The book first begins by observing that price, a theme to be repeated later, is ultimately what determines the rate of return. The company will grow however fast it grows, but the cheaper it was purchased, the greater the increase for the investor. The next point is that Warren Buffet considers that the company’s earnings are his (in proportion to his share of ownership). Thus the company can either give it back to him as a dividend, or invest it for him in the company. Addressed third is the book’s foundation for evaluating the value of a business—its present value, that is, amount necessary to invest today (at a particular rate of return) in order to end up with a certain amount at a set point in the future.
With fundamental ideas address, Mary Buffett begins explaining Warren Buffett’s methods. The key concept is the ownership of businesses with excellent economics, generally companies with effective monopolies, two varieties of which are described. The first, referred to in the book as “consumer monopolies”, are products that have a such a strong brand that consumers are more sensitive to the brand than the price. Grocery stores pretty much must carry Coca-Cola because of buyer loyalty, giving Coca-Cola a high degree of flexibilty in the price. The second, “toll-road” companies, control goods that can only be accessed through them. Cable companies and newspapers that have no competition in a particular region are the examples cited. Mary Buffett argues that Warren Buffett limits himself to effective monopolies because, empirically, those are the only companies whose earnings can be predicted with a high degree of certainty. Without certainty the present value calculation is not very useful and thus the business cannot be reliably valued.
After spending several chapters describing the characteristics of excellent and mediocre businesses, and some methods of finding the former, Mary Buffett describes Warren Buffett’s buy timing. Warren Buffett strongly believes in buying at a good price and will refuse to purchase the excellent companies he has identified until the price is low enough to offer him a good return, which Mary Buffett claims to be a 15% or greater return. Unlike baseball, you can’t get a strike in investing until you swing. So don’t swing until you know that you have a great pitch.
The final principle is when to sell. Classic Grahamian value investing (Buffett’s early strategy) sells as soon as the stock exceeds the value of the company. Unfortunately, this produces taxes, which lowers the rate of return. Therefore, if the company still has excellent economics, there is no point to selling, regardless of how the market is currently valuing the company.
Finally, Buffettology discusses some miscellaneous issues (like how share repurchases tends to increase share value by more than the value of the shares purchased) and gives case studies of several companies that Warren Buffett had invested in. These are straightforward applications of the principles discussed earlier.
Buffettology is a worthwhile book for the beginning investor. However, it falls short on several accounts. First, it fails to live up to the claim of its subtitle, “The previously unexplained techniques that have made WARREN BUFFETT the world’s most famous investor” (emphasis as taken from the front cover). The only principle that is not discussed in other value investment books is the effective monopoly, and even this has strong premonitions in Fischer’s book and is alluded to frequently in Warren Buffett’s Berkshire Hathaway letters, although not nearly as clearly in either case. Second, while the book makes a good deal of use of the present value calculation, nowhere did they bother to mention that this may be calculated as
present value = future value / ((1 + r) ^ nYears)and instead direct the reader to press the present value on their calculator. What happens if you don’t happen to have a calculator? And is the accessibility of the book to “people on the run” going to be reduced by introducing division and exponents, normally taught in elementary school? Then there is the fact that the present value calculation is only run for an arbitrarily chosen 10 years. Third, the book spends a fair amount of time convincing the reader that a few percentage points makes a large difference in money over many years. A valuable point to make, but not three or four times, and not by comparing a thirty year investment at Warren Buffet’s unparalleled returns (which the reader is unlikely to get) to a thirty year investment at normal returns (which the read is likely to get) and saying “wow, it’s millions of dollars larger”. True statement, but one very, very few people in the world are going to experience.
While the Warren Buffet almost surely uses the principles described in the book, it is questionable whether he does so in the fashions described and for the reasons given. Unbounded exponential growth is impossible, which makes the present value calculation somewhat unhelpful—when do you stop extrapolating earnings? It seems likely that Warren Buffett uses a measurement technique whose value does not change depending on the number of years used in the calculation. There also seems to be the assertion that Buffet likes effective monopolies because the earnings are accurately predicted. This is quite a bit of wishful thinking: the example company, Coca-Cola, fell into some earnings problems in and after the Internet Bubble, and the number of excellent companies where a change in management has produced a devaluing is legion. How do you predict a change in management in your ten year calculations? It seems more reasonable that Buffet likes effective monopolies because, as the book does point out, he discovered that his investments in mediocre companies often did not rise to their intrinsic value. Most probably he realizes that it is only effective monopolies that can achieve the maximum return on investment.
In short, Buffettology is clearly a best-seller. Its easy to read style, its target audience of “people on the run”, its clear points, and even the empasis of the name “Warren Buffet” on the cover (as quoted above) all point to this. Unfortunately it shares all the deficts of a best-seller: lack of depth, oversimplification, and examples using companies unmarred by imperfections in the time periods used. Despite that, beginning investors would do well to read it and will enjoy the process.
Clearly written and with clearly labelled concepts that even a busy person will have little trouble finding or remembering. Gives a good background on how Warren Buffett’s current thinking evolved but unfortunately abandons the implications in favor of business-school present-value. Content is good. However, the book is definitely not an instructive text of any depth and will be obsolete as soon as one is written.
- Buffett views earnings of a company to be his. The company either pays them to him as dividends or invests them for him.
- If the company can more profitably employ the earnings than he can, the company should reinvest them.
- The quality of management is paramount.
- Buy only when the price is cheap. Do something else until it becomes cheap.
- Commodity businesses produce inferior results because low prices
mean low margins.
- Characteristics of a commodity business
- low profit margins
- low returns on equity
- absence of brand-name loyalty
- multiple manufacturers
- excess production capacity in the industry
- “Nine questions to help you determine if a business is a truly excellent one”
- “1. Does the business have an identifiable consumer monopoly?”
- “Go stand outside a convenience store, supermarket, pharmacy,
bar, gas station, or bookstore and ask yourself, What are the
brand-name products that this business has to carry to be in business?”
- “2. Are the earnings of the company strong and showing an upward trend?”
- “3. Is the company conservatively financed?”
- “4. Does the business consistently earn a high rate of return on shareholders’ equity?”
- “... the average return on shareholders’ equity for an
American corporation over the last forty years has been approximately
12%. That means that as a whole, year after year, American
business earns only 12% on its shareholders’ equity base. Anything above 12% is above average. Anything below 12% is below
average. And below average is not what we are looking for.”
- “5. Does the business get to retain its earnings?”
- “6. How much does the business have to spend on maintaining current operations?”
- “7. Is the company free to reinvest retained earnings in new business opportunities, expansion of operations, or share repurchases? How good a job does the management do at this?”
- “Warren’s preference is to invest in cash cows; these
are very profitable businesses that require very little in further
research and development or replacement of plant and equipment.”
- “8. Is the company free to adjust prices to inflation?”
- “9. Will the value added by retained earnings increase the market value of the company?”
- Buffett does not believe in diversification. It protects you against yourself, which is fine unless you are knowledgeable to not need it.
- “Warren has often said that a person would make fewer bad investment decisions if he were limited to making just ten in his lifetime.”
- The value of earnings is value = earnings / rate of return. So you can get an idea of a company’s value by comparing the stock price to earnings / government bond rate. If the stock price is less (and it is a good company) it is a no-brainer decision.
- A stock with a dividend can be looked at as a bond with a variable (hopefully increasing) coupon (i.e. interest payment) where the dividend payment is the interest payment. With a bond you have a fixed rate of return, but as the dividend increases due to increased earnings, the rate of return increases. However, from this point of view, the initial investment gets a fixed rate of return (generally rather low), but the increases compound at the return on equity.
- Corporate stock repurchases have no net change in value to the
business: if they kept the cash or bought stock back, they have
the same amount of value. However, repurchasing stock increases
per-share earnings, and because companies’ stock is generally valued at
P/Es (based on per-share earnings) of > 1, the increase in stock
price is larger than the value added. Ex: Suppose a company
has earnings of $.50/share, a price of $10 and a P/E of 20. It
buys back half its stock and earnings stay the same the next
year. Now the earnings are $1.00/share. If the P/E of 20 is
constant, the stock is now $20. (Plus ROE increases and you own a
larger portion of the company)
- But you need to check that increases in earnings aren’t just a result of buying back stock.