warren buffet book summary.doc
TRANSCRIPT
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THE WARRENBUFFETT
WAY
Investment Strategies of the
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Worlds Greatest Investor
RBERT G! HAGSTR"MAINIDEA
Warren B#ffett is one of the most s#$$essf#l sto$% mar%etinvestors of the &ast '( )ears!
His entire a&&roa$h is to fo$#s on the val#e of the *#siness and its mar%et &ri$e! n$e B#ffettfinds a *#siness he #nderstands and feels $omforta*le +ith, he a$ts li%e a *#siness o+nerrather than a sto$% mar%et s&e$#lator! He st#dies ever)thing &ossi*le a*o#t the *#siness,*e$omes an e-&ert in that field and +or%s +ith the management rather than against them! Infa$t, often his first a$t on *#)ing shares in an) $om&an) is to grant the managers his &ro-)vote for his shares to ass#re them that he has no intention to tr) and move the $om&an) a+a)from its $ore val#es!
B#ffett $ham&ions the val#e investment strateg), and ts no $reden$e in da) to da)movements in share &ri$es, the im&a$t of the e$onomi$ mood overall or an) other e-ternal
fa$tors! He maintains a long.term &ers&e$tive at all times, and never loses sight of the#nderl)ing val#e of a *#siness!
THE BUFFETT APPROACH TOINVESTMENT
/! Never follo+ the da) to da) fl#$t#ations of the sto$% mar%et!
The mar%et onl) e-ists to ma%e it easier to *#) and sell, not to set val#es! 0ee& an e)e onthe mar%et onl) for someone +ho is +illing to sell a sto$% at a not.to.*e.missed &ri$e!
1! 2ont tr) and anal)3e or +orr) a*o#t the general e$onom)!
If )o# $ant &redi$t +hat the sto$% mar%et +ill do from da) to da), ho+ $an )o# relia*l)&redi$t the fate of the e$onom)4
'! B#) a *#siness, not its sto$%!
Treat a sto$% r$hase as if )o# +ere *#)ing the entire *#siness,
#sing the follo+ing tennets5 B#siness Tennets
/! Is the *#siness sim&le and #nderstanda*le from )o#r &ers&e$tive as an investor4
1! 2oes the *#siness have a $onsistent o&erating histor)4
'! 2oes the *#siness have favo#ra*le long.
term &ros&e$ts! "anagement Tennets
/! Is management rational41! Is management $andid +ith its
shareholders4 Finan$ial Tennets
/! Fo$#s on ret#rn on e6#it), not earnings &er share!
1! 7al$#late 8+ner Earnings8!
'! Sear$h for $om&anies +ith high &rofit margins!
9! For ever) dollar of retained earnings, has the $om&an) $reated at least one
dollars e-tra mar%et val#e4 "anagement Tennets
/! What is the val#e of the *#siness4
1! 7an the *#siness $#rrentl) *e r$hased at a signifi$ant dis$o#nt to its val#e4
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9! "anage a &ortfolio of *#sinesses!
Intelligent investing means having the &riorities of a *#siness o+ner :fo$#sed on long.termval#e; rather than a sto$% trader:fo$#sed on short.term gains and losses;!
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The Warren Buffett Way - Page4 -
1. WARRENBUFFETT
In the /
t#rnover of=1!( *illion and earned =/? millionafter ta- . a*o#t '.&er$ent of the gor#&so&erating earnings!
Warren B#ffett and his +ife no+ o+n aro#nd9(.&er$ent of the sto$% of Ber%shire.Hatha+a)He +or%s as 7hief E-e$#tive of the $om&an)for an ann#al salar) of =/((,((( &er )ear"an) of his em&lo)ees +ho manage different&arts of the $om&an) earn m#$h more!
Ber%shire.Hath+a) had a $or&orate net +orthof =11 million +hen Warren B#ffett ass#med
$ontrol! Toda), it is +orth more than =/(!1*illion! B#ffetts goal is to in$rease the$om&an)s +orth *) a /.&er$ent $om&o#ndrate ea$h )ear!
Ber%shire &a)s no dividends *#t reinvests almone) earnt! Therefore, shareholders loo% toa $a&ital gain in the val#e of their sto$%! Sin$e/
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The Warren Buffett Way - Page5 -
2. TWO MENTORS
"ainIdea
Warren B#ffets investment methodolog) is ah)*rid mi- of the strategies t for+ard *) t+o/
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'! "argin of Safet)A&&roa$hInvest onl) in $om&anies +hi$h have a largemargin *et+een earnings and fi-ed $osts! Ina do+nt#rn, that $om&an) is most li%el) toride o#t a re$ession +ell! A&&l)ing this$on$e&t to a sto$%, *#) shares onl) in a
$om&an) for +hi$h the share &ri$e is *elo+its intrinsi$ val#e as determined *) assets,earnings, dividends and f#t#re &ros&e$ts!
Graham strongl) advo$ated the margin ofsafet) a&&roa$h +ith investment in $ommonsto$% of gro+th $om&anies! His a&&roa$h toinvestment +as to r$hase gro+th$om&an) shares +hen the overall mar%et istrading at a lo+ &ri$e or +hen gro+th$om&an) shares are trading *elo+ theirintrinsi$ val#e! Ho+ever, sin$e *#)ing at
mar%et lo+s is ever)ones o*@e$tive, there isno $om&etitive advantage in that a&&roa$h!Therefore, Graham s#ggested thatidentif)ing #nderval#ed sto$%s, regardlessof mar%et sentiment, +as the %e) to sto$%mar%et investment s#$$ess!
Intrinsi$ val#e is $losel) lin%ed to a$om&an)s f#t#re earning &o+er and fi-ed$osts! It is hard or real assets &l#s the f#t#reval#e of the earnings those assets +ill
&rod#$e!Graham advo$ated t+o a&&roa$hes to*#)ing shares5/! B#) for less than t+o.thirds a $om&an)snet asset val#e!1! Fo$#s onl) on lo+ &ri$e.to.earningsratio sto$%s!
These sto$%s +ill generall) *e o#t of favo#r+ith mar%et sentiment! The mar%etineffi$ien$), $reated *) emotions, generatesval#a*le o&&ort#nities for the rationalinvestor!
1! Chili& Fisher
A#thor of "ommon Stoc#s And $ncommon%rofits, Fisher +as a sto$%*ro%er +ho set #&in *#siness @#st after the /
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al+a)s tried to garner an a$$#rate &i$t#re ofrelative strengths and +ea%nesses *) hisresear$h!
Fisher s#ggested it +as *etter to holdsto$% in a fe+ o#tstanding $om&aniesthan a large n#m*er of average $om&anies!He al+a)s invested +ithin his o+n $ir$le of$om&eten$e . that is, +ith $om&anies he
#nderstood and felt $omforta*le +ith!
3. FOUNDATIONS OF THE BUFFETTAPPROACH
"ainIdea
Warren B#ffett lets $om&anies inform him *)their o&erating res#lts, not *) short.term sto$%mar%et fl#$t#ations! His is a ver) &atientinvestment strateg) *ased on the val#e of the
*#siness! B#ffetts +hole a&&roa$h is to loo% ata share r$hase from the &ers&e$tive of a*#siness o+ner rather than as a sto$% mar%etda**ler!
S#&&ortingIdeas
/! There is a large differen$e *et+eeninvesting in a &arti$#lar sto$% and tr)ing to&redi$t the dire$tion of the general mar%et!
In s&ite of te$hnolog), it is still &eo&le that
ma%e mar%ets! Investor sentiment has thelargest infl#en$e over short.term mar%etdire$tion and sta*ilit)! Ho+ever, the long.term val#e of a sto$% is #ltimatel)determined *) the e$onomi$ &rogress of the*#siness, not the da).to.da) mar%etfl#$t#ations!
1! The "r! "ar%etAllegor)!
Imagine )o# are the o+ner of a small
*#siness in &artnershi& +ith "r! "ar%et!Ever) da), "r! "ar%et 6#otes )o# a &ri$e at+hi$h he is +illing to *#) )o#r half of the*#siness or sell )o# his half! While the
*#siness is so#nd and ma%es good&rogress, "r! "ar%ets 6#otes var) +idel)a$$ording to the mood he is in!
When he is in an #&*eat mood, his &ri$e ise-$e&tionall) high! 7onversel), stri%e him ona *ad da) and he is ver) &essimisti$ and6#otes an #n#s#all) lo+ &ri$e!
If )o# +ere in *#siness +ith "r! "ar%et and
)o# tried to ta%e advantage of his +isdom,)o# +o#ld *e on an emotional roller $oasterride! Rather, it is "r! "ar%ets &o$%et*oo%)o# sho#ld ta%e advantage of, not his+isdom! It is disastro#s if )o# fall #nder hisinfl#en$e!
A s#$$essf#l sto$% mar%et investor sho#ldt aside the emotional +hirl+ind "r!"ar%et #nleashes on the general mar%etever) da) and e-er$ise so#nd *#siness
@#dgement!'! Investors m#st *e finan$iall) and
&s)$hologi$all) &re&ared to deal +ith theever)da) mar%et fl#$t#ations! Unless )o#$an +at$h the val#e of )o#r sto$% holdingsde$line *) (.&er$ent or more +itho#t*e$oming &ani$ stri%en, )o# +ill nevers#$$eed!
9! Cri$e de$lines are a +el$ome +a) to addmore shares to )o#r &ortfolio at a lo+er&ri$e! As long as )o#r are investing in aso#ndl) r#n *#siness +ith goodf#ndamentals, management and &ri$es, themar%et +ill event#all) a$%no+ledges#$$ess!
! The a*ilit) to sa) DDno #nless all the fa$tsare in )o#r favo#r is a signifi$ant advantagefor an) sto$% mar%et investor! Rather than$onstantl) *#)ing and selling shares inmedio$re *#sinesses on the strength of ar#mo#r, B#ffett *#)s and holds shares
&ermanentl) in @#st a fe+ o#tstanding,+ell.managed *#sinesses! His a&&roa$h isal+a)s to +ait &atientl) #ntil a tr#l) greatinvestment o&&ort#nit) s#rfa$es and then goto it!
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?! Investment s#$$ess is not the same asinfalli*ilit)! Instead, s#$$ess $omes a*o#t *)doing more things right than +rong! To dothat, red#$e the n#m*er of things )o# $anget +rong and fo$#s on the things )o#e-&e$t to get right!
! The "ar%et R#mo#r
Cara*leAn oil &ros&e$tor +as met at the gates ofheaven *) St! Ceter +ho told him there +asno room for him to $ome in! The &ros&e$toras%ed if he might sa) @#st fo#r +ords to theoil &ros&e$tors &resent! He )elled, DDildis$overed in Hell With that, all the oil menmar$hed o#t of heaven headed for hell! St!Ceter +as im&ressed and invited the man inno+ there +as &lent) of room! DDNo than%s,
said the ne+$omer! DDI thin% Ill @#st go along+ith the rest of the *o)s! There @#st might *esome tr#th to that r#mo#r after all!
2es&ite all the e-&erien$e and ed#$ational6#alifi$ations fo#nd in sto$% mar%etinvestors :in$l#ding instit#tions;, it still a$tsirrationall) and +ith a DDfollo+ the mo*mentalit)! B#ffett ta%es no $omfort fromhaving DDim&ortant &eo&le agree +ith him,and does not lose $onfiden$e +hen the)disagree!
>! An investor and a *#siness&erson sho#ldloo% at a $om&an) in the same +a)! The*#siness&erson +ants to *#) the entire$om&an) +hile an investor +ants a &art!
The first 6#estion an) *#siness&erson +illas% is, DDWhat is the $ash generating&otential of this $om&an)4 ver time, there+ill al+a)s *e a dire$t $orrelation *et+eenthe val#e of a $om&an) and its $ashgenerating $a&a$it)! The investor +o#ld
*enefit *) #sing the same *#sinessr$hase $rieria as the *#siness&erson!
7hange )o#r thin%ing from *#)ing andselling shares in a $om&an) to *#)ing andselling a *#siness )o# +ant to o+n and)o#ll have a m#$h im&roved &ers&e$tive!
>! Short term &ri$e fl#$t#ations are an #n+ise$riteria *) +hi$h to @#dge a $om&an)ss#$$ess! Instead, loo% at5.. Ret#rn on *eginning
shareholders e6#it)!
.. &erating margin$hanges!.. 2e*t level$hanges!.. The $om&an)s $ashgenerating a*ilit)!
That is, #se e$onomi$ $riteria rather than
&ri$e $hanges!
With this a&&roa$h, investors a$t li%eo+ners of the $om&anies the) o+n sharesin! The) &rovide &atient $a&ital allo+ingmanagement to rs#e long.term gro+tho&&ort#nities! Sto$% is held long.term andinvestors +or% +ith management to im&rove$or&orate &erforman$e!
/(! Warren B#ffett #s#all) assigns voting rights
for shares he r$hases to the managementof the $om&an)! That sends the $lear signathat he is not see%ing $hanges! He avoids$om&anies in need of ma@or overha#lsHe also avoids $onfronting management toim&rove shareholder ret#rns! B#ffett sim&l)+ill not invest in an) $om&an) +hi$h he$onsiders re6#ires a $hange in offi$ers*efore tr#e val#e $an *e reali3ed! Hedoes not loo% for a $om&an) +hi$h is#ndergoing a t#rnaro#nd or restr#$t#ring
e-er$ise, as this $reates a sit#ation in +hi$hthere are too man) varia*les!
//! B#ffett is 6#ite $ontent to hold an) se$#rit)indefinitel), so long as the &ros&e$tiveret#rns on e6#it) $a&ital of the *#siness
is satisfa$tor), managemenisshareholder.oriented and $om&etent andthe mar%et does not overval#e the *#sinessGenerall) s&ea%ing, B#ffett sells onl) +henthe sto$% &ri$e sho+s the mar%et isa&&re$ia*l) overval#ing the *#siness *) hisre$%oning!
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0e)Tho#ghts
The farther one gets from &all Street, the
more s#epticism one will find as to the
pretensions of stoc#'mar#et forecasting or
timing.!!
.. BenGraham
I have long felt that the only value of stoc#forecasters is to ma#e fortune tellers loo#good.!!
.. WarrenB#ffett
The most common cause of low prices is
pessimism ' sometimes pervasive,
sometimes specific to a company or industry.
&e want to do business in such an
environment, not because we li#e pessimism
but because we li#e the prices itproduces. It!soptimism that is the enemy of rational buyers.!!
.. WarrenB#ffett
An investor should act as though he had a
lifetime decision card with (ust twenty punches
in it. &ith every investment decision his card is
punched, and he has one fewer for the rest of
his life.!!
.. Warren
B#ffett
As time goes on, I get more and more
convinced that the right method in investments
is to put fairly large sums into enterprises
which one thin#s one #nows something about
and in management of which one thoroughly
believes. It is a mista#e to thin# that one
limits one!s ris#s by spreading too much
between enterprises about which one #nows
little and has no special reason for special
confidence. One!s #nowledge and e)perienceis definitely limited and there are seldom more
than two or three enterprises at any given time
which I personally feel myself entitled to put full
confidence.!!
.. ohn "a)nard0e)nes
The reasonable man adapts himself to the
world. The unreasonable one persists in trying
to adapt the world to himself. Therefore all
progress depends on the unreasonable man.!!
.. George Bernard
Sha+
"an you really e)plain to a fish what it!s li#e to
wal# on land* One day on land is worth a
thousand years of tal#ing about it and one day
running a business has e)actly the same #ind
of value.!!
.. WarrenB#ffett
Invest within your circle of competence. It!s
not how big the circle is that counts, it!s how
well you define theparameters.!!.. Warren
B#ffett
+ationality is the uality that uffett thin#s
distinguishes his style with which he runs
er#shire ' and the uality he often finds
lac#ing in other corporations.!!
.. 7arol oomis, Fortune-againe
eware of past performance proofs in
finance. If history boo#s were the #ey to
riches, the Forbes /00 would consist of
librarians.!!
.. WarrenB#ffett
After we buy a stoc#, conseuently, we would
not be distrurbed if mar#ets closed for a year
or two. &e don!t need a daily uote on our 100
percent position in See!s or 2.2. rown to
validate our well being. &hy, then, should we
need a uote on our 3 percent interest in"o#e*!!
.. WarrenB#ffett
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"ain Idea
4. THE WARRENBUFFETT WAY
/! B#siness Tennets
Business Tennet 1.
Is the business simple andunderstandable from the
Rational allo$ation of $a&ital is the %e) to an)investment s#$$ess!
The B#ffett a&&roa$h to investment is5
/! Never follo+ the da) to da) fl#$t#ations ofthe sto$% mar%et!
1! 2ont tr) and anal)3e or +orr) a*o#t thegeneral e$onom)!
'! B#) a *#siness, not its sto$%!
9! "anage a &ortfolio of *#sinesses )o#
+ant to o+n! S#&&orting Ideas
/! Never follo !"e #$% !o #$% fl&'!&$!(o)*of !"e *!o'+
,$r+e!.
In essen$e, a sto$% mar%et e-ists sim&l) tofa$ilitate the *#)ing and selling of shares!
An)time an investor tries to t#rn the mar%etinto a &redi$tor of f#t#re &ri$es, the) r#n into&ro*lems!
The essential 6#estion is +hether )o#vedone )o#r home+or% or not! If )o# %no+more a*o#t a $om&an) than the mar%etdoes, then +h) give an) attention to +hatthe mar%et sa)s4
Se$ondl), if )o# *#) a share *e$a#se )o#*elieve a $om&an) has so#nd finan$ial&ros&e$ts and )o# intend o+ning it for an#m*er of )ears, +hat ha&&ens in themar%et on a da) to da) *asis is totall)in$onse6#ential!
An investor does not need the mar%etsvalidation for an) share r$hase the) have$om&leted!
The onl) #se for a reg#lar glan$e at themar%et is to $he$% +hether an)one is foolisheno#gh to sell a good *#siness at a great&ri$e!
1! Do)-! !r% $)# $)$l%e or orr% $/o&!!"e 0e)er$l e'o)o,%.
If it is im&ossi*le to &redi$t +hat the sto$%mar%et +ill do from da) to da), ho+ $an it *eeven remotel) a$hievea*le to fore$ast +hatthe e$onom) as a +hole +ill do in the ne-t
fe+ )ears4
The &ro*lem is some investors *egin +ithan e$onomi$ ass#m&tion a*o#t thedire$tion of the e$onom) and sele$t onl)
sto$%s +hi$h fit their model! In this +a)the &redi$tions *e$ome *oth self.f#lfillingand limiting!
A s#&erior a&&roa$h is to *#) a *#siness+hi$h has a realisti$ o&&ort#nit) to&rogress regardless of +hether theoverall e$onom) is e-&anding or$ontra$ting! A *#siness +hi$h has thea*ilit) to &rofit in an) e$onomi$environment is ver) val#a*le!
'! B&% $ /&*()e** )o! (!* *!o'+.An investor sho#ld onl) *#) shares in a$om&an) +hi$h he +o#ld *e +illing tor$hase o#tright if he had s#ffi$ien$a&ital! From this &ers&e$tive, an investosho#ld loo% for a $om&an) +ith *#sinesso&erations that are #nderstood, hasfavo#ra*le long.term &ros&e$ts, iso&erated *) honest and $om&eten&eo&le and is availa*le at an attra$tive&ri$e!
The de$ision to *#) a*#siness is *ased on5.. B#sinesstennets.."anagementtennets.. Finan$ialtennets.. "ar%et
tennets
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perspective of theinvestor?
2o )o# #nderstand ho+ the $om&an)generates sales, in$#rs e-&enses and&rod#$es &rofits4
That means )o# need to #nderstand reven#es,e-&enses, $ash flo+, la*o#r relations, &ri$ing,fle-i*ilit) and $a&ital re6#irements . ane-$e&tionall) high level of %no+ledge! It meansthat investors sho#ld *#) shares onl) in$om&anies +ithin their o+n $ir$le of finan$ialand intelle$t#al #nderstanding!
An investor need to *e realisti$ a*o#t +hatthe) do not %no+! A*ove average res#lts aremost often a$hieved *) doing ordinar) thingse-$e&tionall) +ell!
Business Tennet2.
oes the business have a consistent
operating history?
In general, the *est level of &rofits over thelong.term are a$hieved *) $om&anies thathave *een &rod#$ing the same &rod#$t orservi$e for a n#m*er of )ears! ne.off+indfalls generated *) #n#s#al events are @#sttoo hard to reasona*l) &redi$t!
An investor sho#ld never ignore a $#rrent*#siness realit) *e$a#se of some vision off#t#re s#$$ess! oo% to *#) a *#siness +hi$h
has sho+n it $an reasona*l) +eather differente$onomi$ $)$les and $om&etitive for$es!
The *est time to *#) an) *#siness is +hen&rofita*ilit) has *een interr#&ted for somee-ternal short.term reason! This $an $reate arare one.time o&&ort#nit) to r$hase a so#nd*#siness at an #n#s#all) lo+ &ri$e!
Business Tenent
!.
oes the business have favourable long-
termprospects?
The e$onomi$ +orld is divided into a largegro#& of $ommodit) $om&anies and a smallgro#& of $om&anies that o+n the fran$hisefor their &rod#$t or servi$e!
7ommodit) $om&anies $om&ete solel) on
&ri$e, +ith no differentiation *et+eens#&&liers! As +ell as the traditional oil andgas $om&anies, the $ommodities gro#& no+in$l#des $omters, a#tomo*iles andairlines!
B) $ontrast, $om&anies +hi$h o+n thefran$hise have a &rod#$t or servi$e +hi$h isneeded, has no $lose s#*stit#tes and for+hi$h an #nreg#lated mar%et e-ists!
Ideall), a *#siness r$haser +ill +ant to
*#) a fran$hise t)&e of $om&an)! These$om&anies have an a&&re$ia*le margin ofsafet) +here*) &ri$es $an *e raised tooffset management mista%es!
The onl) &ro*lem is a strong fran$hiseholder soon attra$ts $om&etitors ands#*stit#te &rod#$ts, +hi$h in t#rn leads tothe $reation of a $ommodit) mar%et aro#ndthat &rod#$t or servi$e! Whenever thatha&&ens, the val#e of the management*e$omes even more $riti$al to the e$onomi$
&erforman$e of the $om&an)!
If it is not &ossi*le to r$hase a fran$hise$om&an), the ne-t *est o&tion is to *#) thelo+est $ost s#&&lier in a $ommodit) mar%et!ver the long.term, the lo+est $ost s#&&lieral+a)s $omes to dominate a $ommodit)mar%et!
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1! "anagementTennets
"anagementTennet 1.
Is managementrational?
2oes the management a$t and thin% li%e an
o+ner of the $om&an) #nfailingl)4 In&arti$#lar, ho+ is $a&ital allo$atted *) the$om&an)4 Rational managers +ill investan) e-$ess $ash generated *) the $om&an)in &ro@e$ts that &rod#$e earnings at rateshigher than the $ost of $a&ital! ver thelong.term, allo$ation of $a&ital determinesthe val#e of the $om&an)!
All $om&anies move thro#gh an e$onomi$life $)$le! In the develo&ment stage, the
$om&an) loses mone) +hile esta*lishingmar%ets and im&roving its &rod#$ts! 2#ringthe ne-t stage of ra&id gro+th, the $om&an)re6#ires $ash to gro+ and retains earningsand *orro+s or iss#es more e6#it)! In thethird stage :mat#rit);, the $om&an)generates more $ash than it needs as salese-&and! In the last stage, e-$ess $ashta&ers off as sales de$line!
The %e) 6#estion is +hat managers do +iththe e-$ess $ash in the mat#rit) and de$line
stages! A rational management +ill investthis $ash in &ro@e$ts that earn a higher rateof ret#rn than the $ost of $a&ital on the o&enmar%et . other+ise the f#nds sho#ld *eret#rned to shareholders as dividends or *)*#)ing *a$% the $om&an)s o+n shares!
B) $ontrast, irrational managers are oftenover$ome *) their o+n &ro+ess and$ontin#e to reinvest in &ro@e$ts +ithdiminishing ret#rns!
"anagementTennet 2.
Is management candid #ith itsshareholders?
The ideal *#siness manager re&ortsfinan$ial &erforman$e o&enl) and gen#inel),+ith an a*ilit) to admit mista%es and re&ortthe &rogress of all as&e$ts of the $om&an)!The management sho#ld also *e a*le toreaffirm that the $om&an)s &rime o*@e$tiveis to ma-imi3e the ret#rn on shareholders
investment! This $on$e&t sho#ld $olo#r
ever) a$tion ta%en!
The tenden$) to in$l#de ever) &ie$e ofinformation that o+ners +o#ld deemval#a*le +hen @#dging the $om&an)se$onomi$ &erforman$e is a $hara$teristi$of a strong management team!
"anagement
Tennet !.oes management resist theinstitutional imperative?
The instit#tional im&erative is thetenden$) of $or&orate managers to mimi$the a$tions of other $om&anies, even+hen those a$tions are destr#$tive oirrational! "ost managers are soinfl#en$ed *) +hat other $om&anies aredoing that the) are #n+illing to do
an)thing +hi$h res#lts in short.term &ainin e-$hange for long.term &rofit!
A meas#re of an) $om&an)smanagement s%ill is ho+ effe$tivel) the)thin% for themselves rather than settle fomindless imitation of +hat ever)one elseis doing! In essen$e, s#$$essf#$om&anies have managers +ho ref#se tofollo+ the herd into medio$rit)!
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'! Finan$ialTennets
$inancial Tennet1.
$ocus on return on e%uity& not earningsper share.
7om&anies are $ontin#all) adding to their$a&ital *ase *) retained earnings in &arti$#lar!
Therefore, )o# e-&e$t earnings &er share toin$rease )ear *) )ear!
A *etter meas#re of a $om&an)s &erforman$eis ret#rn on e6#it) . the ratio of o&eratingearnings to shareholder e6#it)! This meas#resthe managements a*ilit) to generate a ret#rnon the o&erations of the *#siness given the$a&ital em&lo)ed!
When $al$#lating ret#rn on e6#it), val#emar%eta*le se$#rities at $ost . not mar%et
val#e :as mar%et val#e is *e)ondmanagements $ontrol;! E-$l#de all non.re$#rring e-traordinar) items +hi$h are#nrelated to the *#siness!
A good management team +ill $onsistentl)a$hieve good ret#rns on e6#it) +hileem&lo)ing little or no de*t, or at leastem&lo)ing a managa*le de*t level for thenat#re of the *#siness!
$inancial Tennet2.
'alculate (()#ner*arnings.++
The #ltimate val#e of an) $om&an) is its a*ilit)to generate a s#r&l#s of $ash! Ho+ever, a$om&an) +ith a high fi-ed asset to &rofit ratio+ill re6#ire a larger share of retained earningsto sta) &rofita*le than a $om&an) +ith a lo+fi-ed assets to &rofit ratio!
DD+ner earnings is $al$#lated *) addingde&re$iation, de&letion and amorti3ation
$harges to net in$ome and s#*tra$ting the$a&ital e-&endit#re re6#ired to maintaine$onomi$ &osition and #nit vol#me!
DD+ner earnings refle$ts the tr#e $ash flo+&osition of a $om&an)! Some enter&rises:li%e a real estate develo&ment for e-amre6#ire heav) e-&endit#re at the start andver) little later on! thers, li%eman#fa$t#ring, re6#ire reg#lar e-&endit#reon &lant #&grades or the *#siness sli&s!DD+ner earnings is an attem&t to &rovide a
$ross ind#str) anal)sis meas#re!$inancialTennet !.
,earch for companies #ith highprofit margins.
Carado-i$all), managers of high.$ost$om&anies tend to find +a)s to $ontin#all)add to their overheads +hereas themanagers of lo+.$ost o&erations ta%e &ridein lo+ering their e-&enses!
An) mone) s&ent on #nne$essar) $ostsde&rives shareholders of e-tra &rofits! The$#lling of #nne$essar) e-&enses is a$onsistent theme of effe$tive managers!
$inancialTennet .$or every dollar of retained earnings&
has the company created at least one
dollar+s #orth of e.tra mar/et value?
ver the longer term, sto$% mar%et val#e+ill a$$#ratel) refle$t the e$onomi$ val#e of
the $om&an)! The same is tr#e forin$reased mar%et val#e $reated *) retainedearnings!A +ell managed $om&an) +ill addat least one dollar of mar%et val#e for ever)dollar of retained earnings!
To estimate this fa$tor, s#*tra$t all dividendsfrom a $om&an)s net in$ome over the lastten )ears! This is the total retained earnings!
Add that fig#re to the $om&an)s mar%etval#e at the *eginning of the ten )ear &eriod
to get TotalA! If the $om&an) has em&lo)edretained earnings effe$tivel), the mar%etval#e at the end of the ten )ear &eriod +ille-$eed Total A! If it doesnt, *e+are!
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9! "ar%etTennets
"ar/etTennet 1.
What is the value of thebusiness?
B#ffett $al$#lates the val#e of a *#siness as
the net $ash flo+s e-&e$ted to o$$#r overthe life of the *#siness dis$o#nted at ana&&ro&riate interest rate! Net $ash flo+s arethe $om&an)s o+ner earnings over a long&eriod! Something li%e the thirt).)ear U!S!treas#r) *ond rate $an *e #sed as ameas#re of the interest rate for this$al$#lation!
B) $al$#lating the *#siness val#e this +a),vastl) different *#siness enter&rises $an
realisti$all) *e $om&ared! If the *#siness isgro+ing ra&idl) *#t has #n&redi$ta*le f#t#rereven#es, then the $om&an) is not $lassifiedas sim&le and #nderstanda*le and thisform#la $annot *e a&&lied! The dis$o#nted$ash.flo+ a&&roa$h des$ri*ed is ver)$onservative as long as an a&&ro&riatedis$o#nt rate is a&&lied!
In our view, what ma#es sense in business
also ma#es sense in stoc#s. An investor
should ordinarily hold a small piece of an
outstanding business with the same tenacity
that anowner would e)hibit if he owned all the
business.!!
.. WarrenB#ffett
"ar/etTennet 2.
'an the business currently be
purchased at a significant discount to its
value?
Armed +ith an a$$#rate $al$#lation of theval#e of the *#siness, )o# sho#ld no+ loo%at the as%ing &ri$e! The r#le for mar%ets#$$ess is r$hase onl) +hen the $#rrentmar%et &ri$e is at a signifi$ant dis$o#nt toval#e!
The intention of an) investor is to earna*ove.average ret#rns! The differen$e*et+een *#siness val#e and &ri$e is theinvestors margin of safet)! "ost investors
set their o+n margin of safet)! B#ffet
generall) aims for a 1.&er$ent dis$o#nt ashis margin of safet)!
Additionall), a +ell $hosen sto$% +ill haveso#nd f#ndamentals, +hi$h over the longeterm +ill lead to an a*ove average gro+th inthe $om&an)s share &ri$e! This, in effe$t*e$omes an additional re+ard for the
intelligentinvestor +ho r$hases at a dis$o#nt!
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4. M$)$0e $ or!fol(o of/&*()e**e*.
The $on$e&t of intelligent investing is that *)*#)ing shares in a $om&an), )o# sho#ld a$tli%e the o+ner of the *#siness, not theo+ner of a &ie$e of &a&er! That means )o#need to #nderstand the $om&an)so&erating f#ndamentals!
2iversifi$ation is onl) re6#ired +hen aninvestor does not %no+ +hat the) are doing!er) fe+ *#siness o+ners are $omforta*leand e-&erien$ed eno#gh to o&erate an#m*er of $om&anies at the same time! Sotoo, an investor sho#ld a$t li%e an o+nerand *#) shares onl) in $om&anies +hi$h arethoro#ghl) #nderstood!
0e)Tho#ghts
I would rather be vaguely right thanprecisely wrong.!!
..0e)nes
The mar#et, li#e the 4ord, helps those who
help themselves. ut unli#e the 4ord, the
mar#et does not forgive those who #now not
what they do.!!
.. WarrenB#ffett
Investing is most intelligent when it ismost businessli#e.!!
.. Ben@aminGraham
I put a heavy weight on certainty. If you do
that, the whole idea of a ris# factor doesn!t
ma#e any sense to me. +is# comes from not
#nowing what you!re doing.!!
.. WarrenB#ffett
5ou are neither right nor wrong because the
crowd disagrees with you. 5ou are right
because your data and reasoning are right.!!
.. Ben@aminGraham
It is not good enough to have goodintelligence. The principle thing is to apply itwell.!!
..2es$artes
As far as I am concerned, the stoc# mar#et
doesn!t e)ist. It is there only as a reference to
see if anybody is offering to do anything
foolish.!!.. Warren B#ffett
-ost managers have very little incentive to
ma#e the intelligent'but'with'some'chance'of'
loo#ing'li#e'an'idiot decision. Their personal
gain6loss ratio is all to obvious7 if an
unconventional decision wor#s out well, they
get a pat on the bac#, and if it wor#s out
poorly, they get a pin# slip. Failing
conventionally is the route to go7 as a group,
lemmings may have a rotten image, but no
individual lemming has ever received bad
press.!!.. Warren B#ffett
It has been helpful to me to have tens of
thousands students turned out of business
schools taught that it didn!t do any good to
thin#. &hat we do is not beyond anybody
else!s competence. It is (ust not necessary to
do e)traordinary things to get e)traordinary
results.!!
.. Warren B#ffett
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SAMPECACUATION
CACUATIN THE VAUE OFA BUSINESS
Ass#m&tions5
/! The $om&an)s $ash flo+ +ill gro+ at a $om&o#nd rate of / &er )ear $onsistentl) for the ne-t/( )ears!
1! A dis$o#nt rate of
'! Ass#me in )ear // that the $om&an)s $ash flo+ +ill again in$rease *) !
9! All dollar amo#nts are in millions!
CRESENT AUE F FUTURE 7ASH FWS
Ye$r 1 2 3 4 5 6 7 8 9 TOT
Crior Year 7ash =1 =' ='? =9/ =9> = =? =' => = = =? = =>9 =< =/,/
2is$o#nt ! ! ! ! ! ! ! ! ! !
2is$o#nted al#e Cer =1< =' ='1 ='9 =' =' =' =91 =9 =9 =',
7A7UATIN F RESI2UA AUE
7ash Flo+ in Year /( =/,/
Gro+th Rate
7ash Flo+ in Year // =/,/
7a&itali3ation Rate
al#e at End of Year /( =1