The Warren Buffett Way
Benjamin Graham
Graham believes that the single most important factor is future earnings
power.
- The formula: A company’s intrinsic value can be determined by
estimating the future earnings of the company and multiplying those
earnings by an appropriate capitalization factor. This capitalization factor,
or multiplier, is influenced by the company’s stability of earnings, assets,
dividend policy, and financial health.
-> The success of this approach is limited by our ability to calculate a
company’s economic future, a calculation that is unavoidably imprecise.
Future factors such as sales volume, pricing, and expenses are difficult to
forecast, which makes applying a multiplier that more complex.
. Start with net asset values as the fundamental departure point.
. A process: attractive business + good management (those are two
qualitative factors that should not be neglected, but hard to measure) +
predicting high future earnings -> attract a growing number of stock
buyers -> price & PE ratio go up -> creating a bubble that eventually will
burst.
margin of safety in three areas: (1) in stable securities such as bonds
and preferred stocks; (2) in comparative analysis; and (3) in selecting
stocks, provided the spread between price and intrinsic value is large
enough.
- safety margin: (1) buy a company for less than two-thirds of
its net asset value, and (2) focus on stocks with low price-to-
earnings ratios. (Graham mostly focuses on the second one,
because it is normally hard to find stocks that fit the first criteria,
especially during a bull market)
Graham: quantitative, emphasized those factors that could be measured:
fixed assets, current earnings, and dividends. His investigative research
was limited to corporate filings and annual reports. He spent no time
interviewing customers, competitors, or managers.
Philip Fisher
Superior performance achieved by: (1) investing in companies with above
average potential and (2) aligning oneself with the most capable
management.
Pay attention to how managers of a company respond to difficulties
( clam up or openly talking about the business difficulties)
In order to be successful, an investor needs to investing in companies
that were within the circle of competence.
Fisher: Qualitative, emphasized factors that he believed increased the
value of a company: principally, future prospects and management
capability.
Warren Buffett
Three tenets: Business, Management and Financial.
Business:
1. A business must be simple and understandable.
2. A business must have a consistent operating history (some of Buffett’s
best returns are achieved by companies that have been producing the
same product or service for several years. Undergoing major business
changes increases the likelihood of committing major business errors).
3. A business must have favorable long-term prospects.
“a bad business offers a product that is virtually indistinguishable from the
products of its competitors—a commodity. Years ago, basic commodities
included oil, gas, chemicals, copper, lumber, wheat, and orange juice.
Today, computers, automobiles, airline service, banking, and insurance
have become commodity type products”
Management:
1. Is management rational?
2. Is management candid with shareholders?
3. Does management resist the institutional imperative?
Financial:
1. Focus on return on equity, not earnings per share.
2. Calculate “owner earnings” to get a true reflection of value.
3. Look for companies with high profit margins.
4. For every dollar retained, make sure the company has created at least
one dollar of market value.
Clash flow - “Should not focus on cash flow, Buffett warns, unless you are
willing to subtract the necessary capital expenditures.”
. Buffett has little patience with managers who allow costs to
escalate.
How Buffett sees value - the value of a business is determined by the
net cash flow expected to occur over the life of the business discounted at
an appropriate interest rate.
Determining the value of a company by Buffett
- 1. the stream of cash flow
- 2. Proper discount rate (mostly the risk-free rate, which is the long-term
bond rate, some people argue that an equity risk premium should also be
added, but Buffett mostly just uses the risk-free rate)
Case Studies
1. Washington Post:
net income + depreciation and amortization – capital expenditures
long term U.S. government bond yield
- Warren used the result (his estimated value of the company) to
compare with the company’s current market cap, and concluded
that the company is undervalued ( 80 million market cap vs. 150
million estimated value)
- Over time, the capital expenditures of a newspaper will equal
depreciation and amortization charges, and therefore net income
should approximate owner earnings. Therefore, in this case, can just
divide net income by the risk-free rate (resulting in 196 million
estimated value).
Summary: bought the company at an attractive price (current market
cap vs. calculated real value), increase in ROE (ROE doubled from the
original 15.7% in the next 10 years), decrease of debt (company was
able to drastically reduce its debt even after new investment and
purchases. The company had a very low debt to equity ratio. In 1992,
the company had a debt to ratio of 5.5%, whereas the industry average
was 42.7%)
Top management: Katerine Graham (the CEO of Washington Posts from
1971-1993) allows the company to outperform the S&P by eighteenfold
and her peers by over sixfold. A dollar invested at the IPO was worth $89
by the time she retired, versus $5 for the S&P and $14 for her peer group.
2. GEICO Corporation
- Company experienced a rapid expansion in its insurance business
and had a big success.
- Due to increased competition, the company implemented strategic
changes. The corporate expansion plan and the plan to insure a
greater number of motorists, occurred simultaneously with the
lifting of the country ’s 1973 price controls. Soon, auto repair and
medical care costs exploded -> resulting in a 6 million underwriting
loss, first in its 28 years of operation.
Actions taken by Buffett: Between 1976 and 1980, Berkshire invested a
total of $47 million, purchasing 7.2 million shares of GEICO at an average
price of $6.67 per share. By 1980, that investment had appreciated 123
percent.
Reasons:
1. Strengths of the company still not lost (ex. Advantage over its
competitors in the cost side).
2. The company still has a good management team.
3. Due to the lack of investing opportunities, the company has been
buying back shares and increase dividend payments to its shareholders.
4. The company has a high ROE relative to its peers (30.8% in 1980, twice
higher than the peer group average). By the end of 1980s, the ROE
decreased, but not because the business was floundering but because its
equity grew faster than its earnings. Hence, part of the logic of paying out
increasing dividends and buying back stock was to reduce capital and
maintain an acceptable return on equity.
5. Over the 10-year period 1983 to 1992, GEICO ’s average pretax margins
were the most consistent, with the lowest standard deviation, of any peer
group company.
6. GEICO ’s combined ratio of corporate expenses and underwriting
losses was demonstrably superior to the industry average. From 1977
through 1992, the industry average beat GEICO ’s combined ratio only
once, in 1977.
* combined ratio of corporate expenses and underwriting losses 解释
(ChatGPT)：
- Combined ratio 是保险行业中用来衡量保险公司运营效率和盈利能力的一个关键指标，它结合了企业费用和承保损失两个部分。这个指标反
映了保险公司在提供保险服务时的盈利水平，具体来说是从保费收入中扣除各类成本和费用之后的表现。
3. Capital Cities/ABC
- News, broadcasting business. Capital Cities decided to merge with
American Broadcasting Companies, requiring 3.5 billion to finance
the deal (Capital Cities offered American Broadcasting Companies a
total package worth $121 per ABC share, twice the value at which
ABC ’s stock traded the day before the announcement).
- Among the 3.5 billion, 2.1 borrowed from banking consortium, 900
million from selling of overlapping televisions, radio stations and
restricted properties that a network was not allowed to own. The
rest 500 million coming from Warren Buffett.
Reasons:
1. Both firms have consistent profitable operating history. Near 20% ROE
and low debt to equity/capital ratio (around 20%).
2. Favorable long-term prospect/good industry. Once a broadcasting
tower is built, capital reinvestment and working capital needs are
minor and inventory investment is nonexistent. Movies and
programs can be bought on credit and settled later when
advertising dollars roll in. Thus, as a general rule, broadcasting
companies produce above-average returns on capital and
generate substantial cash in excess of their operating needs.
-> potential risk of the business: government regulation, changing
technology, and shifting advertising dollars.
3. Determining value -> 3$ million shares sold to Buffett, 172.5$ per
share, total of 517$ million.
- calculate the earning power of the business ->16 million shares
(Capital Cities), 172.5$ offered per share, 10% yield used to discount the
offer (yield of the 30-year U.S. government bond in 1985) -> should have
276$ million earning power.
-> In 1984, Capital Cities (net income 122$ million) + ABC (320$
million) = 442$ million for its earning power.
- In order to finance the 2.1 billion debt, it would cost the company $220
million a year in interest -> net earning combined = 442-220 =200$
million.
The best business to own, says Buffett, is one that, over a long period of
time, can employ ever-larger amounts of capital at sustainably high rates
of return.
Consistent operating history
American Express, as described, has three main divisions: Travel Related
Services (TRS), contributing 72% of sales through its charge card and
Travelers Cheques; American Express Financial Advisors (formerly IDS),
contributing 22% through financial planning and investment products; and
American Express Bank, contributing 5% with a global network. TRS
consistently generates significant profits, producing excess cash for the
company. However, under James Robinson's leadership, this cash was
mismanaged through acquisitions like Shearson-Lehman, which drained $4
billion and underperformed. This led to Buffett's initial investment of $300
million in preferred shares. Only after improved management did Buffett
invest in American Express common stock.
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