Tuesday, December 26, 2006

Some ideas from Warren and Charlie on stock pickings

Firstly, it is important to pick out businesses which you can understand and naturally, when you can understand something, you tend to like them more. So, that narrows it down the pool of available businesses by a whole chunk of 90%. There will always be all types of things one do not understand, but fortunately, there is always enough for anyone to understand - therefore, you would not have to force yourself to understand something you do not understand. You have this big wide world out there and almost every company is publicly owned. So you have all kinds of businesses practically available to you and thus, it makes sense to go with the things you can understand.
Take for example, Coca Cola. Most people will be able to understand this. Since 1886, it is a simple business but it is not an easy business. Always distinguish between simple and easy. No one should go after an easy business as it will be easy for competitors. A simple business with a moat around it is the best form of business that an investor should look out for. Warren wants a very valuable castle in the middle and then he wants the Duke who is in charge of that castle to be honest and hard working and able. Then he wants a moat around that castle. The moat can be in various forms - for example, the moat around his auto insurance business, Geico, is low cost.
Anyone who is driving a car have to buy an auto insurance. You can't sell them 20 but they have to buy one. So what are these people going to base their criteria on when they buy? They will buy based on service and cost. Most people will assume the service is identical among companies or close enough. So they will do it on cost. So when Geico have a low-cost producer - they have the moat. All the time while you are having a castle whether with a moat or not, there are people out there who are going to attack it and try to take it away from you. So he wants both a castle which he can understand and also a castle with a moat around it with all kinds of sharks, crocs and gators thrown in to protect the castle. 30 years back, Eastman Kodak's moat was just as wide as Coca Cola's moat. If you were going to take a picture of you six-month old baby and you want to look at that picture 20 years from now or 50 years from now, so you want to evaluate what is going to look good 20 or 50 years ago. And if you are not a professional photographer, what will then be in your mind about photography? You need a peace of mind and that is what counts. Because Kodak is promising you that the picture you take today is going to be terrific 20 to 50 years from now is something that is very important to you. Well, Kodak had that in spades 30 years ago. They had what is called a share or peace of mind. Forget about share of market, it is share of mind. They had something - that little yellow box - that said Kodak is the best. That is priceless. But they have since lost it. They allow the moat to narrow. They let Fuji in and the moat starts narrowing in various ways. They let them get into the Olympics and take away that special aspect that only Kodak was fit to photograph the Olympics. So Fuji gets there and immediately in people's minds, Fuji becomes more into parity with Kodak.
As for Coke, you haven't seen their moat diminishing, in fact, its moat now is wider than it was 30 years ago. You can't see the moat day by day but every time the infrastructure that gets built in some countries that isn't yet profitable for Coke, that will be 20 years from now. The moat is widening a little bit each time. Things are, all the time, changing a little in one direction or the other. Ten years from now, you will see the difference. Warren wants the managers of his businesses to widen the moat to keep away competitors. That can comes through service, through quality of product, through cost, some times through patents and/or real estate location. So that is the kind of business he looks for.
Now what kind of businesses is he going to find like that? He is going to find them in simple products because he is not going to be able to figure what the moat is going to look like for Oracle, Lotus or Microsoft, ten years from now. Then it is almost certain to figure how their competitors will look like then. But it is easy to figure out how the chewing gum business will look like ten years from now. The internet is not going to change how we chew gum and nothing much is going to change how we chew gum. There will be lots of other products but is Spearmint or Juicy Fruit going to evaporate? It's highly not likely to happen. You can give anyone a billion and tell him or her to go into the chewing business and try to make a real dent in Wrigney's. He or she can't do it. That is how Warren thinks about businesses. He says to himself, "Give me a billion dollars and how much can I hurt the guy?" He can't do it and those are great businesses.
So Warren wants a simple business, easy to understand, great economics, honest and able management and then he can see about in a general way where they will be ten years from now. If he can't see where they will be ten years from now, he do not want to buy it. In other words, he do not want to buy any stock where if NYSE is close tomorrow for 5 years, he won't be happy owning it. If he buys a farm and he don't get a quote on it for 5 years, he will be happy if the farm does ok. If he buys an apartment house and don't get a quote on it for 5 years, he will be happy if the apartment produces the returns that he expects. People buy a stock and they look at the price the next morning and they decide to see if they're doing well or not doing well. It is bonkers. They're buying a piece of the business. That is what Graham - the most fundamental part - taught him. You're not buying a stock, you're buying part ownership in a business. You'll do well if the business does well if you do not pay a silly price. That's what it is all about. You ought to buy businesses you understand. Just like buying any other things, you ought to buy things you understand. It isn't complicated.
By the way, this is pure Graham method for which Warren admitted he was extremely fortunately or the luckiest event in his whole lifetime. That is to pick up Graham book (The Intelligent Investor) when he was nineteen, He got interested in stocks when he was 6 or 7 and he bought his first stock when he was eleven. But he was then playing around with all this stuff - charts, volume and all types of technical analysis. Then he picked up a little book that said you're not just buying some little ticker symbol that bounces around every day, but instead, you're buying part of a business. Soon as he started thinking about it that way, everything else like they say is history. It is very simple but not easy as what is layed out earlier. So he buys businesses he thinks he can understand and avoid all that he can't. There is no one who can't understand Coke.
In Buffett words, if he was teaching a class at business school, and on the final exam he would pass out the information on an internet company and ask each student to value it. If anyone that gave him an answer, he'd flunk him or her.
Investing is really all about putting money to be sure of getting more back later at an appropriate rate at an appropriate time frame. And to do that, you have to understand what you are doing at any time. You have to understand the business, your actions and your basics.