Once I established myself as an investor, I decided to seek out an investing role model, just as amateur sports players look up to the professionals or potential actors look up to movie stars.
I found that the Derek Jeter and Tom Hanks of investing is invariably Warren Buffett – the $50 billion plus investor and CEO of Berkshire Hathaway.
Buffett is the most successful investor in the world. I bring Buffett up, not for a history lesson – albeit he is an interesting fellow – but because his investing techniques can be applied to any portfolio. Learning Buffett’s techniques provides you with practical investing strategies that have been used to produce phenomenal returns at Berkshire, propelling its class A stock price from $8,200 in 1990 to $107,900 today.
Buffett originally gained control of Berkshire in the 1970s when it was a poor performing textile company. Through Buffett’s astute leadership, Berkshire began purchasing insurance companies and eventually dissolved the textile market. It was no accident that Buffett got into the insurance business. Buffett, who by this time was already a great investor, knew that the steady stream of cash and premium payments generated by Berkshire’s insurance holdings could be used to purchase equities and corporations.
Buffett has a clear strategy he utilized for picking equities for Berkshire. Some of this might be a little confusing; I know it was for me for quite some time. However, once you internalize the things I am about to discuss, you will have a better understanding of finance, of the true value of equities and, most importantly, how to invest like Buffett. But keep in mind, there are many ways to value businesses and the one I am about to discuss is by no means the only one.
Buffett, being of the Benjamin Graham school of investing, sought to purchase companies that were trading below their intrinsic value. Intuitively, you may think intrinsic value is a measure of the assets a company has on the books, which are distributable to shareholders – the shareholders’ equity section of the balance sheet.
However, Buffett determines intrinsic value by calculating the sum of the future cash flows of the company, minus capital expenditures, discounted to the present. Buffett subtracts capital expenditures from cash flow to arrive at what he calls the “owner’s earnings.” Buffett has shown us that it is important to factor in capital expenditures, the investments and upgrades a company makes in its property, plant and equipment, because a firm cannot continue to run with making these capital outlays.
While valuing a business is a complicated process, when Buffett is able to confidently determine that the business is trading below its intrinsic value, he scoops up the stock in large quantities, assuming that the stock will eventually increase to its fairly valued level and perform well over the long run.
You may think that with such a strategy, Buffett purchases obscure companies nobody knows about. However, that’s far from the case. Buffett likes to buy simple and understandable high-quality businesses that have strong competitive advantages. Buffett also looks for companies that have consistently performed well and have good long-term prospects.
Buffett has purchased stocks of The Washington Post Company, GEICO, RJ Reynolds Industries, PNC Bank, Freddie Mac, McDonald’s and the Walt Disney Company.
However, his most famous investments have been in Coca Cola, American Express, Wells Fargo and Gillette.
For example, Buffett started buying Coca Cola stock in 1988. During the 1970s, Coke had a lot of problems and the business had been lagging. During the 1980s, Buffett noticed that the new Coke CEO was making significant changes at Coke that translated into increased profitability. In the 2003 annual report, Berkshire reported that it owned 200 million shares of Coca Cola at a total cost of $1.29 billion and a market value of $10.15 billion.
Buffett views the stocks he invests in as businesses, not simply pieces of paper. He has conviction in the businesses he invests in.
When you purchase shares in your company, you have to say to yourself, “Would I like to be the owner of the business?” Too many times, I see people buying stocks for speculation or obscure businesses that they hope will hit it big. Buffett buys established companies that have already proven themselves and which he feels will be able to continue this success in the future. I think you should do the same.
For decades, Buffett has also been purchasing businesses outright, so his principles in stock valuation apply to valuing whole businesses for purchase. Berkshire’s various subsidiaries include GEICO Auto Insurance, Fruit of the Loom, Clayton Homes, The Pampered Chef and Benjamin Moore & Co.
Berkshire Hathaway’s stock holding, as of Sept. 30, 2006, included Coca Cola, American Express, Procter & Gamble (P&G purchased Gillette in 2005), along with more recent purchases in Anheuser Busch, Johnson & Johnson, Conoco Philips, Wal-Mart, Nike, Comcast and General Electric.
Now, I’m not necessarily recommending that you purchase the stocks of these companies, but it’s worth taking a look at each company to determine its strengths and long-term investments and evaluate whether you think Buffett made a good investment.
I think the final, more general point you should take away is that the value of a business is based upon its future prospects, earnings and cash flows. Buffett uses the past to evaluate the future, but he values the business based upon what he thinks will happen in the future.
Now, some of the finance principles I presented may be a little ambiguous to you, and I am by no means an expert. I think you should take some time and learn the basis for business valuation and financial statement analysis. I don’t value my stocks, but I do look carefully at measures that determine the future value of the business, and I do subscribe to the analyst reports at morningstar.com, which value many stocks based on discounted cash flow analysis.
Information from – “The Warren Buffett Way” by Robert G. Hagstrom, investopedia.com and wikipedia.com