The New Buffettology

Mary Buffett, David Clark

• Publisher: Simon & Schuster UK
• Year: 2012
• Print ISBN: 9780743231985
• eBook ISBN: 9781471104435
• Topic: Business
• Subtopic: Business General
• Index: Business

Published in 1997, the bestselling BUFFETTOLOGY was tailored to the conditions of investors in the midst of a long bull market. Now, four years later, that market has seen once hot tech stocks crash and investors scramble to move their assets, or what remains of them, back to the safety of traditional blue chip companies. As peaks turn to troughs, worried investors wonder if there are any constants in today's volatile market. The answer is yes: Warren Buffett's value investing strategies make money. And, as THE NEW BUFFETTOLOGY demonstrates, there is no time to acquire like today's bear market. THE NEW BUFFETTOLOGY is the first guide to Warren Buffett's strategy for exploiting down stocks - a strategy that has made him the world's second richest person. Designed to teach investors how to decipher and use financial information like Buffett himself, this one-of-a-kind guide walks readers step-by-step through the equations and formulas Buffett uses to determine what to invest in and, just as importantly, when. Authors Mary Buffett and David Clark explore Buffett's recent investments in detail, proving time and time again that his strategy has earned enormous profits at a time when no one expects them - and with almost zero risk to his capital.

1

The Answer to Why Warren Doesn’t Play the Stock Market—and How Not Doing So Has Made Him America’s Number One Investor

A fool does not see the same tree that a wise man sees.

—William Blake

Before we bust out of the gate you need to know something important about Warren Buffett. He doesn’t “play” the stock market—at least not in the conventional sense of the word. He is not interested in current investment trends, and he avoids the popular investments of the day. He doesn’t chart stock prices, nor does he partake of the current Wall Street rage known as momentum investing, which dictates that a stock is attractive if its price is rising fast, and unattractive if it is quickly falling. This is the most unusual aspect of his investment philosophy, for throughout his investing life he has made it a point to sidestep every investment mania to sweep the financial world. He happily admits to missing the Internet revolution and the biotech bonanza, and he will tell you with a sly smile and a wily chuckle that he has probably missed all of the big Wall Street plays. Then again, he has managed to turn an initial investment of $105,000 into a fortune that now exceeds $30 billion, solely by investing in the stock market.

Here is the big secret: Warren Buffett got superrich not by playing the stock market but by playing the people and institutions who play the stock market. Warren is the ultimate exploiter of the foolishness that results from other investors’ pessimism and shortsightedness. You see, most people and financial institutions (like mutual funds) play the stock market in search of quick profits. They want the fast buck, the easy dollar, and as a result they have developed investment methods and philosophies that are controlled by shortsightedness. Warren believes that acts of shortsightedness have great potential to unfold into investment foolishness of huge proportions. When this happens, Warren is patiently waiting with Berkshire’s billions, ready to buy into select companies that most people and mutual funds are desperately trying to sell. He can buy fearlessly because he knows which of today’s corporate pariahs the stock market will covet tomorrow.

Warren is able to do this better than anyone else because he has discovered two things that few investors appreciate. The first is that approximately 95% of the people and investment institutions that make up the stock market are what he calls “short-term motivated.” This means that these investors respond to short-term stimuli. On any given day they buy on good news and sell on bad, regardless of a company’s long-term economics. It’s classic herd mentality driven by the sort of reporting you’ll find in the Wall Street Journal on any given morning. As goofy as it sounds, it is the way most people and mutual fund managers invest. The good news—the news that gets them to buy—can be a headline announcing a prospective buyout or a quarterly increase in earnings or a quickly rising stock price. (It may seem insane that people and mutual fund managers would be enthusiastic about a company’s shares simply because they are rising in price, but remember, “momentum investing” is the current rage. As we have said, Warren is not a momentum investor. He considers the approach sheer insanity.)

The bad news that gets these investors to sell can be anything from a major industry recession to missing a quarterly earnings projection by a few cents or a war in the Middle East. Remember that the popular Wall Street investment fad of momentum investing dictates if a stock price is falling, the investor should sell. This means that if stock prices are falling, many mutual funds jump on the bandwagon and start selling just because everyone else is. Like we said, Warren thinks this is madness. On the other hand, it’s the kind of madness that creates the best opportunities.

Warren has realized that an enthusiastic stock price—one that has recently been going up—when coupled with good news about a company, is often enough to push the price of a company’s shares into the stratosphere. This is commonly referred to as the “good news phenomenon.” He has also seen the opposite happen when the situation is reversed. A pessimistic stock price—one that has been going down—when coupled with negative news about a company, will send its stock into a tailspin. This is, of course, the “bad news phenomenon.”

Warren has discovered that in both situations the underlying long-term economics of the company’s business is often totally ignored. The short-term mentality of the stock market sometimes grossly overvalues a company, just as it sometimes grossly undervalues a company.

The second foundation of Warren’s success lies in his understanding that, over time, it is the real long-term economic value of a business that ultimately levels the playing field and properly values a company. Warren has found that overvalued businesses are eventually revalued downward, thus making their shareholders poorer. This means that any popular investment of its day can often end up in the dumps, costing its shareholders their fortunes rather than earning them a bundle. The bursting of the dotcom bubble is the perfect example of this popular here-today, gone-tomorrow scenario.

Warren came to realize that undervalued businesses with strong long-term economics are eventually revalued upward, making their shareholders richer. This means that today’s stock market undesirable can turn out to be tomorrow’s shining star. A perfect example of this phenomenon is when the insurance industry suffered a recession in 2000 that halved insurance stock prices. During this recession Allstate, the auto insurance giant, was trading at $19 a share and Berkshire Hathaway, Warren’s company, traded as low as $40,800 a share. One year later Allstate was trading close to $40 a share and Berkshire popped up to $70,000, giving investors who bought these stocks during the recession quick one-year returns of 75% or better.

What has made Warren superrich is his genius for seeing that the short-term market mentality that dominates the stock market periodically grossly undervalues great businesses. He has figured out that the stock market will sometimes overreact to bad news about a great business and oversell its stock, making it a bargain from a long-term economic point of view. (Remember, as we said earlier, the vast majority of people and institutions like mutual funds sell shares on bad news.) When this happens, Warren goes into the market and buys as many shares as he can, knowing that over time the long-term economics of the business will eventually correct the negative situation and return the stock’s price to more profitable ground.

The stock market buys on good news and sells on bad. Warren buys on bad news. This is why he made sure to miss the good-news bull markets in such popular industries as the Internet, computers, biotechnology, cellular telephones, and dozens of others that have seduced investors through the years with promises of riches. He shops when the stocks are unpopular and the prices are cheap—when short-tem gloom and doom fog Wall Street’s eyes from seeing the real long-term economic value of great businesses.

Key Point

Speculating in good-news bull markets is something that Warren leaves to the other guys. It’s not his game. He never owned stock in Yahoo!, Priceline, Amazon.com, Lucent, CMGI, or any of the other high-tech companies of the Internet boom. Warren’s game is to avoid the popular, to wait for short-term bad news to drive down the price of a fantastic business, then jump on it, buying as many shares as possible. As Warren once said, “The most common cause of low stock prices is pessimism—sometimes widespread, sometimes specific to a company or industry…. We [Berkshire Hathaway] like pessimism because of the stock prices it produces.” Pessimism, not optimism, is the fountain that produced all of Warren’s fantastic wealth.

What You Should Have Learned from this Chapter

• Warren is not interested in popular investments of the day.
• Warren has discovered that the vast majority of stock market investors, including mutual funds, are short-term oriented; they buy on good news and sell on bad.
• The short-term stock market mentality sometimes grossly undervalues the long- term prospects of a great business.
• Warren likes to buy on bad news.
• Warren’s genius lies in his ability to grasp other people’s ignorance about the long-term economic worth of certain businesses.

2

How Warren Makes Good Profits Out of Bad News About a Company

“You know Wall Street,” Warren tried to reassure me. “People don’t think in a long-term way there.”

—Personal History, Katharine Graham

Warren practices a selective contrarian investment strategy. A contrarian investment strategy is one in which the investor is motivated to invest by a falling stock price. Contrarian investors invest in what other investors find unattractive, thereby ensuring a low price, which will hopefully equate to huge profits once the company’s fortunes, and stock price, recover. Warren believes that just because a company’s stock price is in the dumps is not in itself reason enough to invest in a company. He is interested only when the company has exceptional business economics working in its favor and a contrarian stock price. He has found that attractive pricing of these exceptional companies is the result of the stock market’s pessimistic shortsightedness. His basic investment philosophy is contrarian in nature, with the caveat that the companies be exceptional businesses that possess what he calls a durable competitive advantage, a topic we shall explore in greater detail later on. Warren’s philosophy requires the investor to go against the basic human instinct to make a quick buck. It also requires that the investor have loaded into his or her brain the software that will help determine what a company with great economics working in its favor looks like and when it is selling at an attractive price.

Contrarian Investment Strategy Versus Selective Contrarian Investment Strategy

In a contrarian investment strategy, the investor buys stocks that have recently performed poorly and have fallen out of favor with investors. This strategy is based on the stock research of Eugene Fama and Kenneth French, who figured out that buying companies that have had their stock prices beaten down in the two previous years are likely to give investors an above-average return over the next two years. This strategy focuses on falling stock prices and pays little mind to the underlying economics of the companies. With the traditional contrarian investment strategy investors don’t discriminate between price-competitive-type businesses and companies that possess a durable competitive advantage. So long as the share price has recently fallen, the stock is a candidate for purchase.

A selective contrarian investment strategy—Warren’s approach—dictates that investors buy shares only when a company has a durable competitive advantage, and only when its stock price has been beaten down by a shortsighted market, to the extent that it makes business sense to purchase the entire company. This strategy differs from the traditional contrarian investment strategy in that it targets specific companies that have an identifiable durable competitive advantage over their competitors and are selling at a price that a private business owner would find attractive. (Don’t worry if this is cloudy. We’ll fill in the blanks later on.)

Key Point

To be like Warren one has to know what to buy and when to buy it. What to buy? An exceptional business with a durable competitive advantage working in its favor. When? When the stock market’s pessimistic shortsightedness has driven the price of its shares into the dumps.

Pessimistic shortsightedness and the bad-news phenomenon are what create Warren’s buying opportunities. If the vast majority of the stock market did not suffer from occasional pessimistic shortsightedness, Warren Buffett would never have had the opportunity to buy some of the world’s greatest businesses at discount prices. He could never have made his 2000 purchase of 8% of H&R Block for approximately $28 a share or the much discussed 1974 purchase of 1.7 million shares of the Washington Post Company for approximately $6.14 a share. H&R Block now trades at approximately $60 a share and the Post now trades at approximately $500 a share. His pretax rate of return on his H&R Block purchase, after one year, was approximately 41%, and his total pretax return on the Post purchase, after twenty-seven years, is approximately 8,468%, which equates to a pretax annual compounding rate of return of approximately 17.8%. Not too shabby.

It was the stock market pessimism of 2000 and 2001 that allowed Warren to make investments in such companies as Justin Industries, Yum Brands, Johns Manville, Shaw Industries, Liz Claiborne, Nike Inc., Dun & Bradstreet Corp., USG Corp., First Data Corp., and as mentioned H&R Block—investments that we’ll fully explore later.

Warren also discovered early on in his career that the vast majority of those who buy and sell stocks, from Internet day traders (who have the attention span of gnats—professional day traders make an average forty-four trades a day, about one trade every nine minutes) to mutual fund managers (who cater to a shortsighted public), are only interested in making a quick buck. Yes, many pay lip service to the importance of long-term investing, but in truth they are stuck on making fast money.

Warren found that no matter how intelligent most people are, the nature of the beast ultimately controls their investment decisions. Take mutual fund managers. If you talk to them, they will tell you that they are under great pressure to produce the highest yearly results possible. This is because mutual funds are marketed to a public that is only interested in investing in funds that earn top performance ratings in any given year. Imagine a mutual fund manager telling his or her marketing team that their fund ranked in the bottom 10% for performance out of all the mutual funds in America. Do you think the marketing team would jump up...

Table of contents

• Cover
• Title Page
• Copyright
• Dedication
• Acknowledgments
• Contents
• Disclaimer
• Foreword: A Few Personal Things About a Very Private Billionaire
• Introduction: How Warren Buffett Turned $105,000 into $30 Billion
• 1. The Answer to Why Warren Doesn’t Play the Stock Market—and How Not Doing So Has Made Him America’s Number One Investor
• 2. How Warren Makes Good Profits Out of Bad News About a Company
• 3. How Warren Exploits the Market’s Shortsightedness
• 4. How Companies Make Investors Rich: The Interplay Between Profit Margins and Inventory Turnover and How Warren Uses It to His Advantage
• 5. The Hidden Danger: The Type of Business Warren Fears and Avoids
• 6. The Kind of Business Warren Loves: How He Identifies and Isolates the Best Companies to Invest In
• 7. Using Warren’s Investment Methods to Avoid the Next High-Tech Massacre
• 8. Interest Rates and Stock Prices—How Warren Capitalizes on What Others Miss
• 9. Solving the Puzzle of the Bear/Bull Market Cycle and How Warren Uses It to His Advantage
• 10. How Warren Discerns Buying Opportunities Others Miss
• 11. Where Warren Discovers Companies with Hidden Wealth
• 12. Financial Information: Warren’s Secrets for Using the Internet to Beat Wall Street
• 13. Warren’s Checklist for Potential Investments: His Ten Points of Light
• 14. How to Determine When a Privately Held Business Can Be a Bonanza
• 15. Warren’s Secret Formula for Getting Out at the Market Top
• 16. Where Warren Buffett Is Investing Now!
• 17. Stock Arbitrage: Warren’s Best-Kept Secret for Building Wealth
• 18. For the Hard-Core Buffettologist: Warren Buffett’s Mathematical Equations for Uncovering Great Businesses
• 19. Thinking the Way Warren Does: The Case Studies of His Most Recent Investments
• 20. Putting Buffettology to Work for You
• Index