I found that the Tiger Woods and Michael Jordan of investing is invariably Warren Buffett – the $50 billion plus investor and CEO of Berkshire Hathaway.
The main reason I look up to Warren is because of his investing techniques which can be applied to any portfolio. Learning his techniques provides you with practical investing strategies that have been used to produce phenomenal returns at Berkshire, propelling its class A stock price from $8,200 in 1990 to $108,000 today.
He has a clear strategy he used for picking equities or business for Berkshire. Some of this might be a little confusing. However, once you internalize the things I am about to discuss, you will have a better understanding of finance, business, of the true value of equities and, most importantly, how to invest properly. But bear in mind, there are many ways to value business and the one I am about to discuss is by no means the only one.
Warren, being a disciple of Benjamin Graham, inevitably believes in purchasing companies that were trading below their intrinsic value. Intuitively, you may think in intrinsic value is a measure of the assets a company has on the books, which are attributed to the shareholders.
However, Warren determines intrinsic value as the sum of all future cash flows of the business, minus capital expenditures, discounted at an appropriate rate to the present. He subtracts capital expenditures from cash flow to arrival at what he calls the “owner’s earnings.” Warren has shown us that it is important to factor in capital expenditures, the investments and upgrades a company invests in its property, plant and equipment, because a business cannot continue to run without making these capital outlays.
While valuing a business is by no means a simple and straightforward process, it is neither that difficult either. Like Warren’s lifelong business partner, Charlie Munger, puts it best: “If it wasn’t a little difficult, everyone would be a millionaire.” When Warren is able to confidently determine that a business is trading below its intrinsic value, he scoops up the stock in large quantities, assuming the stock will eventually increase to its fair value and perform well over the long run.
You may think that with such a strategy, Warren only purchases obscure companies nobody knows about. However, that’s far from the truth. He likes to buy simple and understandable high quality businesses that have strong and durable competitive advantages, and for those businesses he buys as a whole, he wants an ALL-STAR knight guiding the fort. He has purchases stocks of The Washington Post Company, GEICO, RJ Reynolds, Freddie Mac, McDonalds, Walt Disney, Coca Cola, among many others.
What characterized Warren style of investing in equities is firstly, patience, and second, buying it undervalued. We know Warren is a fan of Coke since young. As a kid, he would buy a pack of coke and peddled each can for a nickel of profit. As much as he likes the business of Coke which satisfied all the characteristics of what he sought for in a business – strong and duration edge with a good management – he did not buy it till he was age 58 in 1988. During that time, Coke has a lot of problems and the business had been lagging. The promotion of its then new product, the new coke, was a disaster. However, none of this problem will cause a dent to their long term advantage. He scooped up 200 million shares of Coca Cola at a cost of $1.29 billion and it is worth $10 billion today. With all the stock repurchases Coke has made throughout the years, Berkshire’s share in Coke has risen too, now they owns 8.6% of all outstanding share of Coke.
He views the stocks he invests in as businesses, not simply pieces of paper. He has conviction in the businesses he invests in. Simply put, he understands the business he is buying at the price he is paying for and he can see with a high proportion of certainty what his initial investment will land up at.
When you purchase shares in your company, you have to say to yourself, "Would I like to be the owner of the business?" Too many times, I see people buying stocks for speculation or obscure businesses that they hope will hit it big. Warren buys established companies that have already proven themselves and which he feels will be able to continue this success in the future. I think you should do the same.
For decades, he has also been purchasing businesses outright, so his principles in stock valuation apply to valuing whole businesses for purchase. Berkshire's various subsidiaries include GEICO Auto Insurance, Fruit of the Loom, Clayton Homes, The Pampered Chef, Benjamin Moore & Co and Dairy Queen.
Berkshire Hathaway's stock holding, as of Sept. 30, 2006, included Coca Cola, American Express, Procter & Gamble (P&G purchased Gillette in 2005), along with more recent purchases in Anheuser Busch, Johnson & Johnson, Conoco Philips, Wal-Mart, Nike, Comcast and General Electric.
Now, I'm not necessarily recommending that you purchase the stocks of these companies, but it's worth taking a look at each company to determine its strengths and long-term investments and evaluate whether you think Warren made a good investment.
I think the final, more general point you should take away is that the value of a business is based upon its future prospects, earnings and cash flows. He uses the past to evaluate the future, but he values the business based upon what he thinks will happen in the future.
Now, some of the finance principles I presented may be a little ambiguous to you, and I am by no means an expert. I think you should take some time and learn the basis for business valuation and financial statement analysis. I do my own valuation of stocks I am interested in, and I do look carefully at measures that determine the future value of the business.