New to Warren Buffett Secrets? A guide to navigating this site

For new visitors, the number of articles on this site can be overwhelming. This is intended as a guide for new readers who are not sure where to start. The following articles will give you a good overview of how Warren Buffett invests, and what is available here.

This is a site dedicated not just to Warren Buffett but to Benjamin Graham and the idea that buying shares as an investment will, in the longer run, provide greater and safer returns than buying shares as a speculation. This principle may sometimes be called value investing but we would prefer to adopt the words so famously used by Bemjamim Graham and call it intelligent investing.

Here are some ways for you to navigate this site.

Grasping the concept of intelligent investing

Ben Graham was Warren Buffett’s mentor and is the so-called father of value investing, which we prefer to call intelligent investing and which Warren Buffett has modified and taken to a new level. Read our short biography of Ben Graham and our summary of his investment principles and either follow the links in that article or look at these articles on specific principles originated by Graham or associated with him such as:

In understanding Benjamin Graham, there is no substitute for reading the words of the great man himself. His classic work The Intelligent Investor should be permanently on the desk of every aspiring investor (and a second copy beside the bed). He also wrote a small book called The Interpretation of Financial Statements which explains complex financial concepts in simple terms and which we find invaluable.

Finding out how Warren Buffett invests

Nobody can be 100 per cent sure of why Warren Buffett puts money into certain investments and steers away from others. He leaves clues behind in his letters to shareholders, interviews, public statements and discussions with financial writers and authors. We have spent many years investigating these sources and looking at his investments and believe that we have come up with a working model of the principles that seem to guide him.

You should first of all read our short biography of Warren to get some understanding of his path to sucesss. We have summarized what we believe are Warren Buffett’s investment principles and tried to bring them all together. In these two articles, you will find links to specific explanations of his investment principles and you should follow those links for further clarity.

Specific Buffett concepts

Like Benjamin Graham, Buffett has come up with particular ideas that are associated with him. These concepts obviously play a big part in his investing strategy and should be in the mind of every careful and intelligent investor. They include:

Company management

It is important for Warren Buffett that companies in which he invests have good and honest managers. In particularly he is concerned with the ability of company management to:

Buffett believes, as do we, that a company whose managers cannot or will not do these things well and who do not keep their eye on the main game are not worth investing in. In particular, companies that steer away from their core business should be avoided.

Some things that you need to understand to understand the Buffett strategy

If you want to get your head around why Buffett does what he does, you need to also understand, and realise the importance to him, of some investment concepts. These include:

Berkshire Hathaway

Buffett’s main investment vehicle is Berkshire Hathaway, a struggling mill company that he bought and turned into an investment giant with its fingers in money pies all around the world. You might like to read the first part of our short history of Berkshire Hathaway and then look at who is likely to succeed Warren Buffett and whether that man will be Ajit Jain, our personal pick at the moment.

Buffett has not done it all on his own however and always gives full credit to his good friend and long term business partner Charlie Munger with whom he teamed up with many years ago on the acquisition of Geico, one of a number of insurance companies that provide them, via Berkshire, with the necessary capital to make their big share plays.

Some companies

The investments of Buffett and Berkshire Hathaway are many and varied. We have looked at just a few companies that Buffett has and has not put his money into. Some of the businesses discussed on these pages that you might like to look at are:

Books about Buffett, books that we like to read and books that Warren likes to read

The gratifying thing about the books that we like to read and those that Buffett recommends is that we sometimes agree. That makes us feel good but we suspect that our book choices probably do not register nearly so much in the mind of the Sage of Omaha as his do on ours. Anyhow, you can see our books reviews on our book review page and also look at those that Buffett recommends from time to time.

There are heaps of books about Warren Buffett and we think that we have reviewed the best of them on our pages.

We hope that you will enjoy this website, and find it instructive. There are many more articles on here which you can read at your leisure. If you enjoy what you find here, you can also subscribe to get new updates via twitter, facebook, or RSS.

Economic goodwill

All solvent businesses have assets and liabilities and, when the business is owned by a corporation, those assets and liabilities are listed on its balance sheet and a value given to them. Assets are either tangible or intangible and each type of asset can produce earnings.

Tangible and intangible assets

Tangible assets are assets that can be ‘touched’ (the literal meaning of tangible). That is, they have a physical presence. Tangible assets include such things as plant, machinery, vehicles, land, buildings, inventory and stock. Assets that are not tangible are intangible and include such things as legal rights, intellectual property (trade marks, patents, copyright), and goodwill. Accounting practice requires that a fair estimate of the value of the assets be given in corporate accounts and regulators impose a heavy duty on directors of corporations to ensure the truth of these valuations.

Benjamin Graham had a view that looking at the net tangible assets of a company was one way of determining whether the price being asked for the company’s shares represented value. Warren Buffett believes that in situations where the earnings returns on a company’s tangible assets are higher than the norm, the excessive return is attributable to the intangible assets of the company. This can be called economic goodwill.

Economic goodwill

Economic goodwill can come from one, some or all of a number of sources.

• The type of product that the company markets and the durability of its appeal to customers (for example Coca Cola, McDonalds).

• The protection from competition that a company enjoys because its area of industry is regulated (banking, energy providers) or because the cost of competitors entering that area of industry is great or impractical or requires expertise that has limited availability (railroads, insurers). Also, a company that holds copyright or patents over its products or has trade marked products can protect itself by refusing to allow others to use its intellectual property or can impose license fees for their use which makes it difficult for others to trade competitively. Examples would include film and music producers which have copyright over their product, manufacturers holding patents and the owner of recognizable trade marks.

• The ability of the business to provide its products at sustainable higher profit margins or lower costs than competitors can reflect a continuing skill in production technique, personnel selection, resource allocation and business sense. This too can be a type of economic goodwill.

It is this economic goodwill that Buffett believes helps make a good and sustainable business. And, what is most important, a company does not have to continually pay out money to maintain and replace this economic goodwill in the same manner as companies that  rely on physical and tangible assets to maintain or improve earnings.

See’s Candies as an example of economic good will

Warren Buffett first bought into See’s Candies  in 1972 for a price based on a value of the business at $25 million. At this time, the company was producing annual earnings of $2 million on tangible assets worth $8 million, a return of 25 per cent on tangible assets. This is a high return on tangible assets. If we then subtract $8 million (the value of tangible assets) from $25 million (the value of the company), this means that Buffett was paying the equivalent of $17 million for intangible assets (whatever they might be made up of).

Now if we assume that See’s, at that time, wants to grow its earnings, whether through increased prices and margins or through expansion, it would probably have to do so by increasing the things that it uses to produce its goods - its tangible assets (plant, machinery, delivery vehicles etc). It would be reasonable to assume that, market conditions allowing, and assuming existing machinery was fully utilized, if it wanted to double its earnings to $4 million, it would have to double its tangible assets. This would cost the owners of the company a further $8 million. So the value of the company, at cost, is now $33 million made up of the original value of $25 million plus $8 million for the increase in tangible assets. This $33 million dollar company would now be earning $4 million a year.

Suppose however that another business was for sale at the same time, again at a value of $25 million and again producing annual earnings of $2 million a year. In this case however the value of the tangible assets is $17 million dollars, meaning that the economic goodwill of the business (whatever it might be made up of) would be $8 million dollars ($25 million minus $17 million).

Doing the same exercise, for this company to double its earnings, it would need to double its tangible assets and this would cost its owners $17 million dollars. The total value of the company is now $42 million ($25 million original valuation and $17 million for additional tangible assets) and it is producing the same annual earnings as See’s Candies of $4 million.

So what we have are two companies each earning $4 million dollars a year. The big difference is that the capital tied up in See’s is $33 million, the capital tied up in the other company would be $42 million. The difference comes from economic goodwill.

A more detailed explanation of this transaction (which took place in two separate tranches) is contained in Buffett’s 1983 letter to shareholders.

Cautions on the use of economic good will as an investment tool

It might seem easy from the See’s example to find good companies in which to invest – just look for companies where much of their earnings comes from intangible rather than tangible assets. But there are things that the careful investor needs to be aware of. Like tangible assets, the value of intangible assets can change. Economic goodwill might actually fall or disappear altogether. There are several ways in which this might happen.

• The protection given to the company’s products by intellectual property rights lessen over time. Patents and copyright are limited in their duration and the worth of a trade mark might fall or disappear because of industry or other changes. For example, 20 years ago the masthead of a newspaper was a valuable asset. In today’s electronic age, not so much. And somebody might come up with a new idea that makes the company product obsolete or a new and better method of making the product that does not infringe any existing patents.

• The popularity of the company’s product might reduce either because of something that the company does (who can forget the debacle of the switch to New Coke) or changing consumer habits (laptop computers challenged by tablets), or overall industrial change (the car replacing the horse, electric lights replacing gas lights).

• Licensing rights and monopolistic or duopolistic positions can be altered by government whim. In recent times for example, we have seen monopoly positions in telephone services and airline routes opened up to increased competition, both domestically and internationally.

A final word on See’s Candies

Having used See’s Candies as an example, what is the economic goodwill that it had when Buffett bought it? Buffet explains it like this.

In our primary marketing area, the West, our candy is preferred by an enormous margin to that of any competitor. In fact, we believe most lovers of chocolate prefer it to candy costing two or three times as much. (In candy, as in stocks, price and value can differ; price is what you give, value is what you get.) The quality of customer service in our shops – operated throughout the country by us and not by franchisees is every bit as good as the product. Cheerful, helpful personnel are as much a trademark of See’s as is the logo on the box. That’s no small achievement in a business that requires us to hire about 2000 seasonal workers. We know of no comparably-sized organization that betters the quality of customer service delivered by Chuck Huggins and his associates.

Or as he said on a later occasion, more colorfully:

When you were a 16-year-old, you took a box of candy on your first date with a girl and gave it either to her parents or to her …. In California the girls slap you when you bring Russell Stover, and kiss you when you bring See’s.

Dividend yield and earnings yield

Calculating the dividend yield or the earnings yield of a stock and comparing it to the yield on government securities is one way of checking whether the price of a stock represents value. There is a difference between the dividend yield and the earnings yield of a stock.

Dividend yield

The formula for calculating the dividend yield of a stock in percentage terms is:

$latex Dividend\;yield\;=\;\frac{Dividend\;per\;share\;\times100}{Price\;of\;share}&s=2$

Example 1

Suppose that the current price of a share is $80 and its annual dividend rate is $4. The dividend yield then is calculated like this:

$latex Dividend\;yield\;=\;\frac{4\;\times100}{80}=5&s=2$

So we would say here that the shares in this company are yielding 5.00% at the current price.

Earnings yield

As a general rule, companies do not return all their earnings in a given year to shareholders. Instead they pay out a lesser amount. As a result, the earnings yield of a share and the dividend yield of a share are usually different. The formula for calculating the earnings yield in percentage terms of a stock is:

$latex Earnings\;yield\;=\;\frac{Earnings\;per\;share\;\times\;100}{Price\;of\;share}&s=2$

Example 2

Suppose that the current price of a share is $80 and its annual earnings rate is $7. The earnings yield  then is calculated like this:

$latex Earnings\;yield\;=\;\frac{7\; \times\;100}{80}\;=\;8.75&s=2$

So we would say here that the shares in this company are yielding an earnings rate of 8.75% at the current price.

To a great extent this is a reflection of the price/earnings ratio (P/E ratio) of a stock. If the above stock is selling at $80 and is earning $7 a share then, if you apply the P/E ratio formula, the answer is 11.42 (80/7). This means that a P/E ratio of 11.42 implies an earnings yield of 8.75 and vice versa.

Using dividend yield to calculate the value of a share

Benjamin Graham placed a lot of emphasis on the dividend rates that a company pays and the consistency of payments. Warren Buffett, because he believes so strongly that owning a share in the company is the same as owning a tiny part of the business that the company is in, focuses on the earnings per share that a company gives him for his investment.

Buffett has a concept that he calls owner earnings which, even though it is more complex than earnings yield, has as its basis the earnings of the company rather than the dividends that it pays. Graham argues that a consistent record of paying dividends is one tool in the process of investment for the defensive investor.

Buffett’s concern about dividends relates to capital allocation. If company management can put surplus earnings to good use by growing earnings at a rate faster than one would expect the average investor to grow the dividends received, then that is the better use for the money. If company management cannot do this, it should give the money to shareholders by buying back shares (where the price of the shares does not exceed intrinsic value), by a return of capital or by payment of dividends (generally the least effective option tax-wise). Because of this, he values companies on what they earn and not on what they pay out as dividends.

Both Graham and Buffett believe that a basis for stock investment is whether buying the shares in a company are likely, taking added risk into account, to be a more profitable investment than a prime commercial bond (Graham) or government securities (Buffett).

For example, if the shares in a company with low growth prospects are yielding little more (dividend yield or earnings yield, as you prefer) than that available in a high quality bond (government or triple A rated), why would you take the extra risk of a share investment? If however the yield from a company is greater than bond yields, or you are confident that  its earnings and dividends will rise over a period, and there is little risk of the company business model failing, you would get a better return for your money bu buying the shares.

 Example 3 Comparing dividend yield to government bond yield

In Example 1, we worked out that the dividend yield on shares in that particular company is 5 per cent. At the time of writing this post, 10 year US Treasury Bills can be bought, yielding a rate of about 2.8 per cent. The dividend yield per share in Example 1, at 5 per cent, is almost double the rate available from the government bond. So, all things being equal, the stock investment seems preferable.

Using earnings yield to calculate the value of a share

We can apply the same approach to earnings per share.

Example 4 Comparing earnings yield to government bond yield

In Example 2, we worked out that the earnings yield on shares in that particular company is 8.75 per cent. At the time of writing this post, 10 year US Treasury Bills can be bought yielding a rate of about 2.8 per cent. The earnings yield per share in Example 2 at 8.75 per cent is more than three times the rate on the government bonds. So, all things being equal, the stock investment seems preferable.

All things are not equal

In making a comparison between the yield available on a common stock, whether earnings or dividend, and the yield available on a government bond or a triple A commercial bond using these methods, the prudent investor would need to make a risk assessment. This is because we are comparing an investment that carries risk and uncertainty (shares) with an investment that is predictable in its yield and virtually risk free (government bond) or low risk (triple A commercial bond). An investor would need to consider:

  • whether bond rates are likely to rise in the near future, in which case if the investor needs to sell before maturity, a capital loss is possible (the reverse would apply if bond rates were to fall).
  • the potential for the earnings of that company to grow (in which case its attractiveness will increase in comparison to the fixed return of the bond) or diminish (the reverse situation).
  • the risk of failure of the company or its business model, or overall economic deterioration.

Using dividend yield to to calculate discounted cash flow (DCF)

If you are adept at higher mathematics, you can look at a paper written by Dr Aswath Damodoran, Professor of Finance at the Stern School at NYU.

Finding intrinsic value: The Graham Formula

There are differing views on how to find the intrinsic value of a particular stock. In The Intelligent Investor, Benjamin Graham suggested a rule of thumb method for, if not getting an exact price, at least providing a filter.

 Benjamin Graham’s original formula

The original formula for finding the value of a share involved multiplying the current earnings per share by the sum of 8.5 and twice the anticipated growth rate. That is:

$latex V=E\times(8.5+2G)&s=2$

where  E = earnings per share and G = the anticipated growth rate over a projected period (normally 10 years).

Graham thought that as the choice for the investor was between putting money into common stocks or into the greater safety of bonds, it was appropriate to take into account the rate of interest paid on a first quality bond in determining the intrinsic value of a stock. In devising his formula, Graham took into account the then prevailing (1962) rate on triple A corporate bonds listed on the New York Stock Exchange  of 4.4 per cent.

The Graham modified formula

As interest rates fluctuate, it became necessary for the formula to be adapted. The modified formula is:

$latex IV=\frac{E\times(8.5+2G)\times4.4}{Y}&s=2$


IV = Intrinsic value
E= Earnings per share
G= expected growth rate
Y= the current yield of triple A rated corporate bonds

Finding the input values

The current earnings per share of the target company are available from the latest company balance sheets or from financial information providers like ADVFN.

The anticipated growth rate is difficult to determine and becomes a matter of subjective judgment. Nobody, least of all brokers and investment advisers, can predict exact future rates of growth even in the short to medium term. It is for this reason that Graham came up with the margin of safety concept: to allow for potential errors in calculating the expected growth rate.

Investors, in calculating anticipated growth rates, should take into account:

• Growth rates in EPS over the past ten years, cross checked against growth rates over the past five years
• Whether these growth rates are consistent or erratic, and whether they show an upward or at least a static trend
• Economic and industry trends
• The extent of competition for the products of the business and the likelihood of new entrants into the business markets
• Continuity and capability of company management

All these factors are part of Warren Buffett’s investment principles.

The yield rate chosen is again subjective but less so. Graham chose the figure of 4.4 because this was the triple A corporate bond rate prevailing at the time that he wrote. He completed the formula in later years to allow for the fact that the yield rates on bonds had changed.

While we have reservations about the concept of triple A rating as an investment guide (who can forget that the credit rating agencies gave triple A ratings to many of the securities that lead to the recent financial panics of 2007 and 2008), we do not argue with Graham’s use of the AAA bond rate as his yield benchmark. After all, the idea behind his formula was to determine whether an investor would be better off putting money into a particular stock or seeking the security and lesser risk of a prime bond.

As an alternative, investors using the Graham formula might prefer to substitute the yield rates for government issued securities. In the United States, an appropriate yield rate would be that for 10 year Treasury Bills or, in looking at shares listed on the stock exchanges of other countries, assuming a regular and orderly economy, the yield rate on similar bonds guaranteed by the government of that country.

Even so, this still remains very subjective. For example, the average yield on 10 year Treasury Notes from 1900 to date is about 4 per cent but in the last forty years, the average has been 6.6 per cent.

The Graham formula suggests that you should use the current rate because you are making your investment decision on today’s values, but we suppose if you really want to build in a safety margin, you could use the higher average yield of 6.6 per cent. This would, however, limit your investment options.

Applying the margin of safety

One way of doing this is to divide the intrinsic value produced by the current price of the stock. If the result is greater than 1, the stock is selling below intrinsic value. The higher the number, the greater is the margin. If the result is less than 1, the stock is selling at a price greater than its intrinsic value.

Warren Buffett has on occasions suggested that the correct margin of safety should be about 25 per cent and this seems a good figure to us but again it would depend upon how much confidence we had in the assumed growth rates. If we were highly confident, we might accept a smaller margin and vice versa. If less confident, then the discount figure used should be greater.

How the Graham formula works

Using a hypothetical example, suppose that the current earnings per share of Company XYZ is $2.78 and that, taking  into account all the factors that you should take into account, you conservatively calculate the projected growth rate at 6 per cent. Suppose also that the current selling price of the stock is $70.55. At the time of writing this post (March 2013) the yield on 10 year American Triple A corporate 10 year bonds is 2.53 per cent.

The values then are E = 2.78, G = 6 (therefore 2G = 12) and Y = 2.53. So:

$latex IV=\frac{2.78\times(8.5+12)\times4.4}{2.53}=99.11&s=2$

Using the Graham modified formula, the intrinsic value of a share in XYZ Company then is $99.11.

Incorporating the margin of safety

To incorporate a margin of safety, we can now divide the intrinsic value (99.11) by the current price of the stock (70.55). We get 1.40 which is a positive ratio and indicates a buy.

If we adopt Buffett’s stated margin of safety value of 25 per cent, we would get a buy price of $74.33(99.11 x .75), again a buy.

Even allowing for the current historically low interest rates, the Graham formula suggests that this hypothetical stock is selling at below intrinsic value.

Using the Graham formula

We don’t suggest that this formula is the best, the most correct or indeed the only way of working out the intrinsic value of a share. It was offered by Graham as a rule of thumb method fifty years ago. Its most appropriate use is, we would think, as a filtering and checking mechanism.

Warren Buffett, Alpha, Beta and leverage, Part 2

A recent report by Yale University researchers argues that there are two reasons why Warren Buffett outperforms the market. In Part 1 of our analysis of the Yale paper, we looked at whether the use of the insurance premiums received by Berkshire to fund investments constituted a leverage sufficient to detract from Buffett’s legendary reputation.

In this article, we look at the conclusion by the Yale researchers that Berkshire’s stock price has a high beta returning excess profits but with higher than normal risk, and that Buffett’s success relies on his ability to choose safe quality stocks with low Beta ratings, bought cheaply.

Some definitions

If you read the Yale report, you need to know what some of the terms mean.

An Alpha characteristic is given to mutual and investment funds and is said to measure performance on a risk adjusted basis. A positive Alpha rating signifies that the fund has outperformed its benchmark measure by 1 per cent, so the higher the positive Alpha number, the better the performance. Negative numbers means that the fund has underperformed.

Beta indicates the volatility of a stock in comparison to the rest of the market. The price of the shares in a company with a Beta of 1 moves up or down generally in line with the market. The price of shares with a Beta of less than 1 move up and down at a lesser rate than the market. The price of shares with a Beta greater than 1 fluctuates more widely than the market does. So you would expect to see greater fluctuations in the share price of a stock with a Beta of 1.2 than you would in one with a Beta of .8. The Beta is also said to be an indication of the risk that attaches to a stock. If this is so, and Beta is some kind of measure of risk, it is not the type of risk envisaged by value investors. For example, the current beta rating for Coca Cola is .50. (Beta values for individual stocks are available free from ADVFN).

The Sharpe Ratio measures risk adjusted performance. To find the Sharpe ratio of an investment portfolio fund, you take away a specified risk-free rate (say the long term rate for US Treasury bonds) from the rate of return for the portfolio and divide the answer by the standard deviation of the portfolio returns. The higher the ratio, the better the portfolio has performed on a risk-afjusted basis.

Berkshire Hathaway’s performance

The Yale Report concludes statistically and mathematically that Berkshire Hathaway has a Sharpe Ratio of .76 over the period of time examined. This is much more than that of the overall stock market but the researchers are surprised that it is not higher, having regard to Buffett’s reputation. They put this down to leverage which we discussed in Part 1.

If his Sharpe Ratio is very good but not unachievably good, then how did Buffett become of the the most successful investors in the world? The answer is that Buffett has boosted his returns with leverage and ….stuck to a good strategy for a very long time.

As we said in Part 1, we do not think that the use of premiums by Berkshire has the importance that the researchers give it. Sure, it gives Buffett an advantage over ordinary investors but other big investors with the same advantage - other insurers, banks - do not invest as successfully as Buffett. To their credit, the Yale researchers acknowledge that Buffett has contributed to his success by astute stock picking.

The Buffett stock picks

The report examines mathematically the public company stocks bought by Buffett and concludes that these stocks are generally stocks of high quality bought at low prices. This would come as no surprise to students of Buffett and are consistent with the Benjamin Graham approach: if you can place a value on a stock and buy it at less than its intrinsic value, this is an investment and everything else is speculation. They are also consistent with what we think are Buffett’s general investment principles.

The report also concludes that these stocks are low beta stocks and the Tables provided as addenda to the report gives Berkshire’s stocks an overall rating of .67. Again, we would think that this is consistent with the Buffett strategy of buying good performing businesses rather than buying on hope and future-gazing.

Curiously, the beta rating of Berkshire itself is quite high, leading the report to conclude that it is a stock that fluctuates in wider arcs than the market and thus bears a higher degree of risk. We would think some of the high beta rating for Berkshire stems from the period of the Boom, when Berkshire’s stock price languished while the stock market went crazy over techno-stocks. Then when the Boom collapsed, the reverse happened. In any event the type of risk posed by a high beta is not the type of risk that either Benjamin Graham or Warren Buffett considers.

Benjamin Graham and beta risk

Benjamin Graham invested in an era when beta theory was just developing but was aware that people could misinterpret what type of risk that beta measures. In a paper written by Bruce Grantier, Benjamin Graham is quoted in the following words.

Beta is a more or less useful measure of past price fluctuations of common stocks. What bother me is that authorities now equate the beta idea with the concept of risk. Price variability yes; risk no. Real investment risk is measured not by the percent that a stock might decline in price in relation to the general market in a given period but by the danger of a loss of quality and earnings power through economic changes or deterioration in management.

Warren Buffett and beta risk

Whatever risk beta measures is not the risk Buffett measures. Aberrations like the and other boom-busts aside, it is probably valid to say that mathematically you can calculate a pattern of fluctuations for a particular stock and compare it to the stock market as a whole. It follows that this model can generally predict that a specific stock is more likely to rise proportionately higher than the market and conversely fall to a greater degree than the market.

The risk attached to such a pattern is, as Graham believes, a price risk. So too with Buffett if you accept his often stated view that you invest in a company on the basis of its value as a business and not on the basis that the price of its shares will be higher on the stock market next week, next month or next year. He has famously said on several occasions that if the stock market closed for a year or ten years it would not bother him. Risk to him then is not a variation of price or price dependent. The risk he takes is whether the business of the company will continue to make profits over the long term. A beta rating is not an expression of the worth of a business. Rather it is an expression of the degree of Mr Market’s bipolarism.

We doubt whether Buffett even considers the beta value of a stock when deciding to buy. The only relevance to  him would be that a stock with a high beta might give him a good chance to buy in when it hit its downward point, assuming that the company otherwise warrants buying on his investment principles. In his 1993 letter to shareholders, Buffett explained his attitude to beta measurement in these words.

In stating this opinion, we define risk, using dictionary terms, as “the possibility of loss or injury.”

Academics, however, like to define investment “risk” differently, averring that it is the relative volatility of a stock or portfolio of stocks - that is, their volatility as compared to that of a large universe of stocks. Employing data bases and statistical skills, these academics compute with precision the “beta” of a stock - its relative volatility in the past - and then build arcane investment and capital-allocation theories around this calculation. In their hunger for a single statistic to measure risk, however, they forget a fundamental principle: It is better to be approximately right than precisely wrong.

For owners of a business - and that’s the way we think of shareholders - the academics’ definition of risk is far off the mark, so much so that it produces absurdities. For example, under beta-based theory, a stock that has dropped very sharply compared to the market - as had Washington Post when we bought it in 1973 - becomes “riskier” at the lower price than it was at the higher price. Would that description have then made any sense to someone who was offered the entire company at a vastly-reduced price?

In fact, the true investor welcomes volatility. Ben Graham explained why in Chapter 8 of The Intelligent Investor. There he introduced “Mr. Market,” an obliging fellow who shows up every day to either buy from you or sell to you, whichever you wish. The more manic-depressive this chap is, the greater the opportunities available to the investor. That’s true because a wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses. It is impossible to see how the availability of such prices can be thought of as increasing the hazards for an investor who is totally free to either ignore the market or exploit its folly.

In assessing risk, a beta purist will disdain examining what a company produces, what its competitors are doing, or how much borrowed money the business employs. He may even prefer not to know the company’s name. What he treasures is the price history of its stock. In contrast, we’ll happily forgo knowing the price history and instead will seek whatever information will further our understanding of the company’s business. After we buy a stock, consequently, we would not be disturbed if markets closed for a year or two. We don’t need a daily quote on our 100% position in See’s or H. H. Brown to validate our well-being. Why, then, should we need a quote on our 7% interest in Coke?

In our opinion, the real risk that an investor must assess is whether his aggregate after-tax receipts from an investment (including those he receives on sale) will, over his prospective holding period, give him at least as much purchasing power as he had to begin with, plus a modest rate of interest on that initial stake. Though this risk cannot be calculated with engineering precision, it can in some cases be judged with a degree of accuracy that is useful.

Risk for Buffett is really that a company in which he invests may not be as good a business as he thought it would be. Beta risk is a price risk.

Value investing and modern market theory

The Grantier Paper contains a good discussion of  possible flaws in modern market theory and is worth reading. We would also add that this type of mathematical analysis is generally viewed with cynicism by value investors. As we said in Part 1 of this post, Benjamin Graham is somewhat disdainful about complex mathematical analysis in finding value stocks. As he said in The Intelligent Investor:

Whenever calculus is brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience, and usually also to give speculation the deceptive guise of investment.

Both Charlie Munger and Warren Buffett hold similar views. Munger told the last annual meeting of Berkshire Hathaway shareholders that:

Some of the worst business decisions I’ve ever seen are those with future projections and discounts back. It seems like the higher mathematics with more false precision should help you but it doesn’t. They teach that in business schools because, well, they’ve got to do something.

Buffett, at the same meeting, said that some of modern investment theory is just ‘false and nutty’ and doubted the worth of complex calculations as to value:

If you need to use a computer or a calculator to make the calculation, you shouldn’t buy it.

We think these astute investors are correct in their scepticism about complex mathematical theories to identify investment opportunities but we have to confess that, even in the simple mathematical calculations that we need in value investing, we resort to a financial calculator. Buffett can do these things in his head or with pad and paper: we need the Texas Instruments B-35 Solar Calculator.

Read the Report

We think that the Yale Report, despite our reservations, is well worth reading, because it statistically examines the Berkshire investments and strategies.

Return on equity

Warren Buffett believes that the return that a company gets on its equity is one of the most important factors in making successful stock investments. Return on capital is also important in finding out how well a company is doing.

Defining equity

Benjamin Graham defines stockholders equity as:

The interest of the stockholders in a company as measured by the capital and surplus.

Calculating owner’s equity

Investors can think of stockholders equity like this. An investor who buys a business for $100,000 has an equity of $100,000 in that investment. This sum represents the total capital provided by the investor.

If the investor then makes a net profit each year from the business of $10,000, the return on equity is 10%:

$latex \frac{10,000}{100,000}\times100=10\%&s=2$

If however the investor has borrowed $50,000 from a bank and pays an annual amount of interest to the bank of $3500, the calculations change. The total capital in the business remains at $100,000 but the equity in the business (the capital provided by the investor) is now only $50,000 ($100,000 - $50,000).

The profit figures also change. The net profit now is only $6500 ($10,000 - $3,500).

The return on capital (total capital employed, equity plus debt) remains at 10%. The return on equity is different and higher. It is now 13%:

$latex \frac{6,500}{50,000}\times100=13\%&s=2$

The approach to financing its operations by a company can obviously affect the returns on equity shown by that company.

Why Warren Buffett thinks that return on equity is important

Just as a 10% return on a business is, all other things being equal, better than a 5% return, so too with corporate rates of returns on equity. Also, a higher return on equity means that surplus funds can be invested to improve business operations without the owners of the business (stockholders) having to invest more capital. It also means that there is less need to borrow.

What rate of return on equity does Warren Buffett look for?

This is a fluctuating requirement. The benchmarks are the return on prime quality bonds and the average rate of returns of companies in the market. In 1981, Buffett identified the average rate of return on equity of American companies at 11%, so an intelligent investor would like more than that, substantially more, preferably. Bond rates change, so the long-term average bond rate must be considered, when viewing a long-term investment.

In 1972, Buffett implied that a rate of return on equity of at least 14% was desirable. Although, at times, Warren Buffett has appeared to downplay the importance of Return on Equity, he constantly refers to a high rate of return as a basic investment principle.

Company rates of return on equity

It is significant that the majority of companies in the Berkshire Hathaway portfolio in 2012 had higher than average returns on equity over a ten-year period. For example, the average return on equity for Coca Cola from 2002 to 2011 was 30.38. The lowest ROE in that period was 27.1 in 2011 and the highest was 38.1 in 2010. If you take any of the companies in which Berkshire has major holdings (detailed in Buffett’s 2012 letter to shareholders) and then extract the figures from the information provided by ADVFN, you can compare and analyze the returns on equity that each of these businesses have maintained over the years.

There can be dangers in averaging returns over a long period. A company might start with high rates which then fall away, but still have a healthy average. Conversely, a company might be going in the opposite direction. As Warren Buffett looks for predictability in a company’s earnings, one would imagine that he would favor companies which increase their ROE or which have consistent levels.

Company annual rates of return

Compare the annual rates of return on equity of the following companies. We have used summary figures provided by ADVFN.

Year Coca Cola Amazon Wal-Mart Stores
2002 33.7 0 19.0
2003 30.8 0 20.4
2004 30.3 0 20.3
2005 29.6 135.4 20.8
2006 30.8 44.1 21.1
2007 27.5 39.8 19.8
2008 28.4 24.1 19.9
2009 27.5 17.2 20.3
2010 38.1 16.8 21.1
2011 27.1 8.1 23.3

It is difficult to predict the future earnings of a corporation but the task becomes easier where a company shows a consistent earning power over a period of time. Looking at the tables above, one would feel more confident about predicting the future earnings of Coca Cola and Walmart than those of Amazon. Guess which of these three companies Buffett has not invested in?

You can do this exercise yourself. Choose a company or companies that interest you. Go to the ADVFN website and extract the relevant figures for the period of time on which you are focusing. Compare the returns on equity and examine them for consistency. (You can read about how to register for free on ADVFN here.)

Return on capital is very important

The example early on this page shows that debt financing can be used to increase the rate of return on equity. This can be misleading and also problematical if interest rates rise or fall. Another measure of the ability of company management to earn profits is the percentage of return on capital. This is the rate of return on all the money available to the company - shareholder equity and the proceeds of loans.

As you can see from the example above, if a company has no debt, then the return on equity is the same as the return on capital. If the company uses borrowed funds, the return on equity will be higher than the return on capital. The amount that the return on equity exceeds the return on capital increases as the debt becomes higher.

This is probably one reason why Warren Buffett prefers companies with little or no debt. The rate of return on equity is a true one and future earnings are less unpredictable. A careful investor like Buffett would always take rates of return on total capital into account as well as return on equity to get the true picture of how the company is going.

Over the years from 2002 to 2011, the average return on equity for Coca Cola was 30.38 and the average return on capital was 25.42. Over the same period the average return on equity for Amazon was 28.55 and the average return on capital was 13.78.A comparison of the rates of return on equity and capital for these companies is significant and readers can make their own calculations.

Warren Buffett, Alpha, Beta and leverage: Part 1

A recent report by Yale University researchers argues that there are two reasons why Buffett outperforms the market:

1. He gains the advantage of leverage by using the cash generated by the various insurance companies owned by Berkshire Hathaway and;

2. He buys ”safe” quality stocks with low beta ratings at cheap prices.

The report credits him with being a good stock picker but asserts that, without the leverage of the insurance company funds, Buffett would be a great investor, but not the legend that he is. It also concludes that Berkshire Hathaway is an Alpha investment company with a high beta factor.

The report is well worth reading in full. It is however highly mathematical and needs to be read with an understanding of basic terms and the ways that insurance companies generate earnings. Bear in mind too what Benjamin Graham said in The Intelligent Investor about the use of higher mathematics in share analysis:

In 44 years of Wall Street experience and study, I have never seen dependable calculations made about common stock values, or related investment policies, that went beyond simple arithmetic or the most elementary algebra. Whenever calculus is brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience, and usually also to give speculation the deceptive guise of investment.

This article is in 2 Parts. We will look at the leverage argument in Part 1 and discuss the Alpha and Beta qualities of Buffett and Berkshire and their investments in Part 2 to be posted shortly.

What is leverage?

Leverage in the context of investment properties involves the use of borrowed money to improve investment returns.

Suppose that I buy an apartment for $100,000 and it returns in rentals $10,000 a year, after deductions for taxes, insurances and other expenses. If I pay cash for the apartment and do not borrow money to finance it, my investment return is 10 per cent(10000 x 100 / 100000).

Suppose however that I only put in $50,000 of my own money and borrow $50,000 to finance the transaction at an interest rate of 7 per cent. The interest per year will amount to $3500 and I will have to pay this from the net rental of $10,000. This leaves me a net income of $6500 ($10,000 - $3500). My return on my investment will be improved as I have only used $50,000 of my own money. The return is now 13 per cent (6500 x 100 / 50000). This is leverage.

This leverage applies whether you are buying real estate, shares, bonds or a business. There are obvious conclusions that we can make from this:

  • The higher the percentage of the cost price borrowed, the greater is the increase in the margin.
  • The lower the cost of the money borrowed, the greater is the increase in the margin.
  • Leverage can work in reverse if interest rates increase and the investment income remains static or decreases.

Generally, Warren Buffett avoids buying stock in companies that have high amounts of debt because the  use of this debt as leverage can give a distorted picture of the company’s real earning rates. The Yale report correctly argues however that he is not averse to using borrowed money in the form of premiums collected by Berkshire’s insurance companies to fund his investments and that he in fact does this at low cost. You can find the leverage of any particular company from ADVFN. (Subscriptions are free).

How an insurance company makes its money

A general insurance company works like this. The insurer collects amounts of money (premiums) from the insured person and in return promises the insured person that it will pay a sum of money (the insured amount)  if a certain event takes place.

This event could be the destruction of a building by fire, damage to a motor car in an accident, loss of wages because of illness or injury or any event that the insurer and the insured can agree upon as an event that can be covered. There are even instances where celebrities insure their body parts against injury.

In most instances the insured event will not happen (the house does not burn down, the car is not in an accident, the insured is not off work, the body part is not injured) and the insurer collects all the premium without having to pay out anything; the insurer makes a full profit on the transaction. If however the insured event does happen, the insurer must pay out the insured amount. Whether it makes a profit or a loss on that particular transaction depends upon how long it has been receiving premiums for it.

An insurer needs to calculate the likelihood of paying out on an event. So for example, if it insures 100,000 houses in California against fire it will need to estimate how many of these houses are likely to be the subject of a claim in the next twelve months (the usual length of a home insurance policy). It does this by making an actuarial assessment (an assessment of risk) and calculates its premium rates on the likelihood of pay outs against the totality of the houses it has insured. So, again for example, a house in a high risk fire region would bear a premium higher than one in a low risk area.

In any event, an insurance company collects the premiums and has these funds available for investment. always keeping some in readily available form to cover potential payouts. It can put these funds into shares, bonds, property or other investments or can retain them as cash. The profits generated  from these investments belong to the insurance company and form part of its earnings.

The majority of insurance company earnings come from the investments bought with the premiums collected. Indeed a company could even lose money on its insurance business but still be profitable through these investments.

The argument that Warren Buffett uses leverage to enhance his investment returns

Berkshire Hathaway owns several insurance and reinsurance companies. The Yale paper argues that because Berkshire Hathaway has access to the  premiums  it gathers, it can use them to buy businesses and shares that earn money. In essence its argument is that the premiums are borrowed money, in that they are borrowed against a possible further payout. This, it is argued, gives Berkshire Hathaway access to what is really almost-free money.

The researchers use mathematical calculations to conclude that the leverage on monies borrowed by Berkshire to buy stocks and businesses is about 1.6 to 1; that is for each dollar of its own money that it uses, it borrows (through premiums paid against possible future insurance claims) $1.60. They also calculate that the cost of this ”borrowing” has a notional interest rate of 2.2 per cent.  They conclude that this leverage contributes about half of Berkshire’s annualized profits of Berkshire’s average excess return.

One school of thought says that the premiums collected (in insurance jargon the ‘float’) are not really borrowings.  The reasoning here is that the premiums received by an insurance company are not borrowed from the policy holder but represent  profits (if the total received exceeds the amount of any claim) or losses (if the total received is less than the amount of any claim). As such they belong to the company and, so long as government requirements are met, can be legitimately used by the insurance company as its own money.

The other and more general view is that the float is borrowed money and this is a view supported by Warren Buffett, who explained it like this in his 2012 letter to shareholders.

To begin with, float is money we hold but don’t own. In an insurance operation, float arises because premiums are received before losses are paid, an interval that sometimes extends over many years. During that time, the insurer invests the money. Typically, this pleasant activity carries with it a downside: The premiums that an insurer takes in usually do not cover the losses and expenses it eventually must pay. That leaves it running an “underwriting loss,” which is the cost of float. An insurance business has value if its cost of float over time is less than the cost the company would otherwise incur to obtain funds. But the business is a lemon if its cost of float is higher than market rates for money.

A caution is appropriate here: Because loss costs must be estimated, insurers have enormous latitude in figuring their underwriting results, and that makes it very difficult for investors to calculate a company’s true cost of float. Estimating errors, usually innocent but sometimes not, can be huge. The consequences of these miscalculations flow directly into earnings. An experienced observer can usually detect large-scale errors in reserving, but the general public can typically do no more than accept what’s presented, and at times I have been amazed by the numbers that big-name auditors have implicitly blessed. As for Berkshire, Charlie and I attempt to be conservative in presenting its underwriting results to you, because we have found that virtually all surprises in insurance are unpleasant ones.

The fact that Buffett runs insurance companies and is able to use the float to fund investments does not in itself detract from his performance as both an investor and a manager. First, as he says, the float must be run, and premiums and risk managed, in such a way as to make a profit for the insurance company so that the float is available for investment and the cost of the float is cheaper than money market rates. Buffett’s insurance activities are highly successful due both to his oversight and his skill in choosing good managers like Ajit Jain, a possible Buffett successor.

Secondly, even though the availability of the float does give Berkshire and Buffett an edge over ordinary investors, it does not give them the edge over those investors with similar access to low cost funds like other insurance companies, banks, and hedge funds and mutual funds with low cost borrowings. If all that was needed was low cost leverage, there would be plenty of companies with results as enviable as those of Berkshire. And their managers would be as legendary as Buffett!

Banks in particular hold huge amounts of money at any given time on which they pay no or little interest as a result of business practices or technical innovation: no or low interest accounts; monies received by merchants from customers on their electronic payment machines that are debited immediately to the customer but not paid to the merchant until days later; checks banked to accounts where the proceeds are paid overnight to the collecting bank but not available to the customer for a few days under antiquated clearance rules formulated before the advent of electronic banking; wages paid electronically by employers debited immediately to their account but which do not become available to employees until a day or days later. On the argument of the Yale report, banks then should be the most successful of investors but they are not.

We don’t think it was leverage or float availability that made See’s Candies (a business that has earned Berkshire nearly a billion dollars in profits over the years) a good buy at $25 million or that caused Buffett to buy shares in Coca Cola and the Washington Post Company rather than in Dot-Com boom shares. We think it was great investment ability.

And Buffett must also get credit for his ability to choose managers of Berkshire insurance companies who are able to run those companies at a good profit because the benefits of the float are diminished if an insurer runs underwriting losses, which Buffett says is the norm with most insurers. Buffett has also said that it is not realistic to believe that the Berkshire insurance companies will necessarily continue generating such a float.

Part 2 of this article: Warren Buffett in the context of alpha and beta stocks.

Buffett’s annual letter to shareholders 2012: highlights and analysis

Warren Buffett’s annual letter to shareholders for the 2012 year was released on 1 March 2013. The letter, as usual, contained Buffett’s thoughts on a number of topics as well as informing shareholders of how their company went in the past year.

Berkshire Hathaway Financial Year 2012

Buffett announced that the book value of the company had increased by 14.4 per cent per share for the year, compared to 4.6 per cent in the previous year. This was not a startling rise, compared to the overall market. Buffett was disappointed in the result, noting that the company had underperformed in recent years but felt that a continuation of the company’s investment principles would ensure that Berkshire outperformed the market over the long term.

To date, we’ve never had a five-year period of underperformance, having managed 43 times to surpass the S&P over such a stretch. (The record is on page 103.) But the S&P has now had gains in each of the last four years, outpacing us over that period. If the market continues to advance in 2013, our streak of five year wins will end.

One thing of which you can be certain: Whatever Berkshire’s results, my partner Charlie Munger, the company’s Vice Chairman, and I will not change yardsticks. It’s our job to increase intrinsic business value – for which we use book value as a significantly understated proxy – at a faster rate than the market gains of the S&P. If we do so, Berkshire’s share price, though unpredictable from year to year, will itself outpace the S&P over time. If we fail, however, our management will bring no value to our investors, who themselves can earn S&P returns by buying a low-cost index fund.

Charlie and I believe the gain in Berkshire’s intrinsic value will over time likely surpass the S&P returns by a small margin. We’re confident of that because we have some outstanding businesses, a cadre of terrific operating mangers and a shareholder-oriented culture. Our relative performance, however, is almost certain to be better when the market is down or flat. In years when the market is particularly strong, expect us to fall short.

He emphasised that the businesses owned by the company had done well but there had been no major purchase during the year. However, 2013 has started big with the buy out of Heinz.

Berkshire Hathaway holdings in publicly listed companies

Berkshire Hathaway holds shares valued at $1 billion or more in the following companies. Table of Berkshire Hathaway 2012 holdings


There have been significant increases in the holdings of shares in Tesco and Walmart (up) and Proctor and Gamble (down) during the year and Johnson and Johnson have disappeared from the major list entirely. The big new stock is DIRECTV, chosen not by Buffett but his investment team. DIRECTV is a direct broadcast satellite service provider with nearly 20 million customers.

The insurance business

According the Buffett, they ‘shot the lights out’,  and ‘neither rain nor storm nor gloom at night can stop … the little lizard’ (GEICO). He acknowledged that part of Berkshire’s investment success came through its access to the funds available from the premiums paid to its insurance companies which are low cost, but only low cost if the insurance companies do not make substantial underwriting losses. He asserted that the Berkshire companies were in a good position as to their underwriting business, a factor which he attributed to the skills of the insurance business managers. He cautioned that not all insurance companies were in this position.

Fortunately, that’s not the case at Berkshire. Charlie and I believe the true economic value of our insurance goodwill – what we would happily pay to purchase an insurance operation producing float of similar quality – to be far in excess of its historic carrying value. The value of our float is one reason – a huge reason – why we believe Berkshire’s intrinsic business value substantially exceeds its book value.

Let me emphasize once again that cost-free float is not an outcome to be expected for the P/C industry as a whole: There is very little “Berkshire-quality” float existing in the insurance world. In 37 of the 45 years ending in 2011, the industry’s premiums have been inadequate to cover claims plus expenses. Consequently, the industry’s overall return on tangible equity has for many decades fallen far short of the average return realized by American industry, a sorry performance almost certain to continue.

Underwriting losses were only one factor in what Buffett sees as poor times ahead for insurance companies. Irrational competition by insurance companies for customers and the possibility of increasing national disasters make it essential to have good risk management.

The American economy

Buffett reaffirmed his faith in the American economy and suggested that it was not a good thing to be out of the market at the moment.

American business will do fine over time. And stocks will do well just as certainly, since their fate is tied to business performance. Periodic setbacks will occur, yes, but investors and managers are in a game that is heavily stacked in their favor. (The Dow Jones Industrials advanced from 66 to 11,497 in the 20th Century, a staggering 17,320% increase that materialized despite four costly wars, a Great Depression and many recessions. And don’t forget that shareholders received substantial dividends throughout the century as well.)

Since the basic game is so favorable, Charlie and I believe it’s a terrible mistake to try to dance in and out of it based upon the turn of tarot cards, the predictions of “experts,” or the ebb and flow of business activity. The risks of being out of the game are huge compared to the risks of being in it.


Buffett explained why he is buying into regional newspapers at a time when doom and gloom surround the print media. He explained that, in the days before television, newspapers abounded and even the smaller cities had more than one newspaper with local news, broader-based news, and advertising. As television became the go-to-place for news, cities other than the really big ones became one newspaper towns and were lucrative because they did things that television networks did not do or did not do well; they covered local news and local advertising. Buffett recited an anecdote about a newspaper publisher who attributed his wealth and prominence to two things - nepotosm and monopoly.

The world has changed dramatically with the Internet and a lot of the information that used to be contained in newpapers - news, stock prices, sport, even the literally mocked shipping news - is available at the touch of a key, is current, and is mostly free. What the Internet does not do well is local news and this creates a place for local newspapers.

Newspapers continue to reign supreme, however, in the delivery of local news. If you want to know what’s going on in your town – whether the news is about the mayor or taxes or high school football – there is no substitute for a local newspaper that is doing its job. A reader’s eyes may glaze over after they take in a couple of paragraphs about Canadian tariffs or political developments in Pakistan; a story about the reader himself or his neighbors will be read to the end. Wherever there is a pervasive sense of  xommunity, a paper that serves the special informational needs of that community will remain indispensable to a significant portion of its residents.

Buying good regional newspapers will be a continuing strategy for Berkshire Hathaway and we welcome this.

Charlie and I believe that papers delivering comprehensive and reliable information to tightly-bound communities and having a sensible Internet strategy will remain viable for a long time. We do not believe that success will come from cutting either the news content or frequency of publication. Indeed, skimpy news coverage will almost certainly lead to skimpy readership. And the less-than-daily publication that is now being tried in some large towns or cities – while it may improve profits in the short term – seems certain to diminish the papers’ relevance over time. Our goal is to keep our papers loaded with content of interest to our readers and to be paid appropriately by those who find us useful, whether the product they view is in their hands or on the Internet.


We have studied Buffett for a few years now and while it is certain that his financial skills and boldness have contributed greatly to his success, we believe that it is his ability to think differently to others that has made him the greatest investor of them all.  This is an example of his different way of thinking.

Capital intensive businesses

Berkshire’s two main capital intensive businesses are BNSF Railway and MidAmerican Energy.

Now we know that Buffett does not like to buy shares in companies that require continuing large inputs of capital, where the capex exceeds depreciation and replacement. This is one reason why he has generally steered clear of the large airline companies (plus they are in a very competitive industry).

Where however, Buffett has control of the business and where the market is regulated, Buffett is not averse to capital intensive investments. BNSF, for example, carries about 15 per cent of all inter-city freight and has good contracts in a regulated industry. MidAmerican operates across 10 American states and is a, if not, the leader in renewable energy, a good position to be in having regard to the new focus on the environment by the Obama administration promoted by the President in his 2013 State of the Union report.

The good news is, we can make meaningful progress on this issue while driving strong economic growth. I urge this Congress to pursue a bipartisan, market-based solution to climate change, like the one John McCain and Joe Lieberman worked on together a few years ago. But if Congress won’t act soon to protect future generations, I will. I will direct my Cabinet to come up with executive actions we can take, now and in the future, to reduce pollution, prepare our communities for the consequences of climate change, and speed the transition to more sustainable sources of energy.

Four years ago, other countries dominated the clean energy market and the jobs that came with it. We’ve begun to change that. Last year, wind energy added nearly half of all new power capacity in America. So let’s generate even more. Solar energy gets cheaper by the year – so let’s drive costs down even further. As long as countries like China keep going all-in on clean energy, so must we.

In the meantime, the natural gas boom has led to cleaner power and greater energy independence. That’s why my Administration will keep cutting red tape and speeding up new oil and gas permits. But I also want to work with this Congress to encourage the research and technology that helps natural gas burn even cleaner and protects our air and water.

Buffett has acknowledged that these two companies are going to require large capital contributions in the future but believes that the investment will return reasonable earnings in their respective regulated industries. The figures would seem to justify this belief with both companies returning increased profits over 2011. And he is confident that the earnings of both companies can more than adequately cover present and potential debt.

A key characteristic of both companies is their huge investment in very long-lived, regulated assets, with these partially funded by large amounts of long-term debt that is not guaranteed by Berkshire. Our credit is in fact not needed because each business has earning power that even under terrible conditions amply covers its interest requirements. In last year’s tepid economy, for example, BNSF’s interest coverage was 9.6x. (Our definition of coverage is pre-tax earnings/interest, not EBITDA/interest, a commonly-used measure we view as deeply flawed.) At MidAmerican, meanwhile, two key factors ensure its ability to service debt under all circumstances: the company’s recession-resistant earnings, which result from our exclusively offering an essential service, and its great diversity of earnings streams, which shield it from being seriously harmed by any single regulatory body.

Whether companies should pay dividends

Most companies pay dividends and this keeps shareholders happy as it gives them a return for the capital locked up in a shareholding. Berkshire Hathaway has never paid a dividend under Buffett’s control and this has caused some dissatisfaction among shareholders as the only way that they can get walking-around money is to sell some of their stock. It has also dissuaded some investors and institutions from buying Berkshire stock because they need to generate income from their investment.

Buffett does not advocate that companies should not pay dividends. His view is that if a company can use its earnings productively to grow the company (investing in income producing assets, in improving productivity, and buying back shares when the price is below its intrinsic value), it should do so, rather than return the money to shareholders by way of dividends. If, and only if, the managers of the company cannot do this, they should return the money to its owners by way of dividends.

Buffett believes that he and Charlie Munger can and do do this and this is why Berkshire does not pay dividends and is unlikely to do so under the present regime. So what about those shareholders who need income? Buffett’s solution is for them to sell a certain portion of their shareholdings as he does (well, actually he gives his to charity) and they will be better off financially than if the company paid dividends. How is this possible? Buffett explains it like this (Caution: you need to think this one through.).

We’ll start by assuming that you and I are the equal owners of a business with $2 million of net worth. The business earns 12% on tangible net worth – $240,000 – and can reasonably expect to earn the same 12% on reinvested earnings. Furthermore, there are outsiders who always wish to buy into our business at 125% of net worth. Therefore, the value of what we each own is now $1.25 million.

You would like to have the two of us shareholders receive one-third of our company’s annual earnings and have two-thirds be reinvested. That plan, you feel, will nicely balance your needs for both current income and capital growth. So you suggest that we  pay out $80,000 of current earnings and retain $160,000 to increase the future earnings of the business. In the first year, your dividend would be $40,000, and as earnings grew and the one third payout was maintained, so too would your dividend. In total, dividends and stock value would increase 8% each year (12% earned on net worth less 4% of net worth paid out).

After ten years our company would have a net worth of $4,317,850 (the original $2 million compounded at 8%) and your dividend in the upcoming year would be $86,357. Each of us would have shares worth $2,698,656 (125% of our half of the company’s net worth). And we would live happily ever after – with dividends and the value of our stock continuing to grow at 8% annually.

There is an alternative approach, however, that would leave us even happier. Under this scenario, we would leave all earnings in the company and each sell 3.2% of our shares annually. Since the shares would be sold at 125% of book value, this approach would produce the same $40,000 of cash initially, a sum that would grow annually. Call this option the “sell-off” approach.

Under this “sell-off” scenario, the net worth of our company increases to $6,211,696 after ten years ($2 million compounded at 12%). Because we would be selling shares each year, our percentage ownership would have declined, and, after ten years, we would each own 36.12% of the business. Even so, your share of the net worth of the company at that time would be $2,243,540. And, remember, every dollar of net worth attributable to each of us can be sold for $1.25. Therefore, the market value of your remaining shares would be $2,804,425, about 4% greater than the value of your shares if we had followed the dividend approach.

Moreover, your annual cash receipts from the sell-off policy would now be running 4% more than you would have received under the dividend scenario. Voila! – you would have both more cash to spend annually and more capital value.

This calculation, of course, assumes that our hypothetical company can earn an average of 12% annually on net worth and that its shareholders can sell their shares for an average of 125% of book value. To that point, the S&P 500 earns considerably more than 12% on net worth and sells at a price far above 125% of that net worth. Both assumptions also seem reasonable for Berkshire, though certainly not assured.

Moreover, on the plus side, there also is a possibility that the assumptions will be exceeded. If they are, the argument for the sell-off policy becomes even stronger. Over Berkshire’s history – admittedly one that won’t come close to being repeated – the sell-off policy would have produced results for shareholders dramatically superior to the dividend policy.

In Buffett’s case it has worked like this. He says that the book value of his current interest in Berkshire in 2005 was $28.2 billion and it is now worth $40.2 billion. Even though in that time he has given away a heap of shares (shareholding reduced from 712,497,000 B-equivalent shares - split adjusted - to 528,525,623), the value of his holding has grown by $12 billion, a rise of 43 per cent. And the other advantage is that in most regimes the tax payable on capital gains is less than that payable on income.


This is another example of Buffett’s original thinking. I think I will write to the directors of companies in which I hold shares and where management is putting earnings to good use and ask them to stop paying dividends.

The succession

Buffett fulsomely praised Todd Coombs and Ted Weschler, two possible successors, and increased the amount of Berkshire money that they have to play with. He said that they are both young and will be managing the Berkshire portfolio after he and Munger have gone. As he has done in the past few letters, he has again acknowledged the contribution made to the underwriting business of Ajit Jain but in no greater terms than he praised other Berkshire insurance managers.

Nothing in Buffett’s comments have caused us to alter our belief that the leadership of the company will, after Buffett leaves, be divided.


As in past years, Warren took the opportunity to recommend some good books for investors. We have added these to our list of Buffett’s book recommendations.

Will Ajit Jain succeed Warren Buffett?

The culture of a company is important to Warren Buffett, and culture is embedded in Berkshire Hathaway more than in most companies. Buffett has said that:

Your attitude on such matters, expressed by behavior as well as words, will be the most important factor in how the culture of your business develops. Culture, more than rule books, determines how an organization behaves.

This means that the successor to Buffett is likely to be someone who values the Berkshire culture, as well as having the skills and personality necessary for a chief executive. Buffett would want somebody who will be a custodian of Berkshire’s culture and his culture.

Ajit Jain, the CEO of Berkshire Hathaway Reinsurance Group, and who also currently heads Berkshire Hathaway Assurance Company, is seen by many as a carrier of Berkshire’s culture and a contender to take the throne after Warren Buffett. Known as “Superstar” to the Oracle of Omaha, Buffet has described Ajit Jain as being  invulnerable to kryptonite, with the skill and audacity to turn risky insurance accounts into profitable ones.

Ajit Jain’s career

Ajit Jain was born on July 23, 1951 in India’s coastal state of Orissa. He graduated in 1972 from the Indian Institute of Technology (Kharajpur) with a Bachelor’s degree in Engineering, but his subsequent career confirms the comment by his former class mate, Ronojoy Dutta, that his interests lay more in economics and sociology than the subject he chose to enter. That said, his degree at the prestigious IIT created opportunities for him at the Tata Steel Company and IBM India, and a pathway to his future career.

Ajit moved to the United States in 1976 and received an MBA from Harvard Business School in 1978. He joined McKinsey and Co after graduating from Harvard, but went back to India in the early 1980s and, after his marriage to Tinku Jain, returned to the USA to work again for McKinsey. In 1986, despite knowing little about the insurance business, he left McKinsey to join the insurance operations of Buffett on the reference of his former boss at McKinsey.

Berkshire Hathaway’s reinsurance business

Jain has worked for Buffett ever since and now heads Berkshire Hathaway Reinsurance Group. Reinsurance involves insuring other insurers. Insurance companies often reduce their potential pay-outs on particular risks by off-loading some of that risk to other insurance companies and for this they pay a premium. Berkshire Hathaway Reinsurance specializes in this form of transaction, taking on part of the risk of other companies and charging fees for doing so. It is a complex and business and requires great actuarial skills in assessing and managing risk.

Jain has built up Berkshire’s reinsurance business and, under the umbrella of his leadership, his unit controls some seventy insurance companies around the world. Jain also set up the Berkshire Hathaway Assurance Company which insures state and municipal bond issues.

Jain is said to take on and profit from risks that his rivals avoid, including mega-catastrophe insurance coverage. For instance, he covered the Sears Tower in Chicago, America’s tallest building, even after September 11, and the Winter Olympics at Salt Lake City in 2002, which other insurance groups thought too risky. This has been a succcesful strategy to date but it is a high risk venture which could go horribly wrong. Jain, and Buffett, seem to believe that it is a calculated risk. And we understand that in policies of this nature, very high premiums are charged, coverage kicks in only for the excess over a certain amount of monetary loss, and loss caused by events involving weapons of mass destruction are excluded.

Buffett on Jain and Jain on Buffett

Jain is said by Buffett to have made more money for Berkshire than he has. Warren Buffett describes Jain’s role like this:

From a standing start in 1985, Ajit has created an insurance business with a float of $30 billion and [he has made] significant underwriting profits, creating a remarkable benchmark that no CEO of any other insurer has come close to matching.

Jain in turn has described Warren Buffett as ‘the best boss ever’ and feels that he has been extremely fortunate to work with Buffett, because Buffett is an easy and flexible person to work with. Jain has said of Buffett:

You get what you see. He is a very simple, down to earth person with very simple tastes.

Jain has stuck with Berkshire because he feels that he has won a giant lottery. According to Jain this lottery is not in terms of money; instead it is the opportunity to work for Warren, and no amount of money can substitute for working for a boss for whom you have the utmost respect. Ajit has also said that he prefers to stay with Berkshire because Warren Buffett has treated him more than fairly, and he has learned a lot from him.

Will Jain succeed Buffett?

Warren Buffett continues to praise Ajit Jain in his annual letters to shareholders and this is one reason why he is favored by many to be Buffett’s successor. His proven skills in assessing risk and making money for Berkshire, and Buffett’s belief that Jain has soaked up the Buffett culture, all add to his chances of getting the top job and carrying on the legacy.

There are however other candidates and it remains a strong possibility that there will be not one successor but several – Chairman, CEO, Investment Guru. Even if Ajit Jain does not become the successor to Buffett, it is certain that he will occupy a key position in the Berkshire group.

Durable competitive advantage: Why Buffett likes food and drinks

We know that Warren Buffett likes to buy companies that have such a competitive advantage in the market that it is like a moat protecting a castle. A business with this competitive edge would have all or most of the following attributes:

  • an easily recognized brand name (or brand names)
  • a predominant share in a market or market segment
  • a product that people need or want to buy over and over, and
  • a place in a market that is not easy to enter.

Berkshire Hathaway and Buffett have in the past put a lot of money into things that we eat and drink. They continue to do so because many companies in this field have a moat. Berkshire’s latest acquisition in Heinz is no exception.

At first glance the markets in which these companies operate seem highly competitive. The food and drink businesses in the Berkshire portfolio all have competition for their products, not only from other brand name manufacturers (Coca Cola and Pepsi, Heinz and Campbell) but from the home brands of grocery chains. However, in a competitive market, it is possible for businesses to occupy a place that, because of their name, the nature of the product and customer preference,  still gives them that competitive edge. This is because customer loyalty, sometimes bordering on fanaticism, creates a monopoly for that group of customers.

Take the hamburger industry. You can buy hamburgers anywhere, but there is a large segment of the hamburger-consuming market that will only eat McDonalds and for whom McDonalds is a life-long eating passion. These people will keep producing profits for McDonalds day in and day out for the foreseeable future.

Look at the cola market where the world is divided between Coke drinkers, Pepsi drinkers and the rest. The loyal Coca-Cola drinker will continue to drink Coke in preference to the others no matter what, will continue to buy it even if the price goes up a few cents, and this attitude ensures that retail outlets will always stock it. This has been happening for many years and should continue for many more, unless some foolish CEO, wanting to fix something that works well, decides to change the recipe. (You can read about the New Coke debacle in Mark Pendergrast’s history of the Coca Cola company - For God, Country, and Coca-Cola: The Definitive History of the Great American Soft Drink and the Company That Makes It).

This type of thinking has seen Buffett buy stock over the years, not only in Coca Cola and Pepsico (which has Frito-Lays and other brand name snack foods as well as Pepsi) but in businesses like Yum Foods (KFC, Taco Bell and Pizza Hut), See’s Candies, Anheuser-Busch (Budweiser), Wrigley and Hershey: all companies with brand-name foods or drinks, all within a competitive market (fast food, snack food, alcoholic drinks, non-alcoholic drinks) but which, because of customer preference and loyalty built up over many years, occupy a position within that market that has a moat.

This reasoning applies to food companies like Campbells and Heinz, both of which have attracted Buffett’s interest over the years (Heinz now in a very big way). There are several brands of canned soup, baked beans, spaghetti and the like on the market but there are segments of the population who will only buy Heinz or Campbells and will go on buying them forever. Try putting a ketchup other than Heinz on the hamburger of a Heinz fan and sit back for the complaints. And on this basis, the Heinz takeover makes sense, although Berkshire has probably paid top price.

Companies like these, although in price-competitive markets, can also generally raise the price of their products gradually to cover inflation and rising production costs without losing customers. And they are big enough not to be taken advantage of by the large supermarket chains.

But remember that Buffett only buys into these companies when they satisfy all his other investment guidelines and when he can buy at the right price. And he will sell, despite his preference to own stock in a company forever, when the company ceases to hold its value and when he can put the money invested in it to better use.