In his letter, Shai asks just a single question:
“At the Q&A I arranged you told me that today (May 23, 2005) you were ‘85% Graham and 15% Fisher.’ If you were today 20-something years old, again looking to allocate less than $10 million, and free to allocate capital into well over 8,000 opportunities (before even considering anything overseas), would your Latticework of Mental Models primarily be searching for:
a) Situations reminiscent of 1957 – akin to Daehan Flour Mills, or
b) Situations reminiscent of 1987 – akin to Moody’s Corporation?”
In response to Shai’s 1091-words letter that accompanied the question above, Warren got straight to the point with an 8-words hand written reply. Mr. Buffett wrote:
“Either is fine.”
“[a] Better for small sums.”
“[b] Better for large sums.”
If we probe further, if one has only a small sum, the classic Graham method is superior to the other methods. Those situations reminiscent of 1957 follow the Graham approach to value investing that focuses on very low P/E and/or net assets per share greater than the current trading price. I must say I was a little taken back from Warren’s choice because of some of the other ideas which I read from him – for example “buying a great business at a fair price is better than buying a fair business at a great price.” Now after rethinking, I think it depends on the situation, for example, the amount of funds you have on hand to invest. So now with this, it puts certain thoughts I had originally back into perspective – Is finding a company with a durable competitive advantage selling at a price with a margin of safety not quite as important as I thought? Should I be also looking for deep value opportunities in the class Graham method? I’ll be probably thinking about all these questions for quite some time.
These are some excerpts from past interviews or quotes which either Buffett or Munger have remarked in the past. And perhaps it can shed some light on this important question.
Mr. Buffett, on June 23, 1999 shared with Business Week:
“If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”
If you noticed, what stands out for me here is the time when he made the comment. It was right at the peak before the dot-com crash. It kinds of debunk the notion that when a market is overly valued, there’s not a single opportunity. But what Warren seems to indirectly suggest is there’s an opportunity in all kinds of market, be it a bull or a bear.
More recently, Morningstar reported:
Munger also recalled a comment made by Buffett at the Berkshire annual meeting concerning how cheap Korea stocks had become during that country’s financial meltdown in 2002: “There were flour mills trading at two times earnings. Warren thought he was young again.”
Here’s one of the two mental models used by Warren in his investment patterns over the years. The first is the classic Graham approach.
At a talk to Colombia students in 1993, he shared:
“When I got out of Colombia the first place I went to work was a five-person brokerage firm with operations in Omaha. It subscribed to Moody’s industrial manual, banks and finance manual and public utilities manual. I went through all those page by page.
I found a little company called Genesee Valley Gas near Rochester. It has 22,000 shares out(standing). It was a public utility that was earning about $5 per share, and the nice thing about it was you could buy it at $5 per share.
I found Western Insurance in Fort Scott, Kansas. The price range in Moody’s financial manual was $12 - $20. Earnings were $16 per share. I ran an ad in the Fort Scott paper to buy that stock.
I found Union Street Railway, in New Bedford, a bus company. At that time, it was selling at about $45 and, as I remember, had $120 a share in cash and no liabilities.”
In late 2005, he explained to a group of Harvard students:
“Citicorp sent a manual on Korean stocks. Within 5 or 6 hours, twenty stocks selling at 2 or 3x earnings with strong balance sheets were identified. Korea rebuilt itself in a big way post 1998. Companies overbuilt their balance sheets – including Daehan Flour Mill with 15,000 won/year earning power and selling at “2 and change” times earnings. The strategy was to buy the securities of twenty companies thereby spreading the risk that some of the companies will be run by crooks. $100 million was quickly put to work.”
The following will reflect the second mental model which Warren adopts – the Fisher method.
The following is from an article written by Carol Loomis published on April 11, 1988 in Fortune provide interesting clarity on the modus-operandi of Berkshire in 1987:
On Unusual profitability (High ROE with Low Debt, i.e., high ROIC)
“But in his 1987 annual report, Buffett the businessman comes out of the closet to point out just how good these enterprises and their managers are. Had the Sainted Seven operated as a single business in 1987, he says, they would have employed $175 million in equity capital, paid only a net $2 million in interest, and earned after taxes, $100 million. That’s a return on equity of 57%, and it is exceptional. As Buffett says, ‘You’ll seldom see such a percentage anywhere, let alone at large, diversified companies with nominal leverage.’”
Paying for Quality
“By 1972, Blue Chip Stamps, a Berkshire affiliate that has since been merged into the parent, was paying three times book value to buy See’s Candies, and the good-business era was launched. ‘I’ve been shaped tremendously by Charlie,’ says Buffett. ‘Boy, if I had listened only to Ben, would I ever be a lot poorer.’”