The book is interesting. The theme is broadly on how Buffett came to think the way he does. How does he look at investment in business, and how he built his expertise. It also gives a glimpse on how four people have influenced Buffett’s investment style: Benjamin Graham, Philip Fisher, John Burr and Charlie Munger.
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INFLUENCE
Given below is the synthesis of what Hangstrom had to say about these four personalities.
Banjamin Graham is the father of value investing and he is to a lot of extent considered as the person who articulated what is investing and how it should be done. Since his disciples are considered the so successful – Buffett, Walter Schloss, etc. that he has become iconic. He is also the author of investing classics such as The Intelligent Investor and co-author of Security Analysis
P.13 - Graham reduced the concept of sound investing to a motto he called “Margin of safety”.Philip A. Fisher was an American stock investor best known as the author of Common Stocks and Uncommon Profits. And he is also known from the fact that Buffett had at one point said, he is “85% Graham and 15% Fisher.”
P.15 – The first approach was buying a company for less than two-thirds of its net assets value, and the second was focusing on stocks with low price-to-earnings (P/E) ratio.
Graham gave no weight to a company’s plant, property and equipment. Furthermore, he deducted all the company’s short & long term liabilities. What remained would be net current assets. If the stock price was below this per share value, Graham reasoned that a margin of safety existed and purchase was warranted.
P.17-Fisher came to believe that people could make superior profits byNOTE: It is important to understand that since Fisher emphasized so much on management and business valuation style that he believed in ‘concentrated holdings’ style. Also he extensively used Scuttlebutt to cross-check about the company, the principle of which he laid down in his book.
Fisher used to see –
- Investing in companies with above average potential
- Aligning themselves with the most capable management.
Companies’ ability to grow sales over the years at rates greater than the industry average.
Adequate accounting controls and cost analysis. Keep an eye on margins for this part. This activity is done in a way to keep an eye on inefficiencies. Further it acts as an early warning device. (See how the margins are relative to the industry and why.)
- A significant commitment in research and development.
- Effective sales organisation.
Check management –
- How they have communicated during good and bad times?
- Compare management within industry. The integrity of management is of utmost importance.
John Burr Williams. Let me just quote the Wikipedia on this:
He was an economist, recognized as a founder and developer of fundamental analysis, and for his pioneering analysis of stock prices as reflecting their “intrinsic value”. He is best known for his 1938 text "The Theory of Investment Value", based on his Ph.D. thesis, which was amongst the first to articulate the theory of Discounted Cash Flow (DCF) based valuation, and in particular, dividend based valuation.Now Hagstrom, writes –
John Burr Williams two step discounting model.Charles Thomas Munger is among the most successful American lawyer of his day and currently ranked among great investor and philanthropist. A very good friend of Buffett. Buffett on various occasion has described Charlie Munger as "my partner." The entire synthesis that of everything about Charlie Munger in the book is:
1st measures the cash flows to determine a company’s current and future worth.
2nd discount those estimated cash flows, to allow for some uncertainty. For this Buffett uses –
- Interest rate for long-term US bond
- When interest rates are low, the average return of the overall stock market.
Charlie Munger believes in common sense investing.--------------------------------------------------
THE QUESTIONS
Based on the various letters to the shareholder, speeches, etc. Though Hagstrom believes that the central idea for Buffett to buy any business or share was to understand if the business has good economics and has trustworthy management. He has also shares his thought according to which there are four segments that Buffett uses to evaluate a business. If he can answer for all of them then it’s a good business to buy. (P-59)
Business TenetsAt this point it is necessary to understand the meaning of institutional imperatives, these are:
Management Tenets
- Is the business simple and understandable?
- Does the business have a consistent operating history?
- Does the business have favourable long-term prospects?
- Is management rationale?
- Is management candid with shareholders? (Do they accept mistakes?)
- Does management resist the institutional imperative?
- The organisation resists the change in current direction
- Corporate projects & acquisition is used for poor resource allocation
- Strategic studies & detailed rate-of-return reports are prepared.
- Behaviour of peer companies will be mindlessly imitated. (Expansion, acquisition, executive compensation, etc.)
Financial TenetsAlso one should check if the EPS has increased without increase in equity base, debt, issuing options, etc. (basically any other EPS gimmick). (P-110)
Value Tenets
- What is the return on equity?*
- What is the owner earnings?**
- What the profit margins? (This consists of: Have they been sustainable? Are they better than the industry averages?)
- Reinvestment performance by the management? (If the management has kept more than required money with them then how is their asset allocation pattern.)
- Value of the company?
- Is it available at a discount?
*Return on Equity = Operating earnings / Shareholders' equity value
NOTE: Adjust shareholders equity value for market anomalies, meaning any convertible bond that is not accounted should be kept in mind. The same goes for issues of rights or anything that is not taken into account.
Also it is important to understand that operating earnings (i.e. operating profit) should be adjusted for-
- Exclude capital gains/loss
- extraordinary Items
The idea is to check how well the management accomplishes its tasks of generating a return on the operations of the business given the capital it employs.
** Owner earnings = Company's net income + depreciation + amortization - amount of capital expenditure - any additional working capital that might be needed.Also another point to take into account when looking at companies is that though Buffett recommends low debt level, it really depends more from industry/company to industry/company, there are no one size fits all approach here that can be used.
In order to shed more light on the management then old adage has been mentioned about where in one should read about annual reports from a years in the past, see what the management is saying and check what it has done since. There are three specific red-flags, he has mentioned.
- Beware of companies displaying weak accounting. Companies that do not expense stock options.
- Companies that have 'unintelligible' footnotes. If they don't make sense, then perhaps they are hiding.
- Suspicious of companies that trumpet earnings and projections.
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DECISION TO SELL
If you own a lousy company then you meed to move out because your capital because your capital is tied up. But if you own a superior company, the last thing you want to do is to sell it
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OBSERVATION: Even a good investor under-performs the markets between 25-40% of the time.
You only need to right and outperform 60% to become a great investor over long period of time which is approx 15 years or more.
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GOLDEN RULES
Hagstrom's mentions about the golden rules that investors should follow if they are looking at investment from Warren Buffett's perspective. (P-160)
- Concentrate your investment to outstanding companies and management
- Limit yourself to the number of companies that you can understand
- Pick the very best of companies and put the bulk of your investment there
- Think long term: 5-10 years
- Volatility happens. Carry on.
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Although Buffett tells and invests from long-term perspective but once a year he checks for (P-192):
- Return on beginning shareholders equity
- Changes in operating margins, debt level and capital expenditure
- The company's cash-generating ability
"When the economics of your business slows and the discount to intrinsic value narrows, the future opportunity for outsized investment returns diminishes."
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Hagstrom has also mentioned a some interesting questions to Ponder as Bill Miller, former Chairman and Chief Investment Officer of Legg Mason Capital Management, has put it (P-206):
- What are Value Creators (in the company)?
- How does the company generate cash?
- What level of cash can a company produce and what is the rate of growth it can expect to achieve?
- What is the company's return on capital?
Value Generation => Return on Capital > Cost of capital
And then Hagstrom also mentions about some of the qualities common to successful investment managers that he has observed (P-208):
- Portfolio Turnover -- 30% (approx.)
- Portfolio Concentration -- 37% of assets in top 10 holding (approx.)
- Investment Style -- Intrinsic value approach
- Geographic location -- Away from wall street (majority of them)
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My view: The book is well written, interesting examples throughout the book are intertwined with the various aspects of the book.
I don't agree with the view that Buffett's orientation has changed from being a Graham disciple to being more like Fisher today. That view is because Graham is viewed as a statistician and most of his work on finding stocks using more of quantitative value is read. But to truly understand one should first read about the various styles mentioned in 'The Superinvestors of Graham-and-Doddsville', that was developed using Grahams philosophy of Value Investing. Once you see how using the same framework different style can spawn. Then its clear that Graham could also have changed the way he looked at things, and for this one will have to read all his interviews, and read perhaps read the various editions of his seminal book, 'Intelligent Investor'. Especially on the direction that he gives to
'enterprising investors'. And this could be highly debatable.
Although it may not be easy, but it would be worth the shot to combine the quantitative factors that the author, Robert Hagstrom, has mentioned, and to build a model to see how it has performed over the years.
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