Warren Buffett

It is well known that Warren Buffett has been very successful in the markets. He amassed his fortune from his base in Omaha, NE, far from Wall Street, and did so by ignoring the conventional wisdom of other professional investors. His philosophy is to "be fearful when others are greedy and greedy when others are fearful."

Buffett was a protègè of Benjamin Graham, whom many consider to be the father of security analysis. Buffett was a student of Graham at Columbia University; at the time, Graham was a part-time instructor there as well as president of a money management firm. After graduating in 1951, Buffett worked for Graham as a security analyst. He also invested his own funds, and was able to turn $9,800 into $140,000 by 1956.

Buffett absorbed Graham's ideas, but then moved beyond them to develop his own investment philosophy. In 1956, he returned to his hometown and began Buffett Associates, an investment partnership that he funded with his family and friends. This partnership eventually evolved into Berkshire Hathaway, a corporation now traded on the New York Stock Exchange (NYSE).

Buffett informed his early investors that he couldn't promise them results. What he could do, however, was select investments on the basis of value and not popularity, keep the risk of permanent capital loss (as opposed to short-term loss) to a minimum, and keep his and his family's entire net worth in one partnership.

Those who had confidence in Buffett have been amply rewarded. An investment of $1,000 made with Buffett in 1956 would be worth more than $30 million today (even after taking into account the market declines of 2000). Buffett has always said that he has two rules for successful investing: The first is never to lose money and the second is never to forget the first rule.

FIVE PRINCIPLES OF INVESTING

Like Benjamin Graham, Buffett is a contrarian. His approach rests on five main principles of investing, derived from Graham's teachings:

1 Think independently.

2 Invest in high-return businesses run for the benefit of shareholders.

3 Pay only a reasonable price, even for an excellent business.

4 Invest for the long term.

5 Do not diversify excessively.

In addition to Graham's influence, there was another person who played an important role in shaping Buffett's investment philosophy. That man is his friend of more than 30 years, Charles Munger, the vice chairman of Berkshire Hathaway. Ironically, Munger's pivotal contribution to Buffett's success was his ability to influence Buffett not to be frozen into Graham's philosophy of buying stocks that are selling at bargain prices (as determined by careful analysis) and selling them when they are fully valued by the market.

This method worked exceptionally well when buying securities during the Great Depression of the 1930s and immediately afterward. Back then there were many undervalued stocks, simply because relatively few people had the cash to invest. Those who did were often frightened by their painful memories of the stock market crash of 1929. However, the rewards of "bottom-fishing" diminished in the decades following, when it was no longer a common occurrence for a stock to be greatly undervalued. Moreover, it became apparent that merely because a stock is fully valued does not mean it does not have the potential for above-average growth.

In the words of Warren Buffett: "Charlie shoved me in the direction of not just buying bargains, as Ben Graham had taught me. This was the real impact he had on me. It took a powerful force to move me on from Graham's limiting views. It was the power of Charlie's mind. He expanded my horizons."

Munger realized, and argued strenuously to Buffett, that a company selling at a price that would preclude Graham from investing can still be a bargain if it has the potential for a high rate of growth. Such companies have franchises that give them a unique advantage, coupled with first-class management.

Munger and Buffett also depart from Graham's philosophy in that they believe a good stock should be held for as long as the company remains fundamentally sound. Ideally, this means holding the stock forever. According to Buffett, "Lethargy, bordering on sloth, should remain the cornerstone of an investment style." Graham, in contrast, rejected the buy-and-hold approach and would sell a stock as soon as it reached his target price. This approach incurs transaction costs, such as brokerage fees and capital gains taxes, which reduce overall returns.

Buffett is famous for his annual reports to shareholders, in which he candidly and lucidly discusses his investment philosophy and the results for the year. He modestly stated in one such report: "What we do is not beyond anybody else's competence. It is just not necessary to do the extraordinary to get extraordinary results."

THE 10 RULES

Warren Buffett's phenomenal success can be attributed to his rigorous and diligent approach to financial markets. Ten rules guide Buffett's investing style, as reflected in his annual reports of the last two decades:

1 A company's value is based on its expected net cash flow discounted at an interest rate that reflects risk. Although this concept is similar to Benjamin Graham's ideas about intrinsic value, Buffett credits John Burr Williams, author of The Theory Of Investment Value (first published in 1938), as its source. The concept is analogous to the way bonds are traditionally valued in that a determination is first made about how much money the instrument will produce, and then the applicable interest rate is applied to determine the current value. Bonds, however, are different from stocks in that they usually provide a predetermined cash flow (in the form of interest payments), while cash flows attributable to stocks will vary with the success of the issuers. Net cash flow consists of earnings plus non­cash accounting charges (depreciation, depletion, and amortization charges) minus capital expenditures that are necessary to maintain sales. The interest rate that Buffett uses is that of long-term US government bonds.

2 Only invest in companies with predictable earnings. In order to apply Buffett's valuation method, you must have a reasonable basis for determining a company's future earnings. This requires a favorable track record and reasonable grounds for predicting future growth. As a result, Buffett does not invest in companies that have inconsistent earnings. Moreover, this rule precludes investment in leading-edge growth stocks, because Buffett believes there is no firm basis for determining future cash flows.

3 Only invest when there is a margin of safety between a stock's value and the market price. This principle is directly derived from Graham's investment approach. Buffett, like Graham, bases his investment decisions on the belief that market prices often do not reflect the true value of a company. As he opines: "The stock market is a manic-depressive. That's why you can't buy and sell on its terms. You have to buy and sell when you want to."

4 Focus on return on equity to determine if management is doing a good job. "The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, and so forth) and not the achievement of consistent gains in earnings per share." Buffett notes that because companies usually retain a portion of their earnings, the assets that a profitable company has will increase each year. This additional cash allows the company to report increased earnings per share, even if the company's performance is deteriorating. Therefore, Buffett is unimpressed by "record earnings."

5 Avoid companies with significant debt. Debt is "the weak link that snaps you," according to Buffett. A good business "will produce quite satisfactory economic results with no aid from leverage," while a company with significant debt will be vulnerable during economic slowdowns.

6 Only invest in a company whose management is committed to controlling costs. This is reflected by a profit margin that exceeds those of competitors. The superior manager is one who will attack costs vigorously, whether profits are at record levels or under pressure.

7 Only invest in companies whose business you understand. You should have a complete understanding of a company's business, including how it operates, its record of performance, and its prospects for the future. Buffett warns, "Never invest in a business you cannot understand."

8 Only invest in companies that have honest and candid management. Buffett rules out investing in any company that has a history of using accounting gimmicks to inflate profits or that has misled investors in the past.

9 The best-performing companies usually have a "franchise," since it makes their product or service unique. Most of the companies that Buffett invests in have a unique business advantage that allows them to have above-average performance. The best examples of this are his investments in The Washington Post and the Buffalo News, which are the only major daily newspapers in their markets. Among his other investments are Gillette and Coca-Cola, both of which have brand names that are recognized around the world and are synonymous with their products.

10 Invest for the long term. According to Buffett, he is "quite content holding any security indefinitely, so long as the prospective return on equity capital of the underlying business is satisfactory, management is competent and honest, and the market does not overvalue the business." Although he is best known for his long-term investments and is perhaps the best-known advocate of the buy-and-hold philosophy of investing, Buffett also engages in short-term trading. He engages in risk arbitrage when he has unused cash and finds deals that he believes are attractive. This type of transaction involves buying a security when an announced change, such as a merger or liquidation, will increase the price. As there is a risk that the change will not be accomplished, the stock will usually sell at a discount prior to the expected event.

James Maccaro is an attorney and freelance writer. He has written articles for Newsday, Ideas on Liberty, The Massachusetts Law Review, and other magazines. He can be reached at jam@juno.com.

SUGGESTED READING

Maccaro, James [2001]. "The Father Of Security Analysis," Working-Money.com, November.

Williams, John Burr [1997]. The Theory Of Investment Value, Fraser Publishing: Burlington, VT.

Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.