The Buffett Series – Investment Analysis

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By Investment Master Class

Charlie Munger loves the concept of simplicity. When it comes to investing it’s important to understand what a company does and what the key factors are that will determine the company’s success. You don’t need a 2,000 line spreadsheet to determine if an investment is likely to be successful. But you do need to think.  Talking to people involved in the industry and with the product can provide a huge edge.

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In Berkshire Hathaway's 1997 annual letter, there's a great snippet where Buffett details how he came about building a significant position in Amex. Buffett had purchased $300m of American Express hybrids in a private placement in 1991. The hybrids were due to convert to common stock in 1994 and in the month before Buffett had been mulling over whether to sell upon conversion.  While he thought the CEO was outstanding and likely to maximise whatever Amex's potential was, he was leaning toward a sale, as the company faced relentless competition from a multitude of card issuers, led by Visa. Buffett continues ...

"Here's where I got lucky. During that month of decision, I played golf at Prouts Neck, Maine with Frank Olson, CEO of Hertz. Frank is a brilliant manager, with intimate knowledge of the card business. So from the first tee on I was quizzing him about the industry. By the time we reached the second green, Frank had convinced me that Amex's corporate card was a terrific franchise, and I had decided not to sell. On the back nine I turned buyer, and in a few months Berkshire owned 10% of the company.

We now have a $3 billion gain in our Amex shares, and I naturally feel very grateful to Frank. But George Gillespie, our mutual friend, says that I am confused about where my gratitude should go. After all, he points out, it was he who arranged the game and assigned me to Frank's foursome."

In a recent CNBC interview, Buffett explained some of the analysis he undertook when he bought Berkshire's $17b stake in Apple ….

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"Well, I would say Apple's — I mean, obviously it's very, very, very tech-involved, but it's a consumer product to a great extent too. And I mean, it has consumer aspects to it. And one of the great books on investing, which I've touted before, is one that Phil Fisher wrote back around 1960 or thereabouts, called "Common Stocks and Uncommon Profits." It had an effect on me. I went out to meet Phil Fisher after reading the book, I found him in this little office in San Francisco. And I recommend any investor read that book. And it's still in print. And he talks about something called the scuttlebutt method, which made a big impression on me at the time. But I used it a lot, which is essentially going out and finding out as much as you can about how people feel about the products that they ... it's just asking questions, basically. And Apple strikes me as having quite a sticky product and enormously useful product that people would use, and not that I do. Tim Cook's always kidding me about that. But it's a decision-based ... but again, it gets down to the future earning power of Apple when you get right down to it. And I think Tim has done a terrific job, I think he's been very intelligent about capital deployment. And I don't know what goes on inside their research labs or anything of the sort. I do know what goes on in their customers' minds because I spend a lot of time talking to 'em."

Buffett expands on the scuttlebutt process

"I had learned that from a fella named Phil Fisher who wrote this great book called "Common Stocks and Uncommon Profits." And he calls it the scuttlebutt method. And Phil was a remarkable guy.  And I first used it back in 1963 when American Express had this great Salad Oil Scandal that people were worried about it bankrupting the company. So I went out to restaurants and saw what people were doing with the American Express card, and I went to banks to see what they were doing with travelers' checks and everything. And clearly American Express had lost some money from this scandal, but it hadn't affect their consumer franchise. So I ask people about products all the time. When I take my great-grandchildren to Dairy Queen they bring along friends sometimes. They've all got a iPhone and, you know, I ask 'em what they do with it and how ... whether they could live without it, and when they trade it in what they're gonna do with it. And of course, I see when they come to the furniture mart that people have this incredible stickiness of — with the product. I mean, if they bring in an iPhone, they buy a new iPhone. I mean, they're ... it just has that quality. It gets built into their lives. Now, that doesn't mean something can't come along that will disrupt it. But the continuity of the product is huge, and the degree to which their lives centre around it is huge. And it's a pretty nice, it's a pretty nice franchise to have with a consumer product."

and on the Apple products ...

"But what I do know is when I take a dozen kids, as I do on Sundays out to Dairy Queen they're all holding their Apple, they barely can talk to me except if I'm ordering ice cream or something like that. And then I ask 'em how they live their lives. And the stickiness really is something. I mean, they do build their lives around it, just like you were describing. And the interesting thing is, when they come into ... when they come into get a new one, they're gonna get they overwhelmingly get the same product. I mean, they got their photos on it and, I mean, yeah, I know you can ... you can make some shifts and all that. But they love it."

Buffett reminded us of the need for simplicity in his 1994 letter ...

"Our investments continue to be few in number and simple in concept:  The truly big investment idea can usually be explained in a short paragraph.  We like a business with enduring competitive advantages that is run by able and owner-oriented people.  When these attributes exist, and when we can make purchases at sensible prices, it is hard to go wrong (a challenge we periodically manage to overcome).

Investors should remember that their scorecard is not computed using Olympic-diving methods:  Degree-of-difficulty doesn't count. If you are right about a business whose value is largely dependent on a single key factor that is both easy to understand and enduring, the payoff is the same as if you had correctly analyzed an investment alternative characterized by many constantly shifting and complex variables."

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While Buffett no doubt analysed Apple's historical financial statements, he recognised that it is Apple's future earnings power that will determine the success or failure of the investment.  A key factor that will determine that future earnings power is the strength and sustainability of the consumer product franchise.   Here, observing, speaking to, and thinking about the company's products and customers can provide an edge.  Understanding the qualitative factors can be more important than the historical numbers.  Keep it simple, it's not rocket science.

“The most important question you should be asking: will this business still be around a decade from now?  Numbers alone won’t tell you the answer; instead you must think critically about the qualitative characteristics of your business” Peter Thiel


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