Author Archives: Julian Livy

Review: Why I left Goldman Sachs: A Wall Street Story, by Greg Smith

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After reading this book, I have became more convinced than ever that intelligent investors should make their own investment choices, using the sound principles recommended by Ben Graham and Warren Buffett. If they can’t do that, they should put their share investment money into an appropriate index fund rather than a mutual fund. Greg Smith’s account of his time at Goldman Sachs says a lot about the way mutual funds invest your money.

Smith went to work for Goldman Sachs as an intern and worked his way up to the position of vice-president - not as grandiose as it sounds, because there are hundreds of them in the firm. Still, it was high enough for Smith to be in a position to see exactly what the firm was doing while he was there.

Smith bemoans the gradual erosion of ethical principles at Goldman Sachs. The founders and their successors, before the firm went public, formulated ethical business rules for Goldman managers and employees. Rule 2 stated that:

Our assets are our people, capital and reputation. If any of these is ever demolished, the last is the most difficult to fill.

Smith says that, as people in the firm became greedier, this rule went by the wayside and was replaced by an ethos of putting the firm before the client. This led to a belief that there was no form of fiduciary duty owed to clients who traded through Goldman Sachs, allowing the firm to benefit from trades at the client’s expense. Smith details many instances of this.

Allied to this was the personal greed of individuals in the firm from high to low, partly caused, in Smith’s view, from a change in the way bonuses were paid. When he first went there, bonuses were calculated on fees earned by the employee and an assessment of the value that the employee added to the firm. This was replaced by a system of bonuses payable only on the amount of fees that the employee generated. As Smith was told by his supervisor, “We are not interested in ideas … only in numbers.”

This in turn generated a loss in reputation. Smith was shocked when, after being posted to London, and giving a long talk on the ethos of the firm to a client, he was told by the client that it did not trust Goldman Sachs an inch but would still continue to deal with it because of its expertise and reach.

What particularly surprised me, and the thing that convinces me to steer clear of mutual funds, is that Goldman Sachs, as with presumably other banks and advisory firms, was able to persuade, with little effort, managers of mutual funds, (even those that were otherwise capably run or which were conservative in their investment attitude) to buy risky derivatives of the kind that almost wrecked the financial system. I got the impression that many of these fund managers were just too lazy or too dumb, or simply didn’t care. I suspect that if you recommended to the average mutual fund member that he or she put their money into some bizarre and complex derivative, they would turn you down flat. Yet, at the heights of this insanity, and without the knowledge or approval of members, fund managers were doing just that with members’ funds.

Smith recounts how, at a crisis point in the financial meltdown, Warren Buffett publicly stepped in and helped out Goldman Sachs by taking a multi-billion dollar position in the firm in preferred shares. This was a good transaction for Buffett as he got a good coupon rate and priority of payment with the option to convert into ordinary stock down the track. It also boosted the confidence both of Goldman and the market generally. Buffett said at the time that Goldman Sachs was an exceptional institution with outstanding intellectual and financial capital and emphasized its global reach and good management. A Goldman director commented that Buffett’s investment meant that he had great faith in the integrity of the firm.

If the director correctly interpreted Buffett’s statement, I can only assume that Buffett was speaking with his tongue in his cheek because shortly after the director spoke, Goldman was prosecuted for misleading a large hedge fund and had to pay out nearly a billion dollars in settlement. This incident is colorfully recounted in Smith’s book. The company subsequently has had fines imposed on it by the SEC but these amounts are insignificant when set against Goldman’s earnings. One might wonder about Buffett’s faith in this company, particularly as he has often commented upon the need for integrity in business.

This is an interesting and well written book. It will not teach you how to invest but it will probably teach you to be very careful in who you choose to invest your retirement funds. I also wouldn’t be buying stock in Goldman Sachs anytime soon.

Purchase Why I Left Goldman Sachs: A Wall Street Story at Amazon.com

Watch an interview with Greg Smith from 60 Minutes:

Why is Warren Buffett buying Heinz?

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Berkshire Hathaway has launched what it appears will be a successful bid for Heinz in conjunction with 3G Capital, a Brazilian private equity firm. But does it fall within Buffett’s normal investment criteria?

Is this a typical Buffett deal?

On the surface, it appears that this is outside Warren Buffett’s usual investment parameters. The buyers are borrowing some of the purchase monies, the price is well in excess of the price to earnings ratio that Buffett normally pays, and Buffett has said in the past that he does not like private equity firms all that much. In addition, private equity firms generally buy a company, restructure it by selling surplus assets and/or downsizing the work force, and then on-selling the new entity as soon as possible. Buffett, on the other hand, is generally a long term investor.

A quick look at the Heinz buy-out from a Buffett perspective

We might take a preliminary look at the buy out, the full details of which are not yet available, in the light of the things Buffett is known to care about.

Does the company sell brand name products that are likely to endure?

Heinz and its brands - Heinz, Lea and Perrins, Greenseas - are known all over the world and have been for many years. The answer here is yes.

Is the business of the company easily understood?

We would think that it is. The company is in the food business with an easy to understand business plan: it makes and wholesales ready-made, or easy to prepare, food products.

Does the company invest in and operate businesses within its area of expertise?

As far as we can make out, the company sticks to what it knows - making and selling foods. It does not appear to dabble in exotic businesses.

Does the company have the ability to maintain or increase profitability by raising prices?

The businesses that it is in are highly competitive but within its industry segment, it has pretty close to what Charlie Munger calls a moat; that is, a competitive edge. Sure - you can buy lots of  brands of soup, baked beans or ketchup but some people will only buy Heinz, and when they use up a can or bottle will replace it. This is the repeat, cash producing business that Buffett loves. And it allows the company to edge up its prices to cover inflation and increased labor costs. Anyone who likes Heinz tomato soup is not going to stop buying it just because it goes up a cent or two.

And the size and market dominance of Heinz means that it is unlikely to be held hostage by big supermarket chains. Can you imagine a supermarket refusing to stock Heinz?

Is the company, looking at both long-term debt and the current position, conservatively financed?

The last balance sheet suggests that the company has long term debts of $4.78 billion and annual profits of $939 million. If we work on Buffett’s theory that a company should be able to pay its long term debt off out of current profits within 5 years, dividing the debt by the profit gives us just over 5 years, a little high and just outside the margin.

The current ratio of 1.46 is also higher than Buffett generally likes.

In addition, the joint buyers are funding part of the purchase price through borrowings, which will flow through to the company’s overall debt position. Although Berkshire is providing part of the purchase monies through taking preferred shares, why did Berkshire not put up all the loan capital, particularly when it is sitting on surplus cash? There could be a couple of reasons for this. First, interest rates in America are historically very low. Second, perhaps part of the deal with the private equity partner is to turn around any surplus assets in the company quickly.

Update

The details of the purchase are becoming clearer. As we understand it, at the offer price, the deal will cost about $23 something billion. Of this amount, Berkshire and 3G Capital will each put in about $4 billion, Berkshire will put in another $9 billion in exchange for preferred shares, and the balance will be by way of loans. Two comments: First, the preferred shares will pay 9 per cent, a good rate of return for Berkshire at a time of low interest rates. Secondly, the loan proportion is quite low , compared to the usual private equity buyout model.

Does the company show consistently high returns on equity and capital?

Return on equity over the last five years has been in percentage terms 44.8, 75.7, 46.7, 32,4, 34.1. Buffett would love this. Even though the rate is coming down, it is still a ROE that most companies would die for. The return on capital is much less, probably reflecting borrowings, but is still acceptable: 12.8, 14.7, 13.7, 16.3, 12.5.

Have the earnings per share and sales per share of the company shown consistent growth above market averages over a period of at least five years?

Earnings per share over five years has been 2.67, 2.94, 2.89, 3.09, 2.87. Steady but would not past the usual Buffett test. Sales tell a similar story.

Has the company been buying back its shares, and if so, has it bought them responsibly?

We have not had time to research this.

Has management wisely used retained earnings to increase the rate of return to shareholders?

We have not had time to make this calculation.

Is the company likely to require large capital sums to ensure continuing profitability?

Probably not, although the increased borrowings to finance the purchase may be a limitation on what the company can do.

Putting it all together

We figure that Buffett and Munger know better than we do what they see in Heinz but, apart from its competitive edge, brand name, and huge capacity to earn money per share, this looks to us as an investment outside Buffett’s usual parameters. Or perhaps he knows something that we don’t. Another curious thing is that Berkshire is handing the management of the deal over to its private equity partner. So Buffett must have a lot of faith in their capacity and their integrity, two traits that he values highly. He has said of the deal that:

Heinz is our kind of company with fantastic brands … Its my kind of deal and my kind of partner.

The owners of 3G seem to be somewhat different to other private equity tycoons insofar as they engage in active management of the bought out company. This may be what Buffett sees in them but still they remain private equity operators.

It remains to be seen what happens at Heinz but it would not surprise us if, after the deal goes through, there is some kind of redistribution of assets with Berkshire being left with a sized-down food company with the famous brands and the repeat consumer business that Buffett so loves.

The Graham defensive strategy and Buffett modifications

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In The Intelligent Investor, Benjamin Graham laid out strategies for various categories of investors in markets. One category is the defensive investor who Graham said had two choices.

One choice was to invest broadly across the field in what he called a Dow Jones Industrial Average type of investment and which is today reflected in index funds. In other words, the investor invests in a particular market (Dow Jones Industrial Average companies, S&P top 500 corporations) by buying units in an index fund that replicates that market.

The other option is for the investor to select a portfolio of stocks and bonds on both a qualitative and quantitative basis using specific criteria that he laid out. The portfolio should be diverse (quantitative) and part of the portfolio should be in bonds or equivalent. These are the criteria for quality.

The target company should be adequately sized

Graham thought that the business should have at least $100 million dollars in annual sales. Bearing in mind the change in value of money since Graham last revised his book, we would think that this figure should be increased to at least $500 million. In an era of larger companies, the figure could perhaps be even higher. We should emphasize here that we are talking in the context of the American business market. Investors in stocks in countries with smaller economies should make their own estimation of what is an adequate size.

Buffett’s perspective on company size

We believe that, as a general rule,  Buffett follows this rule in relation to listed companies. If you look at the current holdings of Berkshire Hathaway, very large businesses dominate their holdings. Buffett’s often repeated statement that he would rather buy shares in a great company at a fair price than in a fair company at a great price would seem to confirm this.

The target company should be in a reasonably strong financial condition

Graham’s way of assessing this is to look at the ratio of current assets to current liabilities. This is the current ratio and should be at least 2:1. This makes sense. A business that has difficulties meeting its commitments as they fall due, irrespective of its long term financial viability, is always at risk if something unexpected happens that could trigger a liquidity crisis. In 2008, in the Global Financial Crisis, banks suddenly called in overdraft loans, causing businesses with an insufficient current ratio to scramble for funds. Some investment advisers think that a ratio of 1.5:1 is acceptable for companies with a short operating cycle.

Buffett’s perspective on current ratio

It is clear that Warren Buffett has a similar approach to Graham. He is known to shun companies that have too much debt although his focus is on long term rather than short term debt. Buffett looks at how long it will take a business to pay off its long term debt from current earnings. The longer the period, the higher the risk.

Earnings stability

Graham is somewhat vague on this criterion stating that the company should have some earnings in each of the past ten years. We are assuming by this that Graham is referring to profits and would comment that this could rule out a company that has one bad year through some event that is unlikely to be repeated. Also, the ten year limit is possibly too prescriptive. This principle is a purely defensive one.

Buffett’s perspective on earnings stability

We think that Buffett looks at companies whose earnings grow over a period rather than being satisfied that they had profits in each of the ten years. This means that he does not necessarily rule out a company that has a year of low growth or even negative earnings as a good investment. If the circumstances causing the low growth or negative earnings are not the result of bad management or a flaw in the company’s business plan and is unlikely to be repeated in following years, and the business otherwise qualifies as a worthwhile investment, we think Buffet would see this as an opportunity to increase his holdings rather than reduce them, particularly if the market overreacted. Remember that he says to be fearful when others are greedy and greedy when others are fearful.

The target company should have an uninterrupted payment of dividends

Graham puts the period for the dividend payments by companies at 20 years.  Again, this is purely a defensive requirement and, as such, is a valid position. As with earnings however, this does not take into account unusual circumstances in a particular year that is unlikely to be repeated.

Buffett’s perspective on dividends

Berkshire Hathaway has never paid a dividend during Buffett’s tenure and this reflects his belief that profits should be retained by a company to increase the value of the business. It is only when management cannot usefully use earnings to grow the company that they should be returned to shareholders. This is one explanation for the high annualized growth of Berkshire. If it had paid some of its earnings back to shareholders by way of dividend, the increase in value of its shares over the years would have been less.

There are also tax advantages. Dividends bear ordinary rates of tax whereas if shares are sold, the capital gain (represented partly in Berkshire by non-payment of dividends) bears tax generally at a lower rate. And of course while the shares remain unrealized no tax is payable. This can cause a problem for some Berkshire investors as, dividends not being paid, the only way they can derive cash from the shares is to sell them.

The target company must have earnings growth

Graham feels that a company needs to show an increase of at least one third per share over the last ten years, using three year averages. This is not a high hurdle and would only keep up with inflation if there are no excessively high inflation years. The USA Consumer Price Index in December 2002 was 179.88 and in December 2012 was 229.554.   This represents a rise of 27.61 per cent, below Graham’s requirement of 33.3 per cent but not by a lot.

Buffett’s perspective on earnings growth

Buffett generally prefers a higher rate of growth but his main concern is that earnings grow rather than remain static or go backwards. That said, one of Berkshire’s main investments  and one in which it continues to acquire shares is Wells Fargo with an average growth rate of 2.2 per cent over the last ten years, satisfying neither Buffett nor Graham’s requirements for earnings growth. Of course, the earnings growth of Wells Fargo in common with those of other financial stocks came to a sudden stop during the years of the Global Financial Crisis and actually regressed. This would indicate that Buffett is not seeing a repitition of the events of 2007 and 2008 as likely.

The price of the shares of the target company must reflect a moderate price to earnings ratio

For Graham, the price/earnings (P/E) ratio should be less than 15 based on the last three years average, reflecting the historical ratio of the market.

The P/E ratio is important in making investment decisions because it provides a way of calculating risk. Look at it this way. If you buy shares in a company for $100 and it has a P/E ratio of 20, this means that it is earning for you as a part owner of the company $5 a year (100 divided by 20). If Treasury Bonds have a coupon rate of 5 per cent, why would you buy shares in a business that carries risk in preference to an almost risk free investment - government guaranteed bonds? This is one reason why the prices of shares fall when government interest rates increase and vice versa.

Graham’s figure of 15 is based on his estimate of the long term average rates of government interest rates and his assessment of the risk in buying common stocks.

Buffett’s perspective on P/E

Buffett’s big and successful purchases have generally been at prices with smaller P/E ratios than 15, so we would think he pays a lot of attention to this requirement.

The price of the shares in the target company must reflect a moderate price to book value ratio (P/BV)

According to Graham, the ratio of price to assets (which he equates to the book value) should not be more than 1.5. However, he suggests that this must be looked at in the light of the P/E ratio. If the P/E ratio is less than 15, then the P/BV ratio can be higher and vice versa. He uses as a rule of thumb a formula that says that the product of the P/E multiplier times the ratio of price to book value should not exceed 22.5. This is sometimes called the Graham ratio. So, using his parameters of 15 for a P/E ratio and 1.5 for a P/BV ratio, we multiply one by the other and get 22.5. If the P/BV ratio was 1.2, then, on the Graham ratio, the stock could have a P/E ratio of 18.75 and still fall within the allowable investment range (1.2 x 18.75=22.5).

Buffett’s perspective on P/BV

To Benjamin Graham, book value  generally meant net tangible assets. He did not take into account intangible assets such as intellectual property, mastheads, goodwill and brand name, what Buffett thinks of as economic goodwill. Buffett appears to think differently, placing a lot of emphasis on what he calls intangible good will, an asset that produces profits without the need to invest further capital in it. It is not clear how Buffett values this, but it is certainly a factor in making a decision as to whether a business has a moat, a decided competitive advantage.

What do we mean by value investing?

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Value investing

Value investing is a much used phrase and means, in general terms, buying something for less than it is worth. It can apply to just about anything. You can value invest in shares, in bonds, in property, in postage stamps, in vintage cars. The difficulty is in calculating the value of the thing in which you are investing. In many things (postage stamps, collectible cars etc), the only way that value can be determined at any given time is the price that someone is prepared to pay for the item at at that time. The investor in that asset is, as a result, subject to the opinion of others.

Benjamin Graham proposed a method of calculating the value of a stock and Warren Buffett has both applied and enhanced Graham’s approach.

Benjamin Graham: the ‘father of value investing’

It was Benjamin Graham who applied to the theory of investing the concept of intrinsic value. According to Graham, if you can determine the intrinsic value of a share, then you can ascribe to that share a real value that is not dependent upon the opinion of others (the whims of Mr Market). If you can then buy that share at a price less than its intrinsic value, giving yourself a satisfactory margin of safety, you have made a prudent and rational investment. An investor who holds a diverse portfolio of stocks acquired by this process should, over time, finish ahead.

Benjamin Graham did not apply the term value investment to this investment approach; that has been done by others. He did however called this intelligent investing, indeed the only real form of investing. Buying shares on the basis of value is investing. Buying shares on other bases such as the belief that the market will rise generally, or that a particular industry is good, or that others will bid the price up, is not investment but speculation.

Graham’s basic principles of value investing

In The Intelligent Investor, Graham sets out his strategies for making investments based on value for various types of investor - passive and active, defensive and enterprising - but each approach rests on these basic principles:

  • When you buy a stock, you are buying a share in a business.
  • The market price of a stock is only an opinion of the value of the stock and does not necessarily reflect the real value of that stock.
  • The future value of a stock is a reflection of its current price.
  • An investor must always build a margin of safety into the decision to buy a stock.
  • Intelligent investing requires a detached and long term approach, based on careful research and reason, and not on the opinions of others or the prospects of short term gains.

Warren Buffett and value investing

The fact that Graham suggested different strategies for what he called defensive investors and enterprising (and more enterprising) investors does not mean that value investments and growth investments are mutually exclusive. Warren Buffett has shown that you can value invest in shares that grow over time. He has always acknowledged that his investment style is based on Benjamin Graham’s principles and he cannot understand why all investors don’t do the same thing. In March 2012, Buffett told a group of MBA  students that:

The principles of value investing have not changed from the teachings of Ben Graham until now.

Buffett identified for the MBA students the two factors that mark the value investor: a long term perspective and the patience to not seek to get rich overnight: value investors are not concerned with getting rich tomorrow but over a ten year period instead.

There is nothing wrong with getting rich slowly.

But Buffett has added his own riders to Graham’s tenets and to some extent introduced a subjective element to the objectivity of Graham, particularly in his preference for businesses with a competitive advantage.

He gave the MBA students his (and our) favorite example  - Coca Cola. He explained that people will go on drinking Coke because they like it; possible loss of markets in the Western world because of health concerns or competition is more than made up by new customers in other countries; the company has been doing the same thing for many years; it sticks to its core business; and if it decides to add a cent or two to the sale price of a Coke to adjust for inflation or to cover any loss of margins, nobody is going to stop drinking it.

At various times, Buffett has decided that Coke has fallen below its intrinsic value and stepped in and bought shares - that is value investing.


Buffett sums up value investing

When Buffett was asked to explain his investment strategy, the words that he used essentially reflect the essence of value investing: look at a stock, assess its value, work out a price that you can pay for it with a minimum of risk, wait patiently for that price and then buy in when you can. Buffett said:

Invest in equities slowly over time … And look to buy companies that will go on forever like Coca Cola … but the key is to buy equities slowly over time and don’t try to time the market. For the more serious investor, buy equities strategically, opportunistically.

Warren Buffett on investing in gold

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The price of gold has has risen sharply in recent years and it is seen as a good hedge against inflation, particularly in the non-Western countries. According to the World Gold Council, the price has just about doubled in the last five years, going from $800 an ounce in 2008 to $1670 or so today. (In 2003, the price was half the 2008 price).

This is a very good return, better than the market and better than Buffett’s own Berkshire Hathaway during that period. So why is Buffett not into gold? He said why in his 2011 letter to shareholders in which he divided investments into three classes; currency denominated investments which are at the risk of inflation, government decisions and speculation; investments that depend on the intention of others (where you buy an asset in the hope or expectation that someone else will pay a higher price);  and investments in productive assets (the preferable investment).

According to Buffett, gold comes within the second class (speculative investments) and although it does have a productive quality (use in manufacture, for example), it still carries the risk that the expectation that others will  bid the price up will not be fulfilled. And its industrial use is limited by supply and demand and is secondary to its use as a holding or speculative asset.

True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.

Buffett acknowledged the dramatic rise in the price of gold over the past ten years but puts this down to both fear and greed and believes that it has been self-generated rather than meaningful in investment terms. He thinks that it is somewhat of a bubble.

What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis.

As bandwagon investors join any party, they create their own truth – for a while.

Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. In these bubbles, an army of originally skeptical investors succumbed to the ‘proof’ delivered by the market, and the pool of buyers – for a time – expanded sufficiently to keep the bandwagon rolling. But bubbles blown large enough inevitably pop. And then the old proverb is confirmed once again: ‘What the wise man does in the beginning, the fool does in the end’.

Buffett argues his case against gold by looking at the total value of the world’s gold and seeing what would happen if you put that amount into productive assets such as farming land and quality businesses. Whereas gold produces no income and the gold owner has to rely upon the opinion of others for an increase in its value, farms produce crops which can be sold at a profit and quality businesses sell things which produce dividends. Over time, Buffett says, the total return from the productive assets must exceed any increase in the value of the gold.

Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion. Call this cube pile A.

Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?

Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about $160 billion. Buyers – whether jewelry and industrial users, frightened individuals, or speculators – must continually absorb this additional supply to merely maintain an equilibrium at present prices.

A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.

We like the parable but you need to realize that Buffett is talking in the long term and not the short term. He is not saying that people will not make short term gains in speculative assets like gold; he is saying that, as a long term investment, quality productive assets carry less risk and will return better gains.

Charlie Munger has gone even further than Buffett in scoffing at investing in gold, saying in response to a question as to whether holding gold was a hedge against inflation, that gold investing makes no sense. This would seem to be statistically correct. In 2012, Credit-Suisse looked at how various classes of assets performed globally against inflation over a  protracted period. The study found that in between 1900 and 2011 investment in equities outperformed bonds, housing and gold (equities 5.4 per cent against gold 1 per cent in real terms).

(Credit Suisse Global Investment Returns Year Book 2012)

(Credit Suisse Global Investment Returns Year Book 2012)

Understanding the company

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Buying the business

Warren Buffett believes, as did Benjamin Graham, that investors should look upon share investment as buying a part of a business. Investors should take the same approach to buying shares as they would if they were buying a business. The only difference is that instead of buying the whole of the business, or a partnership in the business, they are only buying a tiny share. Just to explain this further; whether you buy a business for yourself, or whether you buy shares in a company that runs a business, you are doing the same thing - buying into a business. The only difference is in the percentage of the business that you own. So, if you buy one share in a company that has issued a million shares, you effectively own a one millionth part of the business that the company runs.

A prudent investor never buys a business that they do not understand. Similarly, a prudent share investor should never buy shares in a company whose business they do not understand.

What Warren Buffett says about buying a business

In 1977, Warren Buffett told shareholders in Berkshire Hathaway that their company would only invest in a business that the directors could understand. He has repeated this message many times since. In 1992, he expanded on this theme:

[W]e try to stick with businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change we’re not smart enough to predict future cash flows. Incidentally that shortcoming doesn’t bother us.

Warren Buffett companies

In 2012, Berkshire Hathaway disclosed that it had substantial minority shareholdings in the following listed corporations:

  • American Express
  • Coca Cola
  • Conoco Phillips
  • IBM
  • Johnson and Johnson
  • Kraft
  • Proctor and Gamble
  • Tesco
  • Sanofi
  • Walmart
  • Wells Fargo

These are all not only brand name companies but also businesses that are relatively easy to understand.

  • American Express is a world-recognized name and makes its money through the sale of  financial services and its brand name credit card. It has been in business a very long time and has a simple business model that even the most unsophisticated investor should be able to understand.
  • The Coca Cola Company is the world’s largest beverage company, making and distributing worldwide such products as Coke, Fanta, Sprite, Evian and Minute Maid. It has been in business many, many years and is perhaps the world’s most recognized brand name.
  • Conoco is the largest integrated energy company in America and one of the five largest refiners in the world.
  • IBM still retains its position as a leader distributor of business hardware, despite the inroads of other American and foreign competitors.
  • Johnson and Johnson and Proctor and Gamble are world leaders in the fields of medical and personal care products.
  • Kraft is predominant in foods and food products.
  • Tesco is a huge British supermarket with excellent brand recognition.
  • Sanofi, a  French company, is one of the top pharmaceutical companies in the world.
  • Walmart needs no introduction and is a retailing phenomenon.
  • Wells Fargo has been around since the days of the Wild West. It no longer runs stage coaches to Dodge City but is a huge bank and provider of financial and other services with a well known brand name. Incidentally, it has its own museum.

In 2012, Berkshire Hathaway included in the businesses that it owns: MidAmerican Energy, CTB, TTI and ISCAR. Again these businesses are fairly easy to understand if you put in the time. MidAmerican sells electricity and gas, CTB does farm equipment, TTI primarily sells electronic components and ISCAR focuses on tools.

Update

Berkshire has recently reduced its holdings in Johnson and Johnson.

Complex companies

Take however, a company like Unilever NV. This is a corporation that has been around a long time, has a worldwide reputation and market, and is successful. But how easy is it to understand the way it operates? It seems to have two parent holding companies, one in Great Britain, and one in The Netherlands. It operates as one company but each of the two holding companies owns shares in operating subsidiaries. The director component of both holding companies is the same and there are agreements that equalize dividends and set trading ratios for their respective shares.  Can you understand this? We can’t. This is obviously a good business but this complex structure is just too difficult for the average person to understand.

Or look at General Electric with its complex business structure and its multiple activities over the years that have  included electronics, energy distribution, television, movies, financing, plastics, health care, financing, and the rest. It may be and is a great company but it is not easy to understand.

Warren Buffett and Keynes

In Warren Buffett’s own words, he did not invest in these companies, and many other successful investments, without acquiring as full a knowledge as possible about the company, its business, its management, and its financial position. He has advised individual investors to do the same, as did the great economist and successful investor John Maynard Keynes.

As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about … - JM Keynes

Why Warren Buffett did not invest in Microsoft

As Warren Buffett has said, he knows and admires Bill Gates and the Microsoft Corporation but he never invested in it because he did not understand the way that the company works. We would be very surprised if he ever took a position in Facebook.

This does not mean that Buffett will not invest in companies that use technology and information systems to run a good company. Quite the opposite. Berkshire Hathaway has a holding in Walmart which has been identified by Thomas Friedman in The World Is Flat as using advanced and innovative technology systems in the 1980s -supply chain management, inventory control, deliveries to and from stores, communication with customers,marketing - to grow from a small to medium sized operation to the huge international retail operation it is today. Or take McLane Company owned by Berkshire Hathaway. This company uses technology and communication systems at an advanced level to provide chain supply solutions to other businesses.

In today’s investment climate, knowing the business of a company must of necessity involve understanding how the company uses technology in a globalized world to run and improve its business. And it is necessary to recognize that a company may superficially be a technology company but it is not. For example, we believe that Amazon is not a technology company that markets books but is, rather, a giant book store that uses technology to sell its products.

Knowing a company

Knowing a company involves research as well as personal experience and successful investors approach share investment the way that they would the purchase of a business.

They buy a business in an industry area that they know or that they have learned about, they investigate the financials, they look at how the business operated in the past, they weigh up future potential, and they then make a reasoned decision to buy at the price offered or not buy. Share buyers should take the same approach.

Just as the cobbler should stick to his last, investors should stay with what they know. They should not stray into areas beyond their expertise. As Warren Buffett said in 1992:

What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know.

Robert Hagstrom has looked extensively at Warren Buffett’s investments over the years and agrees that Buffett has made it his business to understand the business of the companies where he puts the money of Berkshire Hathaway. According to Hagstrom, Buffett:

understands the revenues, expenses, cash flow, labor relations flexibility and capital-allocation needs of each of Berkshire’s holdings.

Hagstrom argues that the prudent individual investor should do no less.

Personal experience

Careful investors will use information services to cull potential investments but will, before investment, reach their own conclusions based on the original source materials issued by the company and other primary evidence.

Anecdotal evidence and personal experience can also be useful to an investor. There are various anecdotes of Warren Buffett, in early days, making personal visits to company offices and asking for information. Not all investors can do this but they can relate their personal experience of a product or service to their investment decisions.

Review: The World Is Flat: A Brief History of the Twenty-first Century by Thomas Friedman

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As technology continues to impact on the way companies do business, it has become increasingly important for investors to understand technological change and factor it into their investment choices. This book by Thomas Friedman, which describes his concept of a business world “flattened” by globalization, is interesting to us as students of Warren Buffett and value investing for several reasons:

  • Although Warren Buffett has said that he does not invest in technology stocks because he does not understand them, this does not mean that he avoids buying stock in businesses that use technology to improve their business plan.  For example, Berkshire Hathaway owns McLane Company whose business of providing supply chain solutions to businesses is based upon technology and communication systems.
  • Following from that, in an increasingly globalized world it is very difficult to understand any large company unless you understand the way globalization can affect its business model.
  • Finally, as a framework for understanding, we believe Friedman’s view of the “flattened world” and “triple convergence” provides a fascinating mental model for the investor that goes beyond balance sheets and annual reports - the sort of deep understanding advocated by Charlie Munger.

Friedman explains the flattening world: a world where changes in technology and communication have made the world not only smaller but flatter. Opportunities have been equalized, the advantages of being a business in the West have lessened, and work forces, suppliers and expertise have become international. Friedman identifies as factors in the flattening of the world ten “flattenners” and a “triple convergence”. His ten flattenners, which he explains and exemplifies, are:

  • The collapse of the Soviet Empire beginning in 1989
  • The emergence of Netscape
  • The beginnings of work flow software (for example, sales analysis and marketing tools)
  • Uploading
  • Outsourcing
  • Offshoring
  • The use of supply-chain systems
  • Insourcing
  • Getting information through web searching
  • The development of what he calls “steroids” which both use and assist the other flattenners. These steroids include growth in computing power and IT information exchange, VOIP and video conferencing, improvements in graphics, wireless technology.

The coming together of these flattenners was the first of what Friedman calls the Triple Convergence - three things that have changed the way companies do business. The other two are the development of business systems and methods to take advantage of technological change and the entry of billions of new people into the work force from countries that themselves are benefiting from the flattening world.

Even though Friedman develops other themes in this book, the flattenners and triple convergence form the basis for his examination of the new business world and discussion of specific businesses. One particular business in which Berkshire has invested is Walmart and Friedman shows how this company grew into the mammoth retailer that it is through using technology in stock management,  customer service and product marketing.

If you want to understand  why and how technology is important to any company that you are considering investing in, you should read this book.

This brings us back to our opening remarks - that although Warren Buffett has said that he will not buy into technology companies because he does not understand them, he does invest in companies that use technology to make their business successful. If we follow Buffett’s adage that you need to know the business of a company well before you invest in it, it follows that you need to understand the technology that it uses.

A further thought. It is becoming increasingly difficult to recognize what is a technology company and what is not. Amazon could perhaps be described as a technology company but we don’t think so. We think it is primarily a book shop that uses technology well to sell its products. What about Google? That is more difficult. On the one hand it is primarily a search engine business, i.e. a technology stock. On the other hand its income derives substantially from advertising. Is it a media  stock?

The World is Flat is both informative and though provoking. Friedman has followed this book with two others with similar themes: That Used to be Us: How America Fell Behind in the World It Invented and How We Can Come Back (with Michael Mandelbaum), which discusses America’s place in the new world of technology and communication and Hot, Flat and Crowded in which he discusses the dangers challenges facing the planet in this new world and how those challenges can renew America.

Purchase The World Is Flat at Amazon.com

Berkshire Hathaway Holdings

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We often get asked for information on which companies Warren Buffett and Berkshire Hathaway have bought in to, and which companies they own outright.

The known holdings of Berkshire Hathaway are many and varied and some information can be gleaned from their 2011 balance sheet. Whether the holdings shown at that time remain will only be known when the next annual general meeting takes place in 2013. According to Buffett’s annual letter, Berkshire owns or has holdings in the corporations listed below. This list is not exhaustive.

Companies Berkshire Hathaway owns wholly or substantially

Insurance

  • GEICO. Primarily a motor insurance company, has been providing low cost insurance since 1936 and is a big Berkshire cash cow.
  • Gen Re. One of the largest re-insurers in the world with an AA+ financial strength rating.
  • Princeton Insurance. A leader in professional indemnity and malpractice insurance.
  • Berkshire Hathaway Reinsurance.

Fuel, power and chemicals

  • Mid-American Energy. An energy distribution company based in Iowa with interests in electricity, gas and alternate energy systems.
  • Lubrizol. A specialty chemical company, selling in over 100 countries, with a big market in fuel additives and lubricants.

Transport, systems and leasing

  • BNSF. The former Burlington Northern Santa Fe Corporation bought out by Berkshire in 2009, a railway and transporter amongst other things.
  • XTRA Lease. This company specializes in leasing semi-trailers and associated heavy machinery.
  • McLaneCompany. Provides supply chain solutions for a range of merchants including grocers, druggists, the food industry, the military and chain restaurants. This is the type of business descrIbed by Thomas Friedman in The World is  Flat as one of the ten things that are changing and flattening the world.
  • NetJets. A world leader in the sale and rental of private planes with a program of fractional ownership for those who want to be Donald Trump but lack his wherewithal.

Manufacturing

  • Iscar. An Israeli based company that makes precision tools and associated equipment.
  • Marmon Holdings. a general manufacturing company, still partly owned by the wealthy Pritzer family.
  • CTB Inc. This company makes and distributes farm and agricultural systems all over the world.
  • TTI Inc. Manufactures and distributes electrical components, a market leader, and has been doing so for 40 years.

Building, construction and associated

  • Clayton Homes. Builder of manufactured and modular homes, the biggest in America, and one of Buffett’s big plays for a recovery in the housing market. (Berkshire has also been buying up home mortgage loans at discount prices from home lenders such as ResCap with surplus mortgage in their portfolio.)
  • Acme Brick. This company not only makes a wide variety of bricks and blocks but guarantees them for 100 years. And it seems to have got in early with its domain name.
  • Johns Manville is one of the leading makers and distributors of industrial and domestic insulation.
  • Mitek. Very big in roofs all over the world.
  • Cort Furniture. Cort is a large company that sells and rents office and home furniture.
  • Shaw Industries. A corporation that is probably the world’s largest maker of carpets and other floor coverings and surfaces.
  • Benjamin Moore. This company has been going strong since 1883 and produces high quality paints and industrial coatings.

Long held treasures

  • Nebraska Furniture Mart. This originally family owned company’s store in Omaha is the largest of its kind in the USA, and probably the world, with another huge store in Kansas City of over 450,000 square feet with another store soon to open in Dallas.The story of this family is a Warren Buffett classic and can be found here.
  • Borsheim’s Jewelery. This is another classic Buffett company and an Omaha tradition.
  • See’s Candy needs no introduction.
  • Fruit of the Loom. This is a  Buffett favorite which he never hesitates to promote at the Berkshire AGM. An international mercer, particularly in underwear.

Substantial holdings in other companies

According to Buffett’s 2011 letter to shareholders, Berkshire also owns the following percentage of stock in these companies.

  • American Express Company  13.0 %
  • The Coca-Cola Company 8.8 %
  • ConocoPhillips  2.3%
  • Johnson & Johnson 1.2%
  • Kraft Foods 4.5%
  • Munich Re 11.3%
  • POSCO 5.1%
  • The Procter & Gamble Company 2.6%
  • Sanofi1.9%
  • Tesco 3.6%
  • U.S. Bancorp 4.1%
  • Wal-Mart Stores, Inc 1.1%
  • Wells Fargo & Company 7.6%

The company also holds preferred stock in IBM and Bank of America.

Update

It is understood that Berkshire Hathaway has now reduced its shareholding in Johnson and Johnson and increased its holdings in both Amex and Wells Fargo.

Warren Buffett on investment choices

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In his 2011 letter to shareholders, Warren Buffett explained the choices that he sees as available to investors.

Currency denominated investments

These are investments denominated in a given currency, such as bank deposits, cash funds, mortgages and which are supposedly safe. These investments are not risk free because their value can be eroded by inflation, government policy and the actions of speculators.

Investments dependent on the intentions of others

These are assets that are not productive and where an  increase in value depends upon somebody else buying the asset at a higher price, such as tulips during the great Tulip Bubble or technological stocks during the buying frenzy of the Dot-Com boom. The risk here is that price rises depend upon an ever increasing pool of speculators. Gold falls within this category even though it is productive in the sense that it has industrial use but industrial demand for gold is limited and secondary to its use as a holding asset.

Investments in productive assets

Assets that are productive – businesses, farms, mines etc – and these are the best assets to hold so long as you only buy them on sound investment principles. “Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment.” -Warren Buffett

The risk in risk-free investments

There is no prize for guessing what type of investment appeals to Buffett. What is interesting here is not so much that Buffett considers the third type of investment to be preferable, but that he attributes a risk factor to an investment of the first category that many would consider to be almost risk free - bank deposits, and by implication, government bonds.

If you asked the average uninformed investor whether a bond issued by a reliable government, or a government guaranteed bank deposit, was risk free, most would agree. Not so, says Buffett. There is the risk of losing capital, possibly smaller than with other investments, but still a risk: bonds are subject to market speculation, for example, or the real value of the investment may fall if the rate of return is less than the rate of inflation.

Opportunity cost

There is also the risk of opportunity cost. By investing in one of these ”risk-free investments”, an investor risks losing the opportunity of a better return elsewhere. As Charlie Munger has said:

Intelligent people make decisions based on opportunity costs - in other words, it’s your alternatives that matter.

Buffett has said, on occasions, that cash is a lousy investment, such as in this interview with CNBC:

Prospect theory

Bufffett and Munger are, of course, not ordinary investors and their aversion to holding cash or investments of the first category, is not necessary applicable to us poorer folk. Buffett’s attitude towards risk and investment is well known:

Be greedy when others are fearful and fearful when others are greedy.

This may be true and Buffett’s track record shows that it works. We can also accept as truth what he says about the risks that we take in investing in currency denoninated assets. But, as lesser mortals, most of us find comfort in having some of our capital in easy-to-liquidate, low risk investments. We do not have the access to funds that Buffett and Munger do, nor are we as financial comfortable as they are.

Most of us are likely to fear loss rather than enjoy the prospect of gain, an aspect of prospect theory, by Noble Prize winning economist Daniel Kahneman and Amos Tversky, that proposes that people value risk and gain in different ways.

Note: As at 30 September 2012,  Berkshire Hathaway was holding nearly $42 billion dollars in cash and cash equivalents, up $8 billion from December 2011, so Buffett is either thinking that these currency denominated assets represent a safer bet in the current economy or he is looking around for something to buy. He told CNBC in November 2012 that a couple of multi-billion dollar acquisitions had fallen through and that he was ”salivating” for a big business to buy.

Buffett’s million dollar bet: Index Funds and Hedge Funds

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Warren Buffett and Funds

With Warren Buffett’s opinion of hedge funds, it is a surprise (well, perhaps not, because he is a contrarian) to see that several of his possible successors all come from hedge funds.

Buffett has often said that investors, particularly small ones, who do not have access to the financial expertise and information that he has, or who just want to invest without a lot of thought, would be better off putting their money in an index fund than in picking stocks themselves or running up high fees in mutual funds. Buffett has said that:

A very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money funds …. The gross performance may be reasonably decent, but the fees will eat up a significant percentage of the returns …. You’ll pay lots of fees to people who do well, and lots of fees to people who do not do so well.

Charlie Munger has been even more scathing in his criticism of managed funds, essentially accusing them of lying about their returns, basing their forecasts on past performance that may have been good in the early years after they were formed and were smaller and better managed.

Successful funds attract a massive amount of money, and the later performance typically gets mediocre …., then they keep publishing returns for the whole period for someone who started 20 years ago…. The reporting has falsehood and folly in it.

What is an Index Fund?

An Index Fund puts investor funds in a broad range of investments in a particular category. So the Vanguard 500 Index Fund invests in the top 500 companies in the Standard and Poor Index. They then buy shares in each company in that Index in the proportion that the total value of that company bears to the total value of all the companies in that Index.

So, if company X had a market value of $1 billion dollars and the total market value of the 500 companies in that index fund was $100 billion,  that is 1 per cent (1 times 100 divided by 100), the fund managers would invest 1 per cent of the Index funds in the shares of that company.

Because the fund managers do not have to make investment choices based on their own research and judgment, the costs of administering the fund is far less than with mutual funds, which means lower commissions charged to investors. The only action required of the fund managers is to ensure that, in a changing market where the value of individual companies rises and falls, they adjust the fund’s holdings to approximately reflect the real position.

Buffett”s argument, and Munger’s is, that fees and administration costs deducted from the fund member’s investment means that there is less money to invest. For example, if you put $100 into a mutual fund and the fund manager charges 2 per cent to go into the fund, there is only $98 left to invest and you are behind in your investment from the start. So the fund then has to get you your $2 back to put you in your original position, which means that it has to show a profit of $2.04. If it then charges you an annual management fee of 5 per cent (as some mutual funds do), this too has to be earned. So, at the end of the first year, your fund needs to be 7.04 per cent ahead just to put you in your original position. But it needs to be further ahead than that because you could have put that interest in a bank instead of the fund and earned interest. Index funds generally do not bear an entry or exit fee and annual management fees rarely exceed 1 per cent.

Buffett’s Million Dollar Bet on Index Funds

In 2008, Buffett backed up his opinion as to the comparative merits of index funds and other funds with a million dollar bet with Protégé Partners LLC. He bet that the return on Vanguard Admiral, based on an index of the Standard and Poor 500,  would outperform over ten years an index of five funds that invest in hedge funds.

At the half way mark (January 2013), Buffett’s horse is well in front with a return of 8.69 per cent against the hedgers’0.13 per cent. The hedge funds had jumped to the front in the aftermath of the crash of 2008 but have more than come back to the field.

The $1 million dollars will go to a children’s charity selected by the winner.