Monday, April 23, 2007

An interesting answer from Warren

For most of us, the true value investors, at certain intersection, we are faced with the dilemma of which is the better value investing method – the classic Graham method, or the Fisher method. Fortunately, a former value investing blogger turned private capital manager, Shai Dardashti, asked Warren Buffett a very interesting question in a hand delivered letter this past January. Amazingly, Shai received a hand-written answer to his great question this week.

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.’”


Anonymous said...

Hi, somehow I still find investing in a good company is better though I have less capital. At least I think I will sleep better.

But its worth considering setting a small amount for these low PE and good net current assest /share companies (think the stock screener in the market doesn't have this function). But the search for these companies may not be thorough since it will take a lot of effort and time to search ... may be too much work for an individual like me who has a full time work at the same time.


Berkshire said...

Hi Jojo,

Yes, I agree with you too. I prefer buying businesses which is sustainable and if I am going to buy and sit on it, it's better be one which I don't lose sleep over with. Or simply, that even if the world stock exchanges closes shop for 5 years, I don't give a damn.

But as you say, the other way is also not to be ignored cos the return will definitely be way more if one can chose correctly with due diligence, although not for holding in the long run.

Btw, there is this stock, Telechoice, on SGX which I personally find very interesting and I kind of like it a lot. Seems one which I will not lose sleep over. Maybe if you have the time to look through it, I welcome your comments.

Anonymous said...

I use to own Telechoice several years ago before I turn more serious and go into value investing. Sold it at some profit already … : )

Good Points
My impression is that the earnings on hand phone sector is stable as they have a continuing contract with Starhub and I believe this should continue. Based on my FY2005 data collected, they also cash rich with low PE ratio (8x). Net working cap/share is also $0.11 and ROIC is ~20%. Though I’m unsure of the situation now, I believe this should not have changed much. They are also very generous on their dividend and at times have yielded over 10%. They have also divested some of the businesses that are not generating money for them. I remembered it was Australia hand phone business.

Bad Points
On the international phone calls sector, I do feel that they do face quite a fair bit of competition especially with internet calls such as Yahoo and Skype which offers free overseas call. They may be losing ground in these areas (needs to be verified). I noticed that they have come up with several initiatives to boost this sector but is unsure how successful they are in these.

What’s your opinion ?

Also I have done some research on JNJ… if you are interested, I can send them to you.


Anonymous said...

one other area.. they are also into engineering services and is involved in 3G handphone networks. Not sure if this is successful as we all know that 3G didn;t quite take off as good as they wanted it to be.


Berkshire said...

Hi Jojo,

Sure, I'd be interested in your JNJ research, my major net worth is in JNJ :) They just increase their quarterly dividend by 10.7%, although at a lower rate comparitively to the previous few years at least. Also, in the first quarter, they charged a sum of about $800M on their 2006 acquisition of Conor Medisystems which cost $1.4B. Something I'm trying to make sense of, because to charge $800 (though on the ground of reseach & development in-process) is a lot out of a $1.4B buy. Overall, they are well-positioned for the future I think, with the in-process numbers of products they have which some are potentially block-busters billion-dollars giants.

Berkshire said...

Pls send your research to

Berkshire said...

Hi Jojo,

Forgot to give my assessment of Telechoice. I like the price that it is today, I like it even more it was 2 months ago when it was 24 cents.

Reason why I like?

1) Low P/E ratios.
2) It is a cash cow.
3) I like the distribution business. I believe in SG, there's no one similar to their network. Moreover, I think their competitive strength lies in the volume of business they have and its network. It is a low cost unit producer by having a wide distribution network and thus, they could probably offer a better price to the retail shops, by at the backend, getting maybe a rebate or better price cos of volume.
4) They have temasek backing although to me not very critical.
5) Historically, they have a good dividend policy.
6) Low maintainence biz, with low capex and high ROE.

Bad points
1) Not a business I'll hold for long. I'll sell it when it raise to value.
2) The other parts of its biz is not as good or strong as its core distribution biz.

Ace said...

I answering your question, trying to find companies that have a durable advantage for a fair price is very had to do. Warren has also commented that recently Moats have been getting smaller. It is useful to have a broad tool kit to find value on the balance sheet, or the income statement given any situation. There are few particular situations that I like to invest in that I had success with:
1. Broken "busted" growth companies
2. buying companies where the assets assets can be bought below replacement value. In addition, the business must have sustainable earnings.
3. Special situations: spin offs or legislation set backs, cyclical plays.
4. The classic buy and hold - however, I will only buy when they are valued fairly.

Moats are important but should be evaluated within a reasonable time frame (3-5 years - and continually reevaluated).

Joel Greenblatt - has a better record than buffett and made a lot money this way.

Berkshire said...

Hi Ace,

You seems to be a value investor as well. Yes, finding a company with a wide moat is very hard. And Charlie is somehow right when he says something like, "the future can only be worst than the past."

As to Joel, to put things in perspective, he is managing a smaller amount, and I believe the way he manages other people's money, he's also giving back yearly dividend to "reward" shareholders, and thus, all these actions probably allow his fund to maintain at a slightly higher rate of return.

And also, to compare apple with apple, Warren has been in the market far longer than Joel and thus, as Charlie says, "the future can only be worst than the past," which of course brings down the average rate of return.