Book summary of "Buffettology: The Previously Unexplained Techniques That Have Made Warren Buffett The World's Most Famous Investor"

Book Summary

Buffettology: The Previously Unexplained Techniques That Have Made Warren Buffett The World’s Most Famous Investor

February 11, 2018

This post is also available in: Dansk

Abstract

  • Business perspective investing is the “Warren’s Winning Way”.  It entails projecting a future value for the business and surmise when said value may be reflected in the stock price. If the value can be reached within a timeframe that ensures Warren a compounded annual return of no less than 15%, it “makes sense”.
  • Warren’s “seven secrets to succesful investing from a business perspective” is presented.
  • The expanding value philosophy discards ‘static value securities’, and favors excellent businesses that are destined to experience long-term economic growth. A list of characteristics that such businesses possess is presented.
  • “Don’t try to buy at the bottom and sell at the top. This can’t be done – except by liars.”

Warren Buffett’s former daughter in law has written a great book that outlines “Buffett’s extraordinarily succesful system of business perspective investing.” (p. 15)

Business Perspective Investing
The authors, Mary Buffett and David Clarke, begin by explaining the concept of business perspective investing. Warren only commits capital to an idea if it “makes sense from a business perspective.” (p. 21) For an investment idea to “make sense”, Warren needs to be able to project a future value for the business and surmise when said value may be reflected in the stock price. If the value is reached within a timeframe that ensures Warren a compounded annual return of no less than 15%, it “makes sense”. For instance, say that a stock is trading for $10, and Warren believes it to be worth $50 in 10 years. That translates into a compounded return of 17.46% annually.

To be able to project a future value for a business i.e. ten years out, the business must be simple and predictable. This point is cemented in Warren’s “seven secrets to succesful investing from a business perspective”:

  1. Invest only in companies whose future earnings can be reasonably predicted.
  2. Businesses that can be easily predicted generally have excellent business economics.
  3. Excellent business economics are usually evident by consistent high returns on equity, strong earnings, a consumer monopolyand shareholder-friendly management teams.
  4. The price you pay will determine the return you can expect on your investment.
  5. Choose the business you would like to invest in, and let the price of the security determine the buy decision.
  6. Investing in the right businesses with exceptional economics at the right prices will produce an annual compounding return of at least 15%.
  7. Set-up a partnership structure that allows you to invest other people’s money and skim part of the proceeds.

“Warren’s Winning Way” is first and foremost a question of figuring out what you want to own, and waiting for a price you’re willing to pay, namely a price that makes business sense.

The Excellent Business’ Expanding Value
Ben Graham’s way of investing, the deep value kind of approach, has an innate issue: the realization of value problem. One’s annual compounded return diminishes the longer it takes for Mr. Market to realize the security’s intrinsic value. Furthermore, Uncle Sam takes a cut each time a security is sold.

Warren recognized these shortcomings eventually, and moved towards the expanding value philosophy taught by Phil Fisher and Charlie Munger. In short, this philosophy discards the ‘static value securities’, i.e. a company heading for liquidation but trading at a price below liquidation value (hence allowing investors to capture the proceeds). Instead of focusing on these half-dead businesses, Warren is now on the look-out for excellent businesses that are destined to experience long-term economic growth: “The earnings of the company would continue to grow, thus projecting and expanding his estimated rate of return” (p. 83).

Businesses whose value continuously expands are often excellent. Such excellent businesses often possess several of the below characteristics:

  • An identifiable consumer monopoly, e.g. a brand-name product or a key service that people or businesses are dependent on.
  • A strong and upward earnings trend.
  • A conservative capital structure, i.e. low or no debt.
  • A history of consistent high returns on equity.
  • A history of being able to retain earnings.
  • A history of being able to reinvest retained earnings in new opportunities, expansion of operations and/or share repurchases.
  • The value-added by retained earnings will increase the market value of the company.
  • The business is free to adjust prices to inflation.
  • Low capital expenditure requirements.

In short, Warren desires businesses that seldom require replacement of plant and equipment, that don’t require ongoing R&D, that produces products that never go obsolete, have little or no competition and excellent management teams. “Basic businesses with products that people never want to see essentially change. Predictable product, predictable profits.”

Warren believes that there are three types of excellent businesses that fall into one of two categories, consumer monopolies or toll bridges. “A consumer monopoly is an excellent company that has a brand-name-type product like Coca-Cola; a toll bridge is an excellent company that provides services that other businesses have to use if they want to do business.” (p. 287) The three types of businesses are:

  1. Businesses that make products that wear out fast or are used up quickly, that have brand-name appeal, and that merchants have to carry or use to stay in business.
  2. Businesses that provide repetitive communication services, which manufacturers must use to persuade the public to buy their products.
  3. Businesses that provide repetitive consumer services that people and business are consistently in need of.

When Warren spots one of these types of businesses that possess several of the above characteristics, he bets big. He’s always been fund of a concentrated portfolio consisting of high-upside ideas that he understands well. Mary puts it as such: “Warren believes that diversification is something people do to protect themselves from their own stupidity. They lack the intelligence and expertise to make large investments in just a few businesses” (p. 173)

When to sell?
I’ll end this summary with a small quote on what is probably the investor’s biggest dilemma: selling. Warren has a refreshing take on this discipline: “Don’t try to buy at the bottom and sell at the top. This can’t be done – except by liars.” (p. 178)

This post is also available in: Dansk

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