The Investing Style of Warren Buffett
Buy Businesses - Not Stocks
" Risk comes from not knowing what you are doing." Quote by Warren Buffett
Buffett and Graham
Warren Buffett worked for Benjamin Graham for two years during the 1950s. It was here where Warren learnt the investing strategies Benjamin used at Graham-Newman Corporation.
Benjamin Graham taught Warren the most important lesson of his life - stocks are businesses.
These early days provided Warren with valuable experience which he used when he formed his first investment fund partnership Buffett Associates, Ltd in 1956.
Over the next several years he formed another seven partnerships and managed them all simultaneously.
These partnerships where all limited with between one and six partners and were run in a similar manner to today's hedge funds.
By 1965 Warren Buffett had taken control of the financially distressed Berkshire Hathaway and started to use it as a holding company for his business and investing tactics.
While Warren did try to make the company's textile business profitable, he ceased all the textile operations by 1985 and used the company purely as a holding company.
Warren Buffett's strategies changed somewhat over the years.
In his earlier days he primarily utilized Benjamin Graham's speculative strategies and his partnerships were run in a hedge fund like manner similar to that of Graham-Newman Corporation.
Arbitrage Deals
Warren Buffett made good use of the arbitrage strategies he learnt while working with Benjamin Graham, especially in his early days while managing his own partnerships which were essentially hedge funds.
While he continued to use arbitrage deals once he owned Berkshire Hathaway, they were becoming secondary considerations as he was now focusing more on purchasing companies outright, especially insurance companies.
The arbitrages were then used mainly when he had more cash than good ideas. These arbitrage operations included reorganizations, mergers, takeovers, and spin-offs.
Warren would only buy into an arbitrage after the proposal was publicly announced. He did not participate based on rumors or speculation.
For example, when an acquiring company publicly announced its proposal to takeover a company for a set price, Warren would buy on the announcement if there were sufficient profit based on time to completion and for the risk taken.
There is always the risk that the stockholders' of the takeover company do not accept the takeover bid.
Warren would also buy into mergers and would select the company which gave him the better deal. If one company was overvalued and the other company was undervalued, Warren would buy stock in the undervalued company provided that the combined companies would provide better value based on the new stock issued.
Warren also liked merger acquisitions where a company ABC would merge with a second company XYZ and offered shares in the company ABC along with a cash payment to the stockholders' of company XYZ. If the deal was attractive, Warren would buy shares in company XYZ.
Liquidations
Liquidations were another strategy that Warren Buffett learnt from Benjamin Graham and used extensively with his partnerships.
He would buy into companies where their stock price was trading below the liquidation value.
The liquidation value is not usually the same as the net tangible assets value and thus required a through analysis of the balance sheet statement to arrive at an accurate value.
Fortunately for Warren Buffett he learnt how to do this from the master himself - Benjamin Graham.
Warren Buffett also bought into company's which announced it would liquidate some assets or return cash to stockholders' from the sale of assets - he would buy stock if the end result netted him a sufficient profit.
Outright Acquisitions
Warren Buffett is a businessman and decided to use the financially troubled Berkshire Hathaway as a holding company for his acquisitions.
In his earlier days with Berkshire Hathaway, one of his favorite tactics was to buy financially troubled companies which he could acquire at prices that were less than its working capital - a Benjamin Graham tactic.
Warren ended up closing all the textiles operations that Berkshire Hathaway operated. His focus was more on owning companies outright that were acquired at bargain prices.
Insurance companies provided a lucrative opportunity for businessmen with a solid financial market background.
Warren Buffett started to acquire insurance companies and by now was more willing to pay reasonable prices provided that the companies were financially sound.
Nowadays Berkshire Hathaway owns the insurance company GEICO and owns a large variety of other insurance companies, including a bond insurance company which insures municipal bonds for public works projects.
Berkshire Hathaway also owns outright dozens of various other consumer based companies which Warren has acquired over the years.
Insurance Premiums
This is one of Warren Buffett's secret weapons which he uses with Berkshire Hathaway. Warren's main interest in acquiring insurance companies is due to their business operations.
Insurance companies receive their premiums upfront and at a later date some of these policy holders will make a claim.
Obviously the premiums are calculated so that the dollar value of the premiums received is greater than that paid out.
But the real bonus to a financial market investor is that these premiums are held as cash until the policy holders make a claim.
So what to do with the cash held - it is invested in liquid assets such as stocks and bonds.
But here is the real bonus - the dividends, capital gains and bond coupon payments are keep by the insurance company and not paid to the insurance policy holders.
This means the owners of an insurance company get to use free money to invest with. In other words, the insurance company is receiving a return from the policy holders' money - it's not even Warren's own money.
This is Warren Buffett's interest in acquiring insurance companies - free money to invest with.
Warren Buffett uses his financial market skills to his advantage with all this free money and fortunately for the stockholders' of Berkshire Hathaway, Warren is especially good at investing.
Warren invests this money in both stocks and bonds.
Through his experience with Benjamin Graham, Warren preferred to invest this money in large-cap stocks as the liquidity would make it easy to sell when an insurance claim was lodged.
Due to Warren's business sense he looked for companies trading at a reasonable price. Since he was using lots of free money, Warren was no longer looking for bargains as these were hard to find, he simply looked for reasonable value which was much easier to find.
He preferred companies with a solid earnings history and favored consumer based companies.
The reason Warren Buffett did not invest in overpriced growth stocks was due to the high risk of the stock price collapsing, as he was using insurance money.
Retained Earnings
Warren Buffett is a strong believer in retained earnings and looks for businesses which do not need to reinvest in maintaining operations or financing debt. In other words, the companies Warren acquires use their retained earnings to further increase Warren's wealth.
All of these retained earnings go towards increasing the value of Berkshire Hathaway.
In addition, Berkshire Hathaway itself does not pay any dividends and Warren instead uses the retained earnings of Berkshire Hathaway for further acquisitions.
All the money Berkshire Hathaway makes is used for acquisitions - the more money it makes then the more companies it buys.
Summary
Warren Buffett is an exceptionally good businessman and he is an exceptionally good investor. This is a powerful combination and the reason he became a billionaire.
In Warren's earlier days with his partnerships, he was making a considerable amount of money which he invested with his father in their personal investment account.
He mostly bought smaller illiquid stocks, especially distressed companies selling below their book value.
It was here that Warren modified Benjamin's bargain hunting approach and formed his own version of value investing.
Warren realized that if he paid a fair price for a good quality company with a solid earnings history, he could simply hold the company and not need to worry about the stock price as it would follow the company upwards in the long-term.
It was this approach which Warren Buffett ultimately ended up using with any stocks he purchased through Berkshire Hathaway.
He used this strategy whether they were acquisitions or stocks bought with the free insurance premium money.
Once Warren Buffett acquires a company or buys stocks he does not care about the future stock price - he buys quality businesses and any future stock price will reflect that in the long-term.
He nowadays is forced to concentrate on large companies since he has so much money to invest which needs to find a home.
The liquidity is especially important with any investments made with the free insurance premium money, as these funds may be needed later for insurance claims made by the policy holders.
Value Investing the Buffett Way
" If a business does well, the stock eventually follows." Quote by Warren Buffett
The Early Days
In Warren Buffett's early days, he worked along side Benjamin Graham and learned the strategies Benjamin used.
These early days provided Warren Buffett with valuable experience in evaluating the financial condition of companies and provided Warren with the idea that stocks were actually business which produced a product or service.
While Warren Buffett was effectively trained by Benjamin Graham, Warren began analyzing past investments made and noticed that some of those bargain priced stocks which were then sold actually continued to grow and their stock price continue to increase.
Warren realized that the companies with the most promise were what Warren Buffet referred to as consumer monopolies.
These companies have a long-term competitive advantage over their competitors.
This led Warren Buffett to form his own version of value investing - one with a longer time frame than Benjamin's tactic of sell as soon as the stock became slightly overvalued.
Warren's value investing strategy was in stark contrast to the speculative strategies he used with his investment partnerships in those early days.
These partnerships were more like modern day hedge funds.
With this new perspective, Warren Buffett began to place a lot more emphasis on the future growth prospects of a business and reasoned that a steadily growing business would be worth more in the future and that the future stock price would reflect this.
With this long-term approach, Warren reasoned that the returns would be greater than the shorter term approach he had been using.
Warren Buffett's view was that - people who want to get rich quickly, will not get rich at all. There is nothing wrong with getting rich slowly.
This is the cornerstone for Warren Buffett's approach to business and investing - Don't be in a hurry, it takes time.
The value investing strategy presented here is based on Mary Buffett's book Buffettology which depicts Warren Buffett's version of value investing.
Buy Businesses - Not Stocks
Warren Buffett observed that the vast majority of stock market investors had a short-term outlook - they would buy on good news and sell on bad news.
Warren was not interested in the popular investment themes as these stocks were inevitably overvalued, with their stock prices driven way above what the was justified for the business.
When stock prices peak and sell-off; the market then undervalues the long-term value of business.
The price paid for a stock determines the long-term return achieved and in order to maximize returns Warren would only buy when the stock's price was at a reasonable level.
His primary tactic is buying a company for a lower price so it will provide more earnings per dollar paid.
Warren views the company's earnings as actual profit made, just like a private business owner.
What is important to Warren Buffett is management's ability to grow earnings over the long-term as this is the key to increasing the stock price.
While stocks spend a fair amount of time overvalued, several factors cause the stock price to become undervalued.
These factors include a stock market correction, an industry correction and a problem or issue with the business itself. The best buying opportunities arise when all these factors occur at the same time.
Warren Buffett uses the 10-year bond as a benchmark to determine whether a stock is worth buying at its current stock price. In effect he values stocks like bonds.
After Warren Buffett buys a stock he does not care what happens to the future stock price and is not concerned with the value Wall Street places on the stock. Warren's view is that when earnings increase over the long-term, then the stock price will follow those earnings over the long-term and there is then no reason to track the stock price on a daily basis.
Warren's view is that he bought a business and the stock price is only important when he wants to sell the stock.
The Consumer Monopoly Business
Warren Buffett observed that certain types of businesses had a greater chance of growing their earnings over the long-term.
While various industries had periods of strong earnings growth, they also had periods of little or no earnings growth.
Warren was interested in businesses which would continue to grow well into the future.
Certain types of businesses have a greater chance
of growing their earnings over the long-term
From his analysis, Warren concluded that the successful business had a long-term competitive advantage over its competitors, which Warren attributed to a strong consumer brand.
Warren referred to such a business as a consumer monopoly. These types of businesses tend to have higher profit margins and more reliable future earnings growth.
The reason Warren likes the consumer monopoly type of business is that they have the power to overcome most bad news events.
This is because of brand loyalty - the consumer will still buy their product or service and the business continues to receive its revenue.
The consumer monopoly business is in a unique position - if customers want that product, they have to buy it from that company - just think of McDonald's, if you want their hamburgers where else can you by them.
While the consumer monopoly business typically has a steady earnings growth history, they are still subject to business cycles to a certain degree.
It is during these business downturns where Warren Buffett likes to buy these consumer monopolies.
Look for Value and Growth
Warren Buffett looks for businesses which are easy to understand. He wants to see a product or service which the consumer wants or needs.
These businesses are more likely to have a steady earnings growth history.
A ten year summary of earnings per share gives a good feel for a company. Warren looks for a strong upward trend over the last ten years with a temporary setback in last recent year.
The last earnings reported will likely disappoint the market and typically sell the stock price down.
Warren Buffett is not interested in companies with widely fluctuating earnings, he likes to see a smooth upwards progression in earnings with a setback every now and then.
These setbacks are where Warren Buffett looks to buy stock. Essentially all companies experience a setback in their earnings growth at some stage.
Since Warren is a value investor buying on a temporary setback in earnings, he wants businesses which are financially sound and can weather any short-term financial issues.
While Warren Buffett analyzes past earnings data, this is primarily done so he came project the earnings forward into the future.
Businesses with a steady earnings growth will more likely produce sustainable earnings growth into the future.
The reason Warren emphasis future earnings growth is so that the business will be worth more in the future, which Warren requires so that the stock price will follow this growth.
The reason Warren Buffett avoids businesses with erratic historical earnings is that it's impossible to project their earnings forward.
Warren wants to know with a high degree of certainty what the future earnings growth of a business will be - he does not like to speculate on future earnings growth.
To arrive at a likely future stock price range, Warren uses the average PE ratio over last ten years.
Warren Buffett looks for companies with little debt as these can more readily weather any difficult financial times. Companies which can retain earnings and not spend it all on maintaining current operations are able to reduce debt.
Warren likes companies with high rates of return on stockholders' equity. Companies with a consumer monopoly are more likely to retain earnings.
In addition to reducing debt, they can make share repurchases which is something that Warren looks for.
Share repurchases increases the earnings per share since there are now fewer stockholders to share those earnings with - Warren looks for value and likes to see an additional return from the retained earnings.
Warren Buffett looks for companies that build their business from within rather than through acquisitions. He also looks for companies that do not pay ridiculous salaries and excessive stock options to their key employees.
Nowadays Warren Buffett likes to buy stocks at a reasonable price rather than the bargain prices he used to buy at in his earlier days.
When he gets the opportunity he buys when a scandal, big loss or bad news causes the stock price to drop.
The Life of Warren Buffett
Warren Buffett
Warren Buffett was born in 1930 and is an American businessman and stock investor.
Warren Buffett is a billionaire who consistently ranks in the top five of the world's wealthiest people.
He is acknowledged as one of the most successful investors in history and is considered to be one of the most influential people in the investing world. When Warren Buffett speaks, everyone listens.
The Life of Warren Buffett begins in his hometown Omaha in Nebraska where he was born.
As a child Warren displayed an interest in business and worked in his grandfather's grocery store and amongst other activities he made money by detailing cars, delivering newspapers and some door to door selling.
Warren was brought up in a business environment and this had a significant influence on him. His father owned a stock-brokerage firm and his grandfather owned a grocery store.
In 1947, Warren Buffett initially studied business administration at the Wharton Business School of the University of Pennsylvania for two years.
He then transferred to the University of Nebraska where Warren graduated with a bachelor's degree in Business Administration in 1950.
Warren Buffett was aware of Benjamin Graham and his investing philosophies. One of Warren's favorite books was The Intelligent Investor.
In 1951, Warren moved to New York and enrolled in the Business School of Columbia University where Benjamin lectured and obtained a Master's degree in Economics.
In 1952, Warren returned to Omaha and married his first wife Susan. Warren worked for his father's stock-brokerage firm Buffett-Falk & Co.
In 1953 the Buffett's had their first child, a baby girl whom they named Susan Alice Buffett.
Warren Buffett moved back to New York in 1954 and worked for Benjamin Grahams firm Graham-Newman Corporation. Benjamin offered Warren the role as Benjamin knew Warren from Colombia University.
In the same year the Buffett's had their second child, a boy whom they named Howard Graham Buffett, with the middle name reflecting the surname of Benjamin whom Warren idolized.
Warren Buffett studied under Benjamin Graham
and worked with him for two years
Benjamin Graham retired in 1956 and left the partnership of Graham-Newman Corporation.
Warren Buffett then left the firm and moved back to Omaha where he started an investment partnership called Buffett Associates Ltd.
Over the next couple of years Warren formed another seven partnerships and he extensively utilized the hedge fund style strategies he learnt will working with Benjamin Graham.
In 1957, Warren Buffett bought his house in Omaha where he still lives today
In 1958, the Buffett's had their third child, a boy they named Peter Andrew Buffett.
Warren Buffett first began buying shares in the textile manufacturing firm, Berkshire Hathaway in 1962.
During 1965, Warren Buffett was aggressively buying Berkshire Hathaway shares and finally took control of the company. Warren appointed Charles Munger as Vice President of the newly acquired Berkshire Hathaway.
Berkshire Hathaway was to become a holding company Warren used to acquire stockholdings in other companies using his version of value investing.
In 2004 his wife Susan passed away and Warren re-married in 2006 to his long time friend Astrid.
Warren Buffett has stated that he plans on donating the vast bulk of his fortune to charities with the majority going to the Bill & Melinda Gates Foundation.
Warren's children will only inherit a small portion of his wealth and Warren's reasoning is that if they receive too much money then they will have no ambition to make any for themselves.