Warren Buffet & His Investment Style
By Pramod Pandeya, CFA
When I started my CFA back in 2003, it was the first time, I was acquainted with the legendary name “Warren Buffet”. Since then, he has been my God, Guru, aspiration and motivation. In this article, I try to figure out this legendary investment guru and his investment strategy through which he has made a fortune of whopping $ 52 billion.
Buffet: Born to Make Money
Warren Edward Buffet was born on August 30, 1930, to Howard and Leila Buffett of Omaha ( Nebraska State of USA). Even as a child, he displayed a strong flair for money. While other kids of his age spent time in playing, Buffett’s enterprising nature made him earn money even at a tender age. At the age of five, he set up a gum stand on the sidewalk at his house and sold chewing gum to the pedestrians. When he was nine, he along with a few friends, collected golf balls from the local golf course, segregated them according to their brand names, and repacked and sold them. He earned around $3 a day by selling these golf balls. Buffett was introduced to the world of stocks by his father who opened his own stock brokerage firm. At the age of 11, he took first exposure in the stock market. Soon, young Buffet started keenly observing the ups and downs of the stock market. In 1943, when he was just 13, he declared to a friend that he will be a millionaire by the time he turns 30, or “will jump off the tallest building in Omaha.”
Oracle of Omaha & his investment style
I have read many books, articles or whatever about so-called Oracle of Omaha and his investment strategy. By analyzing his stock picking strategy and investment approach, it can be made out that his investment style is combination of value investing and buy-hold strategy. Buffett, when investing in a particular security, does not refer to any charts or equity research reports nor tracks the up-downs in the DOW and NASDAQ composite as other investors do. In an interview, he once said that even if the Foreign Exchange Department (FED) Chairman was to come and tell him the future interest rate policies are against his investment portfolio, he would not change any of his decision. This level of clarity and confidence on his investment strategy are certainly of worth noting.
In fact, Buffett has developed his own criteria for picking a stock. If a particular stock fits his criteria, he will purchase it regardless of the level of market. For him, investing in a stock is like buying a business. His opinion is that unless one understands a particular business well, he should not invest on it. Buffett’s investment style was influenced by the two persons-- Graham Benjamin Graham and Philip Fisher. The most important learning that Buffett got from Graham was his margin of safety concept. Graham focused on buying stocks for a fraction of what they were worth. On the other hand, Fisher focused on companies which, in his view, had a potential to grow in sales and profits at rates in excess of industry average. He also looked for a strong management in the company.
Buffet developed his strategy as the combination of these two approaches though there are clear difference between Graham’s and Fisher’s approach. The former did a quantitative analysis of companies and simply looked at undervalued companies. The latter, on the other hand, focused on a qualitative analysis and looked for future growth potential of a company. Buffett combined these two styles and came up with an unique investment style which made him the world’s second richest man. To sum up his investment style is to invest in, “A good and easy to understand business with good growth potential, selling at discount to its intrinsic value”.
Tenets of Buffets Investment Style
Buffet, in my understanding, when investing in a particular company, looks for the certain tenets which can be summarized as:
Business Tenet:
This parameter focuses on three aspects of a business. For him, a business should be simple and understandable, have a consistent operating history and favorable long-term prospects. As explained earlier, Buffett looks for companies in his circle of competence. He looks for companies which have a consistent track record and avoids companies which are undergoing major changes. He opines that turnaround companies seldom turn.
Management Tenet:
When buying a business, he looks for companies run by honest and competent people. He looks at three main areas: first, the management should be rational and candid with shareholders and it should resist institutional imperative. Second, he looks for companies which allocate the capital in an efficient way as this is the most important step of management. He prefers companies which are clean and transparent when it comes to financial reporting. He says that most of the time the report is prepared in such a way that it appears beyond understanding. Companies that bring out such reports are avoided by Buffet. He also likes managements which don't simply follow the crowd but take bold independent decisions which are in the best interest of the company.
Financial Tenet:
When valuing a company financially, Buffett does not focus on yearly results, rather takes four or five-year averages. While calculating earnings he deducts any extraordinary income during a calendar year. He also prefers companies that employ little or no debt. Buffett does not consider accounting profits and even cash flow but relies on owner earnings which he describes as net income plus depreciation less capital expenditure and any increase in working capital needs. He also looks for companies which have high profit margins. These companies, he feels, are better placed to combat competition as well as inflation. Earnings and earning growth are very important to Buffett. According to him, in the long-term, stock prices will eventually track earnings.
Market Tenet:
While all the above mentioned principles help Buffett to select a company, the final tenet helps him to take a decision as to when he should purchase it. This is where he introduces his concept of value and price. Price is what you pay and value is what you get. Here again he has two components, viz., what is the value of the business and whether it can be purchased at a significant value. While valuing a business he simply discounts the future cash flows at appropriate discount rate and uses the yields on long-term US bond (Benchmark rate in USA). Like other analysts, he does not add a risk premium. According to him, risk comes from not knowing what you are doing. For him, if you are buying a business at a fraction of its value, you are not taking any risk. For example, if he calculates the owner earnings of a business to be $100 mn and the yield on long-term US bonds as 8%, the value of business as per Buffet will be:
Value= $ 100 mn/0.08 = $1250 mn.
Here, if a company is selling below this value and it fits in other tenets, Buffet would certainly buy the company.
Year |
Berkshire Hathway |
S&P 500 |
Year |
Berkshire Hathway |
S&P 500 |
|
(Book Value) |
(Dividends Included) |
|
(Book Value) |
(Dividends Included) |
1965 |
23.8 |
10 |
1986 |
26.1 |
18.6 |
1966 |
20.3 |
-11.7 |
1987 |
19.5 |
5.1 |
1967 |
11 |
30.9 |
1988 |
20.1 |
16.6 |
1968 |
19 |
11 |
1989 |
44.4 |
31.7 |
1969 |
16.2 |
-8.4 |
1990 |
7.4 |
-3.1 |
1970 |
12 |
3.9 |
1991 |
39.6 |
30.5 |
1971 |
16.4 |
14.6 |
1992 |
20.3 |
7.6 |
1972 |
21.7 |
18.9 |
1993 |
14.3 |
10.1 |
1973 |
4.7 |
-14.8 |
1994 |
13.9 |
1.3 |
1974 |
5.5 |
-26.4 |
1995 |
43.1 |
37.6 |
1975 |
21.9 |
37.2 |
1996 |
31.8 |
23 |
1976 |
59.6 |
23.6 |
1997 |
34.1 |
33.4 |
1977 |
31.9 |
-7.4 |
1998 |
48.3 |
28.6 |
1978 |
24 |
6.4 |
1999 |
0.5 |
21 |
1979 |
35.7 |
18.2 |
2000 |
6.5 |
-9.1 |
1980 |
19.3 |
32.3 |
2001 |
-6.2 |
-11.9 |
1981 |
31.4 |
-5 |
2002 |
10 |
-22.1 |
1982 |
40 |
21.4 |
2003 |
21 |
28.7 |
1983 |
32.3 |
22.4 |
2004 |
10.4 |
10.9 |
1984 |
13.6 |
6.1 |
2005 |
6.4 |
4.9 |
1985 |
48.2 |
31.6 |
2006 |
24.1 |
12.53 |
|
|
|
Avg |
22.8 |
11.41 |
In addition to his well-tested tenet, Buffet has certain other qualities which have helped him to create enormous wealth, namely: determination and confidence. He is willing to see his portfolio fall in the short run as he feels in the long run markets will rightly appraise these stocks. He buys with an assumption that the stock markets might be closed the very next day and would not open for the next five years. So, not surprisingly, he is against short-term holdings of shares and even recommends a 100% capital gains tax on short-term capital gains. He never went outside his circle of competence, although he faced the ire of analysts for missing the technological boom. He relies on annual reports of companies and the competitors; does a lot of reading of newspapers, journals, etc.; does not spend time on computers unlike other analysts. As a matter of fact, not very surprisingly, there is no computer in his Omaha office. He never follows the advice of brokers but takes decisions on his own knowledge and experience. To sum up, with strong belief in fundamentals and his determination and confidence, Warren Buffett has made a fortune and still, Oracle of Omaha has a long way to go.
I understand this article is a tiny approach to understand the legendary Buffet. But I believe, it will provide some insights about this living legend to anyone who is interested in investment industry and capital market.
(Views expressed are personal)
