Value investing the Warren Buffett Way.
Warren Buffett likes to buy high quality companies, run by competent and honest managers, at a reasonable price.
Firstly, he focuses on companies that he believes are easy to understand and judge. That is, he stays within his circle of competence.
Secondly, he thinks carefully about the economics of a business, their competitive advantages, and disadvantages, and the durability of it.
Thirdly, he watches for how managers operate. This includes their alignment with shareholders, discipline with capital allocation and overall integrity.
Finally, to purchase companies at a reasonable price, Buffett looks for a large margin of safety. This is the difference between the companys stock price and his estimate of intrinsic volume. The larger the margin the better.
Hagstroms four tenets
Robert Hagstrom divides Buffetts philosophy into four tenets:
Under each tenet, he outlines several questions that we know Buffett to think about when investing. They serve as a simple checklist to help us identify companies with potentially attractive long-term investment prospects.
Some of this questions are:
-Is the business simple and understandable?
-Does the business have a consistent operating history?
-Does the business have favourable long-term prospects?
-What are the company’s owner earnings?
-What are the return on equity and profit margins?
-Does the company create at-least one dollar of market value for every dollar retained?
-Is management rational?
-Is management candid with shareholders?
-Does management resist the institutional imperative?
-What is the value of the company?
-Can it be purchased at an attractive discount to its value?
Buffett believes great businesses should generate consistently high returns on invested capital. For companies to achieve this, they must have a durable competitive advantage. This is what Buffett famously refers to as the company’s economic moat. These companies tend to be durable franchises with products or service that customers need or desire; have few direct and indirect substitutes; and exhibit strong pricing power over time.
Nevertheless, recognizing a durable competitive advantage that others have not yet seen is a challenge. Finding these companies while they are small, with a runway for growth and at affordable prices, is an even bigger asks.
In his later years, Buffett gravitated from cheap cigar-butt stocks towards companies that earn high returns on equity, high profit magins, and with little to no debt employed. There is nothing impressive about companies that achieve high earnings growth via an ever expanding debt and/or equity base
Warren Buffett looked for managers that operates with integrity, intelligence and energy. Managers that lack one or more of these qualities are more likely to destroy company value. Buffett also liked to see managers operate with an owner mentality, and treat their shareholders as long-term partners.
Managerial stock ownership and remuneration schemes may provide one indication of this. The way they communicate might be another. In Investing Between the Lines, LJ Rittenhouse recommends we evaluate executive communications on the basis of their vision, strategy, accountability, relationships, capital stewardship and candour.
One dollar test
Warren Buffett also looked for rational managers and effective capital allocators. Companies with good prospects and shareholder alignment should see their results reflected in its market value over time. That is, Warren Buffett wanted every dollar of retained earnings to create at least one dollar in market value. He called this the one dollar test.
Furthermore, Hagstrom notes that managements choice between reinvestment and return of capital is another test of their capital discipline. For example, managers that earn consistently poor returns on capital on acquisitions (as opposed to simply returning excess cash) are destroying shareholder value.
Margin of safety
Investors need to buy high quality companies at prices below their estimates of intrinsic value to generate satisfactory investment returns. This value is the expected net cash flow over the investments lifespan, discounted at an appropriate cost of capital. Warren Buffett himself focused on owner earnings.
Owner earnings = Net income + (Depreciation & Amortisation) (Capital Expenditures + Additional Working Capital)
It is easier for us to assess intrinsic value when owner earnings are stable and predictable. Hagstrom notes that Warren Buffett used a discount rate of around 10%, or the yield for long-term bonds. Perhaps this was for ease of calculation and for a margin of safety when bond yields are lower.
Purchasing stocks at prices below underlying value provides investors with a margin of safety and some room for error. It allows investors to absorb some downside risk if the company’s intrinsic value were to deteriorate. Similarly, it acts as a hurdle rate to select investments with higher expected upside relative to its prevailing market price.
Diversification and risk
Warren Buffett and his partner, Charlie Munger, have had numerous bugbears with academic finance. One major contention relates to risk and diversification.
Academic finance typically measures risk on the basis of stock price volatility and co-variances. They promote the benefits of diversification and highlight challenges of outperforming efficient markets. While markets are usually efficient, they are not always efficient (as history often shows). This creates opportunities for disciplined investors like Buffett.
Risk is the likelihood of loss of capital, not the volatility in stock prices.
Hagstrom describes the Warren Buffett Way as a rational approach to investing. Such an approach can help investors to avoid the emotional and intellectual traps that one might otherwise face by relying on intuition. Similarly, such focused investors turn off the stock market. Markets are not soothsayers to them. Rather, they are simple albeit volatile mechanisms to buy and sell shares of stock. You are neither right or wrong because the crowd disagrees with you.
Additionally, Hagstrom notes that outperformers also worry less about the economy. They look for investments that can thrive across multiple scenarios, including downturns. These investors focus on buying outstanding companies with a margin of safety. While patient, they place big bets when the probabilities are in their favor. They hold their portfolios for the long term and avoid panics during temporary price swings.
Hagstroms empirical analysis found market beating fund managers to exhibit four attributes.
Firstly, they have a lower portfolio turnover at an average of ~30% (compared to the all equity fund average of 110%).
Secondly, they employ greater portfolio concentration, where 37% of assets are concentrated in their top 10 picks.
Thirdly, they adopt intrinsic-value approaches.
Finally, they are geographically underrepresented in key financial centers such as New York. This might also present evidence for greater independence and lower hyperactivity.