should be
viewed as an “unfolding movie, not as a still photograph,” that is, as a continuing
process that unfolds over time.
Fifth, be fully informed about each stock in your portfolio. Buffet prefers to invest
in companies of which he has personal knowledge. He explained, for instance, that
his sweet tooth led him to investments in Dairy Queen, See’s Candies and Coca-
Cola.
Most stock market professionals take the position that there are two main styles of
investing based on fundamental analysis: value investing and growth investing. A
value investor looks for undervalued stocks, while a growth investor looks for
stocks that offer the prospect of growth in earnings. Buffett rejects this distinction.
“Market commentators and investment managers who glibly refer to ‘growth’ and
‘value’ styles as contrasting approaches to investment are displaying their
ignorance, not their sophistication. Growth is simply a component – usually a plus,
sometimes a minus – in the value equation.”
Buffett appraises stocks based on their prospects for future cash generation and
then compares this valuation to the market price. Therefore, a company with
rapidly growing earnings can be a bad investment if the stock price is too
expensive, while a company with dimmer prospects for earnings growth can be a
bargain if it is undervalued by the market.
When evaluating a company, Buffett pays special attention to net cash flow, which
he call’s “owner’s cash.” This consists of the corporation’s cash flow minus
capital expenditures needed to maintain the business at current levels.
Owner’s cash is in effect the money generated by the business that can be put to
use elsewhere without harming the firm’s ability to continue its operations in the
future. A drawback to this approach is that separating capital expenditures needed
to maintain the status quo from capital expenditures made for future expansion can
be difficult; often there is a gray area between the two.
Buffett’s criteria for purchasing a company matches his criteria for a stock market
investment. First, the company must have “favorable and enduring economic
characteristics,” that is, it must have good earning power. Secondly, it must have
“talented and honest” management. Finally, it must be “available at a sensible price.”
Buffett stated in 1983 that “one question I always ask myself in appraising a
business is how I would like, assuming I had ample capital and skilled personnel, to
compete with it.”
To continue to Part III, click here
Home
Links
by James A. Maccaro
Warren Buffett amassed his fortune far from Wall Street, from his base in Omaha,
Nebraska, where he returned after his relatively brief stint working for Graham.
Sticking to basic principles and ignoring the conventional wisdom of other
professional investors are the pillars of Buffett’s fortune. His basic investment
philosophy is to “be fearful when others are greedy and greedy when others are
fearful.”
It should not be forgotten that although Buffett absorbed Graham's ideas, he moved
beyond them to develop his own investment philosophy. A particularly important
example of this is the recognition that a company can have great value, beyond its
tangible assets, in the form of widely recognized brand names, trademarks and
other attributes that add value to an enterprise.
Buffett was born in 1930 in Omaha, Nebraska, the son of a U.S. Congressman,
and attended the University of Pennsylvania for two years. He then transferred to
Columbia University, in order to become a student of Graham.
In addition to working for Graham as a security analyst after graduation in 1951,
Buffett also invested his own funds and was able to turn $9,800 into $140,000 by
1956. In that year, he returned to his hometown and began Buffett Associates, an
investment partnership that he funded with his family and friends. This partnership
would eventually evolve into Berkshire Hathaway, Inc., a corporation traded on the
New York Stock Exchange.
Berkshire Hathaway, Inc., was formed by the merger of two New England textile
companies with long histories. The company, however, was in steep decline when
Buffett gained control of it in the 1960’s.
By purchasing Berkshire Hathaway, Buffett gained a company traded on the New
York Stock Exchange. This company had declining market share and earnings
potential but still produced sizable cash flow that could be invested in other
businesses and in the stock market.
Cash flow consists of a company’s earnings before deductions are made for
depreciation and amortization and any other “non-cash” items. Depreciation is
a percentage of the book value of tangible assets owned by the firm (such as real
estate and equipment) and is reflective of the fact that the value of many assets
depreciate over time. Of course, it ignores the fact that many assets, particularly
real estate, can increase in value also.
Amortization is a charge for capital expenditures, the cost of which are deducted
over many years rather than in just the year in which the money was spent. The
rationale behind spreading out the deductions is that capital expenditures have the
potential to benefit the company over a long period of time, not just in the year
during which the expenditure is made. Furthermore, capital expenditures (such as
the purchase of a new factory) can be very large. Therefore, a single deduction of
the whole amount could present a distorted picture of the financial performance of
the firm in that year.
Due to depreciation and amortization, a company can have low reported earnings
or even losses, while also generating significant amounts of cash. This was the
case with old-line textile firms such as Berkshire Hathaway, which had very high
depreciation and amortization charges because of large capital expenditures made
years earlier.
Eventually, Berkshire Hathaway left the textile industry, with only the corporate
name as a reminder of its New England roots. Buffett used the cash flow from
Berkshire Hathaway’s declining textile interests to buy control of a wide array of
companies, including furniture and jewelry retailers, a newspaper publisher, home
improvement products companies, natural gas pipelines and firms involved in the
aviation industry. Most famously, he used Berkshire Hathaway’s cash flow to
invest in the stock market, with dazzling results.
Buffett also bought several insurance companies, most notably the GEICO
company. Buffett realized that control of the premiums paid by the policy holders
would provide a huge pool of capital that could be invested. Even if the insurance
operations were only marginally profitable, large profits could be made because
Berkshire Hathaway could pocket any profits from the investments. This pool of
money is known in the insurance business as “float” and as Buffett stated in the
Berkshire Hathaway annual report of 2004, “float is wonderful.”
Berkshire Hathaway stock has the distinction of having the highest price per share
of any company traded on a major exchange. In the 1960’s, a share cost less than
ten dollars; by the 1980’s, it cost over $2,000, which was thought to be
remarkable at that time; but by the 1990’s, the stock was worth over $50,000 per
share. Today, a single share costs more than $100,000.
Most companies follow the policy of having a “stock split” once the price per share
reaches a high point. Through this action, shareholders receive additional shares,
most often on a two for one basis, with a corresponding drop in price per share.
For example, in a two for one stock split, if a shareholder owns 100 shares, he or
she will be sent an additional 100 shares. However, the value per share, all other
things being equal, should drop a corresponding amount so that the total value of
the investment is unchanged. This begs the question: if a stock split causes no
change in the underlying investment’s value, why bother? The explanation is that it
is a vote of confidence by management in the future prospects of the company,
which attracts attention and might cause the stock’s P/E ratio to rise. In addition,
there is a tendency for some shareholders to gravitate towards stocks selling in the
range of roughly $25 to $60 per share.
Psychologically, many people are under the impression that a stock that sells for a
lower price per share is a bargain when compared to one that has a higher price.
They pick stocks the same way that they would purchase linens or appliances at a
store: they look for the lowest price. But there is no inherent difference between an
investment of $1,000 in a stock that sells for $10 per share, and an investment of
the same amount in a stock that sells for $100 per share. In both cases, the same
amount is put at risk; the fact that ten shares is owned in one and 100 shares in the
other is irrelevant.
To a logical mind, which Warren Buffett has in abundance, a stock split can seem
to be an irrational gimmick. Yet their appeal is strong: most people simply enjoy
receiving them. Buffett, however, rejects them because he feels that they attracts
too many speculators interested in only a quick gain.
Of course, the fact that Berkshire Hathaway’s share price is astronomical means
that many people cannot to afford to purchase even a single share. To meet this
demand, Buffett agreed (after decades of resistance) to the creation of a second
class of stock, Berkshire Hathaway class B, which has an ownership interest of
1/30th of a share of the original (class A) stock and has 1/200th the voting rights.
Due to the high price of the class A stock, the cost of class B is also much more
expense than virtually all other shares.
Another distinction of Berkshire Hathaway is the popularity of its chief executive.
To the investing public, Warren Buffett is the closest we will come to a corporate
folk hero. For this reason, Berkshire Hathaway annual meetings attract over 25,000
shareholders, all eager to see and hear the “Sage of Omaha” in person.
Article Continues After Sponsor's Message
Buffett wrote to his early investors: "I cannot promise results to partners. What I
can and do promise is that: (a) Our investments will be chosen on the basis of
value, not popularity; (b) Our patterns of operation will attempt to reduce the risk
of permanent capital loss (not short-term quotational loss) to a minimum, and, (c)
My wife, children and I will have virtually our entire net worth in one partnership."
Many years latter, when explaining his investments to shareholders, he added, “if
we fail, we will have no excuses.”
Those who had confidence in him have been amply rewarded. An investment of
$1,000 made with Buffet in 1956 would be worth over $30 million today (even
after taking into account the three-year bear market declines that began in 2000).
Buffett has always said that he has two rules for successful investing: Rule No. 1 is
"Never lose money"; Rule No. 2 is "Never forget Rule No. 1."
A careful approach to the stock market can minimize the chances for failure. “In
stocks,” Buffett asserted, “we expect every commitment to work out well because
we concentrate on conservatively financed businesses with strong competitive
strengths, run by able and honest people. If we buy into these companies at
sensible prices, loses should be rare.”
Many corporations fail to perform because of what Buffett refers to as the
"institutional imperative." This causes corporate managers to resist change and to
desire to increase their prestige and power by expanding market share or buying
other companies, even if doing so does not make economic sense. Furthermore, it
leads management to mindlessly imitate other companies in the industry for fear of
looking foolish by being out-of-step, even if the rest of the industry is acting like
"lemmings heading into the sea."
Buffett asserts that companies that are well-managed, i.e., that resist the
institutional imperative, only spend money when the expenditure will result in
earnings that exceed the cost of capital; every dollar of retained earnings should
increase the stock price by more than one dollar. If this is not possible, according
to Buffett, a rational company will transfer all excess earnings to shareholders in
the form of dividends or through a buy back of stock. Unfortunately, not all
companies are rational.
Like Graham, Buffett is a contrarian, that is, at heart, he believes in being
independent and going against the crowd. His approach rests on five core
principles of investing, derived from Graham’s teachings.
First, think independently. Buffett is unconcerned with conventional wisdom.
Secondly, invest in high-return businesses run for the benefit of shareholders.
Third, pay only a reasonable price, even for an excellent business. Buffett once
quoted Samuel Johnson, who said that “ a horse that can count to ten is a
remarkable horse – not a remarkable mathematician.” Likewise, a company with
earnings growth of 20 percent, but with a P/E ratio of 80, is a remarkable company
but not a great investment. When there is a “shortage of attractively priced stocks,”
Buffett is willing to remain on the sidelines. He explained that he would rather hold
cash then do “something stupid” by buying overpriced shares. Like Graham,
Buffett looks for a “margin of safety.”
Fourth, invest for the long term. Buffett stated that a stock portfolio should be
viewed as an “unfolding movie, not as a still photograph,” that is, as a continuing
process that unfolds over time.
Fifth, be fully informed about each stock in your portfolio. Buffet prefers to invest
in companies of which he has personal knowledge. He explained, for instance, that
his sweet tooth led him to investments in Dairy Queen, See’s Candies and Coca-
Cola.
Most stock market professionals take the position that there are two main styles of
investing based on fundamental analysis: value investing and growth investing. A
value investor looks for undervalued stocks, while a growth investor looks for
stocks that offer the prospect of growth in earnings. Buffett rejects this distinction.
“Market commentators and investment managers who glibly refer to ‘growth’ and
‘value’ styles as contrasting approaches to investment are displaying their
ignorance, not their sophistication. Growth is simply a component – usually a plus,
sometimes a minus – in the value equation.”
Buffett appraises stocks based on their prospects for future cash generation and
then compares this valuation to the market price. Therefore, a company with
rapidly growing earnings can be a bad investment if the stock price is too
expensive, while a company with dimmer prospects for earnings growth can be a
bargain if it is undervalued by the market.
When evaluating a company, Buffett pays special attention to net cash flow, which
he call’s “owner’s cash.” This consists of the corporation’s cash flow minus
capital expenditures needed to maintain the business at current levels.
Owner’s cash is in effect the money generated by the business that can be put to
use elsewhere without harming the firm’s ability to continue its operations in the
future. A drawback to this approach is that separating capital expenditures needed
to maintain the status quo from capital expenditures made for future expansion can
be difficult; often there is a gray area between the two.
Buffett’s criteria for purchasing a company matches his criteria for a stock market
investment. First, the company must have “favorable and enduring economic
characteristics,” that is, it must have good earning power. Secondly, it must have
“talented and honest” management. Finally, it must be “available at a sensible price.”
Buffett stated in 1983 that “one question I always ask myself in appraising a
business is how I would like, assuming I had ample capital and skilled personnel, to
compete with it.”
To continue to Part III, click here
Home
Links
