Wall Street Cosmos
Fundamental Analysis
Part III: More on Warren Buffett
Part III: More on Warren Buffett
Fundamental Analysis (Part III)
by James A. Maccaro
Buffett is justly celebrated for his annual reports to shareholders, in which he
candidly and lucidly discusses his investment philosophy and the results for the
year. He modestly stated in one letter, "What we do is not beyond anybody else's
competence. It is just not necessary to do extraordinary to get extraordinary
results."
In the 2002 annual report, Buffett published “three suggestions for investors.”
First, “beware of companies displaying weak accounting,” such as by not treating
stock options granted to management as an expense (which would reduce reported
earnings) or by concentrating on EDITA (earnings before depreciation, interest,
taxes and amortization) rather than earnings after all expenses are taken into
account. Buffett noted that not only are these actions misleading, but that when
management takes the “low road” in one area, such as accounting, it is likely to do
so in other ways that are detrimental to shareholders because “there is seldom just
one cockroach in the kitchen.”
Second, “unintelligible footnotes (in the annual report) usually indicate
untrustworthy management.” They are usually unintelligible because management
wants to hide something from shareholders.
Third, “be suspicious of companies that trumpet earnings projections
and growth expectations.” They might be trying to hype the stock or divert
attention from their record of poor performance. In a similar context, Buffett
quoted the German philosopher Goethe, who said, “when ideas fail, words come in
very handy.” Likewise, for corporate management, when present results
disappoint, rosy scenarios about the future can be very handy.
Ten rules that guide Buffett’s investing style can be discerned from his annual
reports of the last two decades.
1. A company's value is based on its expected net cash flow discounted at an
interest rate that reflects risk.
Although this concept is similar to Graham's ideas about intrinsic value, Buffet
credits John Burr Williams, author of The Theory of Investment Value (published in
1938), as its source. It is analogous to the way bonds are traditionally valued in that
a determination is first made about how much money the instrument will produce
and then the applicable interest rate is applied to determine the current value.
Bonds, however, are different from stocks in that they usually provide for a
predetermined cash flow (in the form of interest payments), while the cash flows
attributable to stocks will vary with the success of the issuers. The interest rate
that Buffett uses is that of long-term United States government bonds.
2. Only invest in companies with predictable earnings.
In order to apply Buffett's valuation method you must have a reasonable basis for
determining a company's future earnings. This requires a favorable track record
and reasonable grounds for predicting future growth. As a result, Buffett does not
invest in companies that have inconsistent earnings. Moreover, this rule precludes
investment in leading-edge growth stocks because Buffet believes that there is no
firm basis for determining future cash flows. If a company’s future likely value
cannot be determined from its past history of financial results, and must be based
solely on assumptions about future developments, Buffett is not interested. He has
cited an assertion by Pogo, the cartoon character created in the 1950’s by Walt
Kelly: “The future ain’t what it used to be.” Those who depend on predictions of
future developments, rather than present developments that can be quantified and
projected into the future, are likely to be disappointed once the future becomes the
present.
3. Only invest when there is a margin of safety between a stock's value and the
market price.
This principle is directly derived from Graham's investment approach. Buffett, like
Graham, bases his investment decisions on the belief that market prices often do
not reflect the true value of a company: "The stock market is a manic-depressive.
That's why you can't buy and sell on its terms. You have to buy and sell when you
want to."
4. To determine if management is doing a good job focus on return on equity,
not earnings per share.
"The primary test of managerial economic performance is the achievement of a
high earnings rate on equity capital employed (without undue leverage, accounting
gimmickry, etc.) and not the achievement of consistent gains in earnings per
share." Buffett notes that because companies usually retain a portion of their
earnings, the assets that a profitable company have will increase each year. This
additional cash allows the company to report increased earnings per share even if
the company's performance is deteriorating. Therefore, Buffett is unimpressed by
"record earnings." He asserts that "after all, even a totally dormant savings account
will produce steadily rising interest earnings each year because of compounding."
5. Avoid companies that have significant debt.
Debt is “the weak link that snaps you." A good business "will produce quite
satisfactory economic results with no aid from leverage" while a company with
significant debt will be vulnerable during economic slowdowns.
6. Only invest in a company with management that is committed to controlling
costs.
Cost-control is reflected by a profit margin that exceeds those of competitors.
"The really good manager does not wake up in the morning and say, 'This is the
day I'm going to cut costs,' any more than he wakes up and decides to practice
breathing." Superior managers "attack costs as vigorously when profits are at
record levels as when they are under pressure." Therefore, be wary of companies
that have opulent corporate offices, unusually large corporate staffs and other signs
of bloat.
7. Only invest in companies whose business you understand.
According to Buffett, "the nine most important words ever written about
investing" are Graham's maxim that "investing is most intelligent when it is most
businesslike." By this, Buffett and Graham mean that an investor should have a
complete understanding of a company's business, including how it operates, its
record of performance and its prospects for the future. Buffett warns, “never
invest in a business you cannot understand.” This is diametrically opposed to the
basic tenet of technical analysis, which focuses solely on price and volume
changes.
8. Only invest in companies that have honest and candid management.
Buffett rules out investing in any company that has a history of using accounting
gimmicks to inflate profits or that has mislead investors in the past. As the earlier
discussion of the “great tycoons” shows, when management shows disregard for
investors, the result can be disastrous for them.
9. The best performing companies usually have a "franchise," something that
makes their product or service unique.
Most of the companies that Buffet invests in have some unique business advantage
that allows them to have above-average performance.
10. Invest for the long-term.
Buffett says that he is "quite content to hold any security indefinitely, so long as the
prospective return on equity capital of the underlying business is satisfactory,
management is competent and honest, and the market does not overvalue the
business."
Buffett advocates a concept that he named “owner-capitalism,” which is the idea
that the interests of the board of directors of a corporation should correspond to
the interests of the shareholders. This occurs when board members own
significant numbers of shares and receive only a small proportion of their income
from director fees. For this reason, all directors of Berkshire Hathaway own
company stock worth at least several million dollars and receive only nominal
payments for serving on the board. Buffet declared to shareholders that under this
approach, “the bottom line for our directors (is): You (the shareholders) win, they
(the directors) win big; you lose, they lose big.”
Buffett also rejects the practice of most every other publicly traded corporation of
obtaining insurance for directors and corporate officers to shield them from
financial responsibility for wrongdoing by the board or management.
Article is Continued After Sponsor's Message
In contrast, most corporations that have ostensibly independent boards of directors
have some, if not most, directors who own only token amounts of shares (and in
some cases no shares at all) and who receive generous director’s fees. They are
also protected against charges of negligence or other wrongdoing by insurance
polices paid for by the corporation (that is, the shareholders). Hence, there is a
strong incentive for a director, under these circumstances, to remain passive, so as
not to endanger his or her lucrative position by questioning the status quo, even if
the status quo leads to disaster.
When judging a person’s fitness to be a director, Buffett said that consideration
should be given to whether the person has “business savvy, a shareholder
orientation and a genuine interest in the company.” He added that “many people
who are smart, articulate and admired have no real understanding of business. That
is no sin; they may shine elsewhere. But they don’t belong on corporate boards.”
Buffett observed that during the stock market boom of the late 1990’s, “CEO’s
who traveled the high road did not encounter heavy traffic.” Some CEO’s engaged
in questionable accounting practices, made poor business decisions and
aggressively increased their own compensation without regard to performance. It
was a period marked -- and marred -- by CEO’s “fudging numbers and drawing
obscene pay for mediocre business achievements.”
It is the job of the board of directors to hold managers accountable for their
actions. In the 2002 Berkshire Hathaway annual report, Buffett cited the Bible
(Luke 16:2), noting that Christ told with approval of “a rich man who said to his
agent, ‘give an account of thy stewardship; for thou mayest no longer be steward.”
For Buffett, a pivotal factor when judging corporate management is the personal
honor of the executives. As regards Berkshire Hathaway, Buffett declared, “lose
money for the firm and I will be understanding; lose a shred of reputation for the
firm and I will be ruthless.”
Although Buffett is best know for his long-term investments and is perhaps the
best know advocate of the “buy and hold” philosophy of investing, he also engages
in short-term trading.
He will engage in risk arbitrage when he has unused cash and finds deals that he
believes are attractive. This type of transaction involves buying a security when an
announced change, such as a merger or liquidation, will shortly increase the price.
As there is a risk that the change will not be accomplished, the stock will usually
sell at a discount prior to the expected event.
Buffett has set forth four questions that he uses as guidelines when evaluating a
possible risk arbitrage: First, how likely is it that the promised event will indeed
occur? Second, how long will your money be tied up? Third, what chance is there
that something better will transpire a competing takeover bid for example, and
finally, what will happen if the event does not take place because of antitrust
action, financing glitches, etc.?
To increase his odds when engaging in risk arbitrage, Buffett focuses on takeover
targets that are selling for a price below their true value. This increases the odds of
the deal being completed and also provides a cushion of safety if the deal falls
through. For example, he invested in General Dynamics when it was a takeover
target but held onto the shares when the deal collapsed (because of anti-trust
objections of the federal government) and profited because the firm had good long-
term prospects.
To return to Part I, click here
To go to Technical Analysis Explained, click here
by James A. Maccaro
Buffett is justly celebrated for his annual reports to shareholders, in which he
candidly and lucidly discusses his investment philosophy and the results for the
year. He modestly stated in one letter, "What we do is not beyond anybody else's
competence. It is just not necessary to do extraordinary to get extraordinary
results."
In the 2002 annual report, Buffett published “three suggestions for investors.”
First, “beware of companies displaying weak accounting,” such as by not treating
stock options granted to management as an expense (which would reduce reported
earnings) or by concentrating on EDITA (earnings before depreciation, interest,
taxes and amortization) rather than earnings after all expenses are taken into
account. Buffett noted that not only are these actions misleading, but that when
management takes the “low road” in one area, such as accounting, it is likely to do
so in other ways that are detrimental to shareholders because “there is seldom just
one cockroach in the kitchen.”
Second, “unintelligible footnotes (in the annual report) usually indicate
untrustworthy management.” They are usually unintelligible because management
wants to hide something from shareholders.
Third, “be suspicious of companies that trumpet earnings projections
and growth expectations.” They might be trying to hype the stock or divert
attention from their record of poor performance. In a similar context, Buffett
quoted the German philosopher Goethe, who said, “when ideas fail, words come in
very handy.” Likewise, for corporate management, when present results
disappoint, rosy scenarios about the future can be very handy.
Ten rules that guide Buffett’s investing style can be discerned from his annual
reports of the last two decades.
1. A company's value is based on its expected net cash flow discounted at an
interest rate that reflects risk.
Although this concept is similar to Graham's ideas about intrinsic value, Buffet
credits John Burr Williams, author of The Theory of Investment Value (published in
1938), as its source. It is analogous to the way bonds are traditionally valued in that
a determination is first made about how much money the instrument will produce
and then the applicable interest rate is applied to determine the current value.
Bonds, however, are different from stocks in that they usually provide for a
predetermined cash flow (in the form of interest payments), while the cash flows
attributable to stocks will vary with the success of the issuers. The interest rate
that Buffett uses is that of long-term United States government bonds.
2. Only invest in companies with predictable earnings.
In order to apply Buffett's valuation method you must have a reasonable basis for
determining a company's future earnings. This requires a favorable track record
and reasonable grounds for predicting future growth. As a result, Buffett does not
invest in companies that have inconsistent earnings. Moreover, this rule precludes
investment in leading-edge growth stocks because Buffet believes that there is no
firm basis for determining future cash flows. If a company’s future likely value
cannot be determined from its past history of financial results, and must be based
solely on assumptions about future developments, Buffett is not interested. He has
cited an assertion by Pogo, the cartoon character created in the 1950’s by Walt
Kelly: “The future ain’t what it used to be.” Those who depend on predictions of
future developments, rather than present developments that can be quantified and
projected into the future, are likely to be disappointed once the future becomes the
present.
3. Only invest when there is a margin of safety between a stock's value and the
market price.
This principle is directly derived from Graham's investment approach. Buffett, like
Graham, bases his investment decisions on the belief that market prices often do
not reflect the true value of a company: "The stock market is a manic-depressive.
That's why you can't buy and sell on its terms. You have to buy and sell when you
want to."
4. To determine if management is doing a good job focus on return on equity,
not earnings per share.
"The primary test of managerial economic performance is the achievement of a
high earnings rate on equity capital employed (without undue leverage, accounting
gimmickry, etc.) and not the achievement of consistent gains in earnings per
share." Buffett notes that because companies usually retain a portion of their
earnings, the assets that a profitable company have will increase each year. This
additional cash allows the company to report increased earnings per share even if
the company's performance is deteriorating. Therefore, Buffett is unimpressed by
"record earnings." He asserts that "after all, even a totally dormant savings account
will produce steadily rising interest earnings each year because of compounding."
5. Avoid companies that have significant debt.
Debt is “the weak link that snaps you." A good business "will produce quite
satisfactory economic results with no aid from leverage" while a company with
significant debt will be vulnerable during economic slowdowns.
6. Only invest in a company with management that is committed to controlling
costs.
Cost-control is reflected by a profit margin that exceeds those of competitors.
"The really good manager does not wake up in the morning and say, 'This is the
day I'm going to cut costs,' any more than he wakes up and decides to practice
breathing." Superior managers "attack costs as vigorously when profits are at
record levels as when they are under pressure." Therefore, be wary of companies
that have opulent corporate offices, unusually large corporate staffs and other signs
of bloat.
7. Only invest in companies whose business you understand.
According to Buffett, "the nine most important words ever written about
investing" are Graham's maxim that "investing is most intelligent when it is most
businesslike." By this, Buffett and Graham mean that an investor should have a
complete understanding of a company's business, including how it operates, its
record of performance and its prospects for the future. Buffett warns, “never
invest in a business you cannot understand.” This is diametrically opposed to the
basic tenet of technical analysis, which focuses solely on price and volume
changes.
8. Only invest in companies that have honest and candid management.
Buffett rules out investing in any company that has a history of using accounting
gimmicks to inflate profits or that has mislead investors in the past. As the earlier
discussion of the “great tycoons” shows, when management shows disregard for
investors, the result can be disastrous for them.
9. The best performing companies usually have a "franchise," something that
makes their product or service unique.
Most of the companies that Buffet invests in have some unique business advantage
that allows them to have above-average performance.
10. Invest for the long-term.
Buffett says that he is "quite content to hold any security indefinitely, so long as the
prospective return on equity capital of the underlying business is satisfactory,
management is competent and honest, and the market does not overvalue the
business."
Buffett advocates a concept that he named “owner-capitalism,” which is the idea
that the interests of the board of directors of a corporation should correspond to
the interests of the shareholders. This occurs when board members own
significant numbers of shares and receive only a small proportion of their income
from director fees. For this reason, all directors of Berkshire Hathaway own
company stock worth at least several million dollars and receive only nominal
payments for serving on the board. Buffet declared to shareholders that under this
approach, “the bottom line for our directors (is): You (the shareholders) win, they
(the directors) win big; you lose, they lose big.”
Buffett also rejects the practice of most every other publicly traded corporation of
obtaining insurance for directors and corporate officers to shield them from
financial responsibility for wrongdoing by the board or management.
Article is Continued After Sponsor's Message
In contrast, most corporations that have ostensibly independent boards of directors
have some, if not most, directors who own only token amounts of shares (and in
some cases no shares at all) and who receive generous director’s fees. They are
also protected against charges of negligence or other wrongdoing by insurance
polices paid for by the corporation (that is, the shareholders). Hence, there is a
strong incentive for a director, under these circumstances, to remain passive, so as
not to endanger his or her lucrative position by questioning the status quo, even if
the status quo leads to disaster.
When judging a person’s fitness to be a director, Buffett said that consideration
should be given to whether the person has “business savvy, a shareholder
orientation and a genuine interest in the company.” He added that “many people
who are smart, articulate and admired have no real understanding of business. That
is no sin; they may shine elsewhere. But they don’t belong on corporate boards.”
Buffett observed that during the stock market boom of the late 1990’s, “CEO’s
who traveled the high road did not encounter heavy traffic.” Some CEO’s engaged
in questionable accounting practices, made poor business decisions and
aggressively increased their own compensation without regard to performance. It
was a period marked -- and marred -- by CEO’s “fudging numbers and drawing
obscene pay for mediocre business achievements.”
It is the job of the board of directors to hold managers accountable for their
actions. In the 2002 Berkshire Hathaway annual report, Buffett cited the Bible
(Luke 16:2), noting that Christ told with approval of “a rich man who said to his
agent, ‘give an account of thy stewardship; for thou mayest no longer be steward.”
For Buffett, a pivotal factor when judging corporate management is the personal
honor of the executives. As regards Berkshire Hathaway, Buffett declared, “lose
money for the firm and I will be understanding; lose a shred of reputation for the
firm and I will be ruthless.”
Although Buffett is best know for his long-term investments and is perhaps the
best know advocate of the “buy and hold” philosophy of investing, he also engages
in short-term trading.
He will engage in risk arbitrage when he has unused cash and finds deals that he
believes are attractive. This type of transaction involves buying a security when an
announced change, such as a merger or liquidation, will shortly increase the price.
As there is a risk that the change will not be accomplished, the stock will usually
sell at a discount prior to the expected event.
Buffett has set forth four questions that he uses as guidelines when evaluating a
possible risk arbitrage: First, how likely is it that the promised event will indeed
occur? Second, how long will your money be tied up? Third, what chance is there
that something better will transpire a competing takeover bid for example, and
finally, what will happen if the event does not take place because of antitrust
action, financing glitches, etc.?
To increase his odds when engaging in risk arbitrage, Buffett focuses on takeover
targets that are selling for a price below their true value. This increases the odds of
the deal being completed and also provides a cushion of safety if the deal falls
through. For example, he invested in General Dynamics when it was a takeover
target but held onto the shares when the deal collapsed (because of anti-trust
objections of the federal government) and profited because the firm had good long-
term prospects.
To return to Part I, click here
To go to Technical Analysis Explained, click here