The Warren Buffett Way: Book Review by Anton F. Balint
Warren Buffett is an investor that needs no introduction. However, many, including myself, deep down are wondering what made Warren Buffett to achieve such tremendous success. Robert G. Hagstrom, in his book –The Warren Buffett Way- managed to capture the investment philosophy, character traits and education of one of the main figures of value investment and one of the richest men on Earth. This book is designed for anyone that is interested in the investment profession: whether you have a remote curiosity into what made Warren Buffett one of the most successful investors or you are seriously considering learning about a career as an a capital allocator, The Warren Buffett Way walks the readers through the thinking of the ‘Sage of Omaha’.
In the first two chapters, Robert G. Hagstrom offers a colourful overview of Warren’s early life and education. Warren Buffett was born August 30, 1930, in Omaha, Nebraska. People close to Mr Buffett for too long have underlined his interest in numbers and money since he was a child: at the age of 10 Warren told his father to take him to New York to see three things: the Scott Stamp and Coin Company, the Lionel Train Company and the ‘almighty’ New York Stock Exchange. A year later, when he turned eleven, the Oracle of Omaha started his journey as an investor when he purchased his first stock: together with his sister, Doris, he invested in Cities Services Preferred three shares each at a price of $114.75 per share. That summer the stock declined and under his sister’s pressure he sold for a profit of $5. However, Cities Services Preferred soon reached an all-time high of $202 a share. Buffett calculated that he missed on a profit of $492. This episode was not without a lesson, which was quickly learnt by the young value investor: investing for large profits implies patience.
It is true that Buffett’s real journey in the investment world started when he picked up a book called The intelligent investor by Benjamin Graham. However, Warren’s mind is the result of a blend of incredible intellectuals: Ben Graham was by the biggest influence on the young value investor’s perception of the business world. However, Philip A. Fisher and his life-long business partner and friend, Charles Munger, played probably the most important roles in improving Warren’s value investment approach developed with Benjamin Graham’s help. This intellectual blend is the base of what the author calls “The Twelve Immutable Tenets” of buying a business. They are as follows:
Business Tenets
- Is the business simple and understandable? Warren Buffett again and again underlined the importance of investors understanding the underlying business that they stock represents: “Invest in your circle of competence.” Buffet advices us. Therefore, knowing what is your circle of knowledge (i.e. your edge) and staying within it will increase the chances of making irrational, misinformed or hasty decisions because you will be aware of the forces that drive the industry and the companies within it. If you do not have such knowledge, then start developing it by reading company reports, books and industry reviews. Moreover, if you cannot clearly analyse a company then do not invest in it simply because it is recommended by your brokers – look at what happened with Enron.
- Consistent Operating History. This principle is clear: the business must have been profitable for a long term. However, I would like to underline that this applies mostly to people that have a substantial enough amount of capital that can be placed with a view for 5 years or more.
- Favorable Long-Term Prospects. Buffett suggests to look for franchises, or business that sells a product or a services that is (1) needed or desired, (2) has not close substitute and (3) is not heavily regulated. The combination of the three points will give the company price flexibility which will allow it to earn above average returns on capital. Another approach to this tenet is to look for the ‘moat’ or the long-term competitive advantage: the totality of a business’ qualities that will protect it from strong competition, will enable price flexibility and further expansion of its market share.
Management Tenets
- Is The Management Rational? Managers are entrusted with one of the most important business actions: capital allocation. Over time, capital allocation will determine the shareholder value. The question that Buffett asks is what has the management done with the earnings? Were the earnings reinvested in the business, retained or returned to shareholders? If the management decided to reinvest them, then the next few years should see an increase in shareholder value. Equally important, if the decision was to retain the earnings, then for each $1 of retained earnings the shareholders should see at least $1 of increased value (calculated as market value). Finally, the management can choose to return the earnings via two channels: share buybacks or dividends. If they decide to buy back shares, the price of the shares ought to be below the company’s intrinsic value if this should benefit the shareholders. Also, dividend policy should be carefully scrutinize overtime so it does not become an excuse for poor performance.
- Is The Management Candid With The Shareholders? In other words, is the management reporting both the mistakes and the achievements in a clear manner so that each investor can understand how the business was run and how it performed?
- Does The Management Resist The Institutional Imperative? One of Warren’s favourite books is The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success by William N. Thorndike, Jr. The book is a detailed collection of how these eight CEOs stood against the crowd and did not follow their fellow CEOs into behaving emotionally in making business decisions. There are suggestions that the management cannot resists the institutional imperative: excessive expansion that adds no value but just expands the corporate empire, hiring people for the sake of expansion instead of hiring for talent and the crystallization of a common pattern of bad business decisions across companies within the same industry.
Financial Tenets
- Return on Equity: Focus on return on equity and not on earnings per share. The ‘bottom line’ can be easily manipulated by one time losses or gains. Therefore, the EPS is not an accurate figure to measure the management’s performance of creating value.
- Owner Earnings: A company’s cash flow is usually calculated as net income after taxes (the ‘bottom line’) plus depreciation, depletion, amortization and other non-cash charges. However, Warren saw a flaw in this equation: it does not account for capital expenditure. Capital expenditure, or capex, is the amount the company uses on new equipment, plant upgrades and other improvements necessary to maintain its economic position and unit volume. Therefore, Buffett suggest to look for Owner Earnings, a figure that we obtain as following: the company’s net income plus depreciation, depletion and amortization minus capital expenditures and any additional capital needed for the business to keep going.
- Profit Margins: Evidently, he looked for profit margins as high as possible, or above average when compared to other competitors. High profit margins suggests that the management is doing a good job at keep costs low or that it has pricing power or that it can increase its sales volume without pilling up additional costs.
- The One-Dollar Principle: This tool was designed to give a rough and quick estimation of how much a business is worth: the increase in value (market value, or for more sophisticated valuations, enterprise value can be used) should at least match the amount of retained earnings dollar for dollar. If the value goes up more than retained earnings, so much better.
Market Tenets
- What Is The Value Of The Business? According to the book, Buffett valuates a business as he valuates a bond. A bond is worth the sum of its coupons divided by the appropriate discount rate (the interest rate of the bond’s maturity). Similarly, a company is worth the estimated owner earning’s cash flow that it will generate into the future and then discounted back to present. Two variables are crucially important here: the stream of cash flow and the proper discount rate. Without these two elements, the Discounted Cash Flow model will give irrelevant numbers.
- Buy At Attractive Prices: This is easier said than done: buy a business for a price lower than its intrinsic value. However, there is no set method for assessing what its intrinsic value is because such value is the result of both quantitative factors (financials, client base etc.) and qualitative elements (the management’s ability to allocate capital, the capacity to profit from R&D etc.). Nevertheless, practice and time will give the investor which is willing to take this approach the necessary insight into understanding how to estimate such intrinsic value.
The author then offers nine case studies, in Chapter 4, of common stock purchases made by Warren Buffett and he walks the read through what investment tenets were used and how they were used. It is probably the most important chapter of the book after Chapter 3 where the Twelve Tenets are detailed. The last four chapters touch on a wide range of subjects, from portfolio management to the psychology of the market and the personal qualities of successful investors.
Therefore, considering that this book addresses anyone that is interested in Warren Buffett’s investment career and philosophy or in value investment in general, it is not a pool of information charged with technical financial jargon: it is a fun and insightful read that I recommend as part of the basic reading for any value investor. In fact, it would be a good idea to read this book before delving deeper into value investment.
Link to the book: http://www.amazon.co.uk/The-Warren-Buffett-Way-Website/dp/1118503252
Link to the Warren Buffett Way website: http://eu.wiley.com/WileyCDA/Section/id-817927.html
The Warren Buffett Way, + Website by Robert G. Hagstrom
