Warren Buffett's 12 Investment Principles | The Warren Buffett Way by Robert Hagstrom (TIP487)

00:57:46
https://www.youtube.com/watch?v=nugX4n3o2ok

Sintesi

TLDRThe video explores Warren Buffett's investment principles as detailed in Robert Hagstrom's book, "The Warren Buffett Way." It outlines Buffett's preference for buying businesses outright to influence capital allocation and emphasizes the importance of understanding the business model, management quality, and financial metrics. The video categorizes Buffett's principles into business, management, financial, and market tenants, highlighting the need for a margin of safety when investing. A case study on Buffett's investment in Coca-Cola illustrates the successful application of these principles, showcasing the importance of investing in simple, understandable businesses with a consistent operating history and favorable long-term prospects.

Punti di forza

  • 📈 Buffett believes in owning good businesses for long-term wealth.
  • 💼 He prefers buying businesses outright for better control.
  • 🔍 Understanding the business model is crucial for investment success.
  • 👥 Management quality is key; they must be honest and competent.
  • 📊 Focus on return on equity over earnings per share.
  • 🛡️ A margin of safety protects against valuation errors.
  • 📉 Market fluctuations can present buying opportunities.
  • 🧠 Emotional discipline is essential in investing.
  • 🍹 Buffett's Coca-Cola investment exemplifies his principles.
  • 📚 Continuous learning and understanding are vital for investors.

Linea temporale

  • 00:00:00 - 00:05:00

    In Chapter 3 of Hagstrom's book, the focus is on Warren Buffett's investment philosophy, particularly his preference for buying entire businesses or stocks in publicly traded companies. Buffett believes in owning good businesses for the long term, which allows him to influence capital allocation decisions and take advantage of market fluctuations.

  • 00:05:00 - 00:10:00

    Buffett's investment approach is rooted in analyzing businesses rather than markets. He emphasizes understanding the business model, profitability, financial health, management competence, and purchase price. Hagstrom distills Buffett's investment strategy into 12 tenets, categorized into business, management, financial, and market principles.

  • 00:10:00 - 00:15:00

    The first business tenet is that the business should be simple and understandable. Buffett avoids complex businesses he doesn't fully grasp, focusing instead on companies he understands well, ensuring he can win in the investment game.

  • 00:15:00 - 00:20:00

    The second tenet is that the business must have a consistent operating history. Buffett prefers companies with a track record of stable growth and profitability, avoiding industries that are constantly changing or innovative products that may not succeed.

  • 00:20:00 - 00:25:00

    The third tenet is that the company should have favorable long-term prospects, including a product or service that is needed, has no close substitutes, and is not heavily regulated. This allows for pricing power and above-average returns over time.

  • 00:25:00 - 00:30:00

    Buffett's management tenets emphasize the importance of quality management. He insists on investing in companies led by honest and competent managers who act rationally and prioritize shareholder value through effective capital allocation.

  • 00:30:00 - 00:35:00

    The second management principle is that management must be candid with shareholders, providing transparent and truthful information about the company's performance and future prospects. Buffett values honesty and openness in management teams.

  • 00:35:00 - 00:40:00

    The third management principle is to resist the institutional imperative, encouraging independent thinking among managers rather than following industry trends blindly. Buffett seeks managers who make unconventional decisions for the benefit of shareholders.

  • 00:40:00 - 00:45:00

    The financial tenants focus on key metrics like return on equity, owner’s earnings, profit margins, and ensuring that retained earnings lead to increased market value. Buffett prioritizes companies that efficiently reinvest earnings and generate high returns on equity.

  • 00:45:00 - 00:50:00

    The market tenants involve determining the intrinsic value of a business and ensuring it is purchased at an attractive price. Buffett emphasizes the importance of a margin of safety in investments, allowing for potential errors in valuation.

  • 00:50:00 - 00:57:46

    Hagstrom concludes with a case study on Buffett's investment in Coca-Cola, illustrating how Buffett applied his principles to identify a great business with strong management and favorable long-term prospects, leading to significant returns over time.

Mostra di più

Mappa mentale

Video Domande e Risposte

  • What are the 12 immutable tenets of buying a business according to Buffett?

    The tenets include business characteristics, management qualities, financial decisions, and market price considerations.

  • Why does Buffett prefer buying businesses outright?

    Buffett prefers buying outright to influence capital allocation decisions.

  • What is the importance of understanding a business before investing?

    Understanding a business ensures that an investor is capable of winning in the investment game.

  • What does Buffett mean by 'circle of competence'?

    It refers to investing in areas where one has knowledge and understanding.

  • How does Buffett assess management quality?

    Buffett looks for honest, competent managers who act in shareholders' best interests.

  • What is the significance of return on equity?

    Return on equity indicates how effectively a company is using its equity to generate profits.

  • What is the 'margin of safety' in investing?

    It is the difference between a company's intrinsic value and its market price, providing a buffer against errors in valuation.

  • How does Buffett view market fluctuations?

    Buffett sees market fluctuations as opportunities to buy undervalued stocks.

  • What is the role of emotional discipline in investing?

    Emotional discipline helps investors avoid making impulsive decisions based on market movements.

  • What was Buffett's investment strategy with Coca-Cola?

    Buffett invested in Coca-Cola due to its simple business model, consistent history, and favorable long-term prospects.

Visualizza altre sintesi video

Ottenete l'accesso immediato ai riassunti gratuiti dei video di YouTube grazie all'intelligenza artificiale!
Sottotitoli
en
Scorrimento automatico:
  • 00:01:28
    [00:02:30] Now in chapter three of Hagstrom’s  book, he has the chapter entitled Buying a
  • 00:01:33
    Business – The 12 Immutable Tenets. Warren  Buffett is someone who believes that the
  • 00:01:37
    best way to build wealth is to own very  good businesses over long periods of time.
  • 00:01:42
    And there are two ways he can go about that,  which very much includes a similar process,
  • 00:01:46
    and that’s buying the whole business outright  and buying stock in the publicly traded company.
  • 00:01:51
    [00:02:53] Buffett prefers buying the business  outright because it allows him to influence
  • 00:01:55
    the company’s capital allocation decisions. But  Buffett, of course, doesn’t limit his purchases to
  • 00:02:00
    just wholly owned businesses. The benefits for him  of investing in the stock market is that one, he
  • 00:02:06
    has thousands of companies to choose from, giving  him a lot of choices to potentially invest in.
  • 00:02:11
    [00:03:13] And two, with changes in Mr.  Market’s mood swings. The stock market gives him
  • 00:02:16
    opportunities to find bargains or stocks, trading  at great prices to start buying shares in the
  • 00:02:22
    company. So from this perspective, Buffett states  that quote, When investing, we view ourselves as a
  • 00:02:28
    business analyst and not a market analyst, not as  macro analysts, and not even as security analysts.
  • 00:02:34
    [00:03:36] In quote, this means  that Buffett first and foremost,
  • 00:02:37
    thinks from the perspective of a business  person. So he’s looking at how the business
  • 00:02:42
    model operates, how profitable it is, what  the company’s financial position looks like,
  • 00:02:47
    how competent the management team, as  well as the company’s purchase price.
  • 00:02:51
    [00:03:53] Hagstrom studied how Buffett invested  and simplified his process down to what he calls
  • 00:02:57
    12 tenets or principles. Within that, the  12 principles fall into four categories.
  • 00:03:02
    One. Business tenants, which are the three  basic characteristics of the business. Two,
  • 00:03:08
    management tenants, which are three important  qualities that senior managers must display.
  • 00:03:13
    [00:04:15] Three financial tenants, which are  the four critical decisions that the company must
  • 00:03:18
    maintain. And four market tenants, which relate to  two tenants around the company’s price. Before we
  • 00:03:24
    dive in, Hagstrom does point out that not all of  Buffett’s purchases fit perfectly into these 12
  • 00:03:30
    tenants, but for the most part, these tenants  or principles are the core of how he invests.
  • 00:03:35
    [00:04:37] So let’s start with the business  tenants. It’s important to remember that when
  • 00:03:39
    you’re buying stocks, you’re buying pieces  of an actual business. So many people go
  • 00:03:43
    out and buy a stock, then when they see  their stock price go down, they sell,
  • 00:03:47
    hoping that they are avoiding even bigger  losses. So it’s important to have that mindset of
  • 00:03:53
    recognizing that stocks are real businesses,  providing real products in real service.
  • 00:03:58
    [00:05:00] To real people. The first  business tenant Hagstrom lays out in
  • 00:04:02
    his book is for the business to be simple and  understandable. This principle is so basic,
  • 00:04:08
    yet I think it can be so overlooked by  people. Oftentimes people will ask me
  • 00:04:12
    about a particular stock and I’m just  like, I don’t really have an opinion
  • 00:04:16
    on that company because I can’t really  say I understand the business fully.
  • 00:04:20
    [00:05:22] Just throwing two examples out  there. Invidia in Roku are examples of stocks
  • 00:04:26
    that look to, you know, be good companies.  They’re growing really fast and they look to
  • 00:04:30
    potentially be really successful businesses,  but I honestly can’t say I fully understand
  • 00:04:35
    their competitive position. Therefore, I  just completely avoid companies like those.
  • 00:04:39
    [00:05:41] Every single business  that Warren has invested in,
  • 00:04:42
    he has a pretty good understanding of how  all of the businesses operate. When he has
  • 00:04:47
    a great understanding of the business, he  is ensuring that he is playing a game in
  • 00:04:51
    which he is capable of winning. If he were to  invest in some sort of obscure tech company,
  • 00:04:56
    he honestly isn’t equipped to win that game,  so why even attempt to play that type of game?
  • 00:05:01
    [00:06:03] As Hagstrom put it in his book, quote,  Buffett also tends to avoid businesses that
  • 00:05:06
    are solving difficult problems. Experience has  taught him that turnarounds seldom turn. It can
  • 00:05:12
    be more profitable to look for good businesses  at reasonable prices than difficult businesses
  • 00:05:18
    at cheaper prices. Buffett admits, Charlie and I  have not learned how to solve difficult business
  • 00:05:23
    problems, but what we have learned to do is  avoid them to the extent we have been success.
  • 00:05:28
    [00:06:30] It is because we have concentrated  on identifying one foot hurdles that we could
  • 00:05:33
    step over rather than because we acquired any  ability to clear seven footers. End quote. A
  • 00:05:39
    helpful way for me to wrap my head around  a business is to actually interact with it
  • 00:05:44
    in my real daily life. With a company like  Costco, for example, I can understand the
  • 00:05:49
    appeal of being a member and why it might be  difficult for competitors to disrupt them.
  • 00:05:53
    [00:06:55] If I were just reading about Costco  as an outsider that has never visited a store,
  • 00:05:58
    then it might be difficult to fully understand  the competitive moat they’ve built over the
  • 00:06:03
    years. It also reminds me of Peter Lynch’s  investment philosophy of looking at a business
  • 00:06:09
    that is in your day to day life. A company  like Starbucks is a prime example of this,
  • 00:06:14
    as my local Starbucks practically has cars  lined outside of the parking lot to buy,
  • 00:06:19
    you know, Starbucks coffee and the  drive through every single day.
  • 00:06:21
    [00:07:23] This also ties into Buffett’s  idea of investing within your circle of
  • 00:06:27
    competence. It’s important to define what  you know. It’s also important to define what
  • 00:06:31
    you don’t know well, because that’s where  you can really get into trouble. So again,
  • 00:06:35
    business principle number one is for the  business to be simple and understandable.
  • 00:06:39
    [00:07:41] Business principle number two, the  business must have a consistent operating history.
  • 00:06:45
    So when Buffett invest, he isn’t looking for a  new, innovative product that’s going to completely
  • 00:06:51
    change the world. Or looking at a company that  is in an industry that is constantly changing.
  • 00:06:57
    This alone eliminates a large number of stocks  that just simply aren’t investible for him.
  • 00:07:03
    [00:08:04] He wants a business that has been  producing a similar product or service for many
  • 00:07:07
    years, because if the business has had sustainable  and consistent growth and profits over the years,
  • 00:07:12
    then he’s able to have confidence in assessing  whether that will continue into the future or not.
  • 00:07:18
    Buffett has been quoting as saying that severe  change in exceptional returns usually do not mix.
  • 00:07:24
    [00:08:26] For example, Buffett has invested  in many industries which are considered staples
  • 00:07:29
    of the economy, such as railroads, energy,  and insurance. These industries are going
  • 00:07:34
    to continue to be staples and key parts  of our economy in some form or fashion
  • 00:07:39
    in the future. So Buffett likes how stable  and reliable these industries truly are,
  • 00:07:44
    and this is a big reason why Buffett has  often avoided tech companies over his life.
  • 00:07:49
    [00:08:50] He has seen so many tech companies  come and go, that he just simply believes that
  • 00:07:53
    he’s better off investing in a company  that is very likely to continue to grow
  • 00:07:57
    consistently for the years to come. The  future is definitely difficult to predict,
  • 00:08:02
    but assuming that a stable industry will  continue to produce profits for a very
  • 00:08:06
    long time, for the very best companies  is still a reasonable assumption to make.
  • 00:08:10
    [00:09:12] So business principle number two, the  business must have a consistent operating history
  • 00:08:16
    business principle number three, the company  must have favorable long term prospects. When
  • 00:08:22
    Buffett is narrowing down the type of  businesses he views as great businesses,
  • 00:08:27
    he oftentimes wants three things.  He wants to ensure that the company
  • 00:08:30
    provides a product or service that  one is needed or desired by society.
  • 00:08:35
    [00:09:36] Two, it has no close substitute,  and three, it is not regulated. Having
  • 00:08:40
    these three attributes allows a company to  have pricing power and earn above average
  • 00:08:45
    returns on capital over time. Buffett says he  likes stocks with high returns on investing
  • 00:08:50
    capital that is likely to persist as well as a  company with a long term competitive advantage.
  • 00:08:55
    [00:09:57] This is drilling down  to the term Buffett uses often,
  • 00:08:59
    which is a moat. A moat is what gives a great  company a clear advantage over its competitors
  • 00:09:04
    and protects the business from invasion  by competition, wanting to tap into their
  • 00:09:09
    share of profits. So a clear competitive  advantage is crucial as well as for that
  • 00:09:14
    competitive advantage or moat to be durable and  is able to stick around for a really long time.
  • 00:09:19
    [00:10:21] Buffett says that a great  company is one that will be great
  • 00:09:22
    for 25 to 30 plus years. Conversely, a bad  business offers a product that is virtually
  • 00:09:29
    undistinguishable from the products of its  competitors, which is a commodity. Years ago,
  • 00:09:33
    basic commodities included oil, gas,  chemicals, copper, lumber, wheat, and so.
  • 00:09:39
    [00:10:42] Today, products like computers,  automobiles, airline services, and banking
  • 00:09:45
    have become commodity like products. So that  wraps up Buffett’s. Three business tenants,
  • 00:09:51
    which include the company must be  simple and understandable. It must
  • 00:09:54
    have a consistent operating history, and  it must have favorable long term prospects.
  • 00:09:59
    [00:11:01] Next tax drum lays out Buffett’s  three management tenants. Buffett pays very close
  • 00:10:04
    attention to the quality of the management. He  tells us that the companies or stocks, Berkshire
  • 00:10:09
    purchases must be operated by honest and competent  managers whom he can admire and trust. Even if
  • 00:10:16
    they’re managing a very high quality business,  he will never make an investment in a team He
  • 00:10:20
    does not admire and trust, as he says, no matter  how attractive the prospects of their business.
  • 00:10:25
    [00:11:27] We’ve never succeeded in making good  deals with a bad person. The first management
  • 00:10:30
    principle that Hagstrom lays out in his book is  that the management must act rationally. He states
  • 00:10:36
    that quote, The most important management act is  the allocation of the company’s capital. It is
  • 00:10:42
    the most important because allocation of capital  over time determines shareholder value in quote.
  • 00:10:48
    [00:11:49] Management needs to figure out  how to best allocate capital in a way that
  • 00:10:52
    maximizes shareholder value. This might mean  taking the earnings and paying out a dividend,
  • 00:10:57
    or potentially taking those earnings  and expanding their business in the
  • 00:11:00
    US or internationally, or even  buying back shares in the company.
  • 00:11:03
    [00:12:05] Once a company has matured to some  degree and is to the point where they’re producing
  • 00:11:08
    free cash flows, management is going to need  to determine what to do with those cash flows.
  • 00:11:14
    If the money could be reinvested  back into the business at a rate
  • 00:11:17
    of return that is higher than their cost  of capital, then it is logical to do so.
  • 00:11:21
    [00:12:23] Retaining earnings and reinvesting at  a rate of return that is lower than the cost of
  • 00:11:26
    capital is irrational, and it’s actually  quite common on Wall Street. This is why
  • 00:11:31
    Buffett wants to see high return on invested  capital in a business. It shows that the company
  • 00:11:36
    is able to produce a lot of cash relative  to the cash that is put into the business.
  • 00:11:40
    [00:12:42] Monger is also known for saying  the following quote, Over the long term,
  • 00:11:44
    it’s hard for a stock to earn a much better  return than the business which underlies it
  • 00:11:49
    earns. If the business earns 6% on capital over  40 years and you hold the stock for 40 years,
  • 00:11:55
    you’re not going to make much  different than a 6% return.
  • 00:11:58
    [00:13:00] Even if you originally buy  it at a huge discount. Conversely,
  • 00:12:02
    if a business earns 18% on  capital over 20 or 30 years,
  • 00:12:06
    even if you pay an expensive looking price,  you’ll end up with a fine result. End quote.
  • 00:12:12
    Costco is a great example of this. They had  return on invested capital just over 10% in
  • 00:12:17
    the two thousands, and ever since 2010, the RO  i c has steadily risen to be in the high teen.
  • 00:12:23
    [00:13:25] Meanwhile, Costco stock has risen on  average by 13.6% per year, excluding dividends
  • 00:12:30
    since 1998. Of course, Costco’s earnings multiple  has risen substantially over the years as well,
  • 00:12:35
    so return on invested capital is not the  sole driver in its long term performance.
  • 00:12:40
    And as many of you in the audience know, Munger  has been a huge fan of Costco over the years.
  • 00:12:45
    [00:13:47] So if a company is not able to reinvest  back into the business at high rates of return,
  • 00:12:51
    Buffett likes to see the business either  returning that capital back to shareholders
  • 00:12:55
    through a dividend or through share buybacks.  Each method has its own pros and cons. Returning
  • 00:13:00
    the capital through a dividend allows the  shareholders to have the cash in their own hands.
  • 00:13:05
    [00:14:07] However, dividends are less tax  efficient than share buybacks, as dividends
  • 00:13:09
    are oftentimes taxed in the US to some degree.  For most investors, Buffett who’s clearly a
  • 00:13:15
    spectacular capital alligator, prefers to perform  share buybacks rather than issuing a dividend.
  • 00:13:20
    Berkshire Hathaway has never paid a dividend,  but he has repurchase shares in the past.
  • 00:13:25
    [00:14:27] The benefit of doing so is twofold.  First, management can opportunistically time
  • 00:13:31
    when they perform, share buybacks, and it’s  oftentimes wise to repurchase shares when
  • 00:13:36
    the stock is trading below its intrinsic  value. Second, When management Repurchases
  • 00:13:41
    shares, it shows they are having the  shareholder’s best interest at heart.
  • 00:13:45
    [00:14:46] As for each share, they repurchase,  they’re increasing the current stockholders,
  • 00:13:49
    overall ownership in the business. For  example, if Buffett were to purchase 1%
  • 00:13:53
    of shares outstanding in a company, and  that company in turn repurchase 5% of
  • 00:13:58
    shares outstanding year after year, after  14 years, he would then own 2% of shares
  • 00:14:04
    outstanding as the share repurchases would have  effectively doubled his stake in the company.
  • 00:14:08
    [00:15:10] Apple is one example of a company  Buffett owns that. Ruthlessly buys back shares in
  • 00:14:14
    2021 Apple Reed, 85.5 billion of their own shares.  This is around 3.4% of total shares when looking
  • 00:14:23
    at the shares outstanding at the beginning, in  the end of the year. So management principle
  • 00:14:28
    number one, management must act rationally  and act in shareholders’ best interest.
  • 00:14:33
    [00:15:35] The second management principle  outlined in the book is that management must
  • 00:14:38
    act candid with shareholders. What this principle  is really getting at is that Buffett wants to see
  • 00:14:43
    that management is truthful, transparent,  and they aren’t trying to hide anything
  • 00:14:47
    from the shareholders. Buffett are used that  through the mandatory reporting disclosures.
  • 00:14:53
    [00:15:55] Management must present data that  helps the financially literate readers answer
  • 00:14:57
    three key questions. One, approximately  how much is the company worth? Two,
  • 00:15:03
    what is the likelihood that it can  meet its future obligations? And three,
  • 00:15:08
    how good a job are its managers doing  given the hand that they’ve been.
  • 00:15:11
    [00:16:14] Buffett frankly points out that most  annual reports are a sham. I think a big reason
  • 00:15:17
    that Buffett might be seeing this in annual  reports is that because a lot of executives
  • 00:15:22
    and CEOs are incentivized to increase their stock  price as much as possible. So if they point out
  • 00:15:28
    and talk about how they didn’t execute effectively  or the business has performed poorly historically,
  • 00:15:33
    then that might lead to shareholders  selling and further decreasing the stock.
  • 00:15:38
    [00:16:40] Buffett is in a position  where he isn’t going to get fired,
  • 00:15:42
    and he openly talks about all of the  many mistakes he has made over the
  • 00:15:46
    years. The reality is that it’s very hard  to find management that talk as openly as
  • 00:15:51
    Buffett about his mistakes. So I would just  encourage the audience to not settle on a
  • 00:15:56
    management team if you aren’t really sure  they are honest and trustworthy people.
  • 00:16:00
    [00:17:02] Related to this idea is the third and  final management principle, which is to resist
  • 00:16:05
    the institutional imperative. The institutional  imperative is the tendency of corporate managers
  • 00:16:11
    to imitate the behavior of others, no matter  how silly or irrational that behavior might
  • 00:16:17
    be. He wants managers who are critical thinkers  and have the ability to think for themselves.
  • 00:16:22
    [00:17:25] He doesn’t want somebody to make a  decision just because all of their competitors
  • 00:16:27
    are doing the same thing. This could be related  to changing the status quo in the industry,
  • 00:16:32
    making acquisitions, selling executive  compensation, etc. It kind of reminds me
  • 00:16:37
    of the overall investment management industry.  You might find one fund manager who is invested
  • 00:16:42
    in a hundred stocks, primarily picking many  of the big names that other funds are holding.
  • 00:16:47
    [00:17:49] There’s that old saying that you  won’t get fired for buying a stock like IBM.
  • 00:16:51
    Because 20 years ago that was considered a safe  pick that everyone was buying. If you’re trying
  • 00:16:57
    to keep your job, then buying IBM is probably a  pretty good idea. If it does well, then the fund
  • 00:17:03
    benefits from that performance. If it does poorly,  then well, all the other funds owned IBM too, and
  • 00:17:09
    you still get to keep your job for not stepping  outside of the lines and crossing any boundaries.
  • 00:17:14
    [00:18:16] Whereas if you took the risk on a new  company in the technology field, you run the risk
  • 00:17:19
    of being humiliated if it does poorly, and then  you might lose your job. It’s all human nature
  • 00:17:24
    and it’s against human nature to stand out and  potentially look bad when compared to your peers.
  • 00:17:29
    Really, it just boils down to the fact that  many managers of companies are thinkers,
  • 00:17:34
    whereas Buffett is looking for the managers  that can overcome these human tendencies and
  • 00:17:40
    make unconventional long term decisions  to the benefit of the shareholders.
  • 00:17:44
    [00:18:46] Another reason that many managers  aren’t very good at their job is because they
  • 00:17:48
    rose the ranks within the company and got  promoted to be on the executive team. So
  • 00:17:53
    their whole life, they were really good at  one particular skill set. Let’s say sales,
  • 00:17:58
    for example. Well, then they’re  on the management team now.
  • 00:18:00
    [00:19:02] They need to be great at managing  and allocating capital and resources,
  • 00:18:05
    even though they’ve only done sales their  whole career. Then naturally they turn
  • 00:18:09
    to others to form their own opinions and  decisions in the institutional imperative
  • 00:18:13
    takes hold in their decision making.  Determining the quality of a management
  • 00:18:18
    team is more difficult than measuring the  financial performance of a company simply
  • 00:18:22
    because you can’t directly measure things like  rationality, candor, and independent thinking.
  • 00:18:27
    [00:19:29] Having a good understanding of these  aspects of the management can allow you as an
  • 00:18:32
    investor to catch the early warning signs  to the eventual financial performance of the
  • 00:18:37
    company. Here are some tips that Buffett shares  in determining the quality of the management team.
  • 00:18:43
    One, look back at the annual reports from  a few years back and compare what they
  • 00:18:47
    were saying about the future and how  that compares to the business today,
  • 00:18:50
    and how the business has changed over that period.
  • 00:18:52
    [00:19:55] Two, read the company’s annual  reports and see how it differs from that
  • 00:18:57
    of their peers. Three, don’t solely  rely on quality managers when making
  • 00:19:02
    investments. Not even the best managers  can turn around a bad business. That
  • 00:19:07
    wraps up the management tenants outlined  in Hagstrom book, The Warren Buffett Way.
  • 00:19:11
    [00:20:13] Next, let’s turn to the four financial  tenants. The first financial tenant is to have an
  • 00:19:17
    adequate return on equity related to our point  earlier about the institutional imperative. It
  • 00:19:24
    seems like Wall Street also puts a big emphasis  on earnings per share. But a method that Buffett
  • 00:19:30
    actually cares more about is the return on  equity more so than the earnings per share.
  • 00:19:34
    [00:20:36] So what is the return on  equity? The return on equity is the
  • 00:19:38
    ratio of the operating earnings to the  shareholder’s equity or the book value.
  • 00:19:42
    So if a company has a net income or  operating earnings of $10 per share,
  • 00:19:47
    and the book value is a hundred dollars per share,  then the return on equity is 10% for that year.
  • 00:19:52
    [00:20:54] When looking at a company’s return  on equity or return on invested capital over
  • 00:19:56
    a period of years, you typically want to  see these measurements either steady or
  • 00:20:01
    increasing over time. A company that has a return  on invested capital of greater than 10% is great,
  • 00:20:07
    and it shows that the company is  efficient at reinvesting their
  • 00:20:10
    earnings back into the business to  produce even more earnings over time.
  • 00:20:13
    [00:21:15] This is important because most  stocks retain their earnings within the
  • 00:20:17
    equity of the business. If a company’s  return on equity or return on invested
  • 00:20:22
    capital is low or it is declining, this should  tell you that the company is not efficient at
  • 00:20:27
    reinvesting the earnings back into the  business. Simply put, great businesses
  • 00:20:31
    have high return on equity and high return  on invested capital, say greater than 10%.
  • 00:20:36
    [00:21:38] Buffett knows that sometimes  adjustments need to be made in these
  • 00:20:40
    calculations. In Berkshire’s case, their books  might have a massive increase in their equity
  • 00:20:44
    holding in one particular year. Well, this  would lead to lower levels of return on equity,
  • 00:20:49
    so that’s something to keep in  mind when analyzing this figure.
  • 00:20:52
    [00:21:54] Also, you’ll want to keep in mind  how much debt the company has on its books.
  • 00:20:56
    If a company is increasing their return on equity  while also increasing their debt to income ratio,
  • 00:21:02
    you should be mindful of this as the company may  be getting too levered up and taking on too much
  • 00:21:07
    risk, and the debt could eventually become  a drag on the company’s financial results.
  • 00:21:12
    [00:22:14] When analyzing the return  on equity, return on invested capital,
  • 00:21:15
    or really any reported number by a company,  you don’t want to put too much focus on one
  • 00:21:21
    particular year because one year might  turn out to be an anomaly. For example,
  • 00:21:25
    if the return on equity for a company is  5% per year and all of a sudden it’s 10%
  • 00:21:30
    in the most recent year, then you might  not want to put too much weight on that
  • 00:21:33
    10% until you’ve seen the company produce that  level, at least for a period of a few years.
  • 00:21:39
    [00:22:41] Wrapping up this tenant Buffett  believes that a good business should be
  • 00:21:43
    able to earn a good return on equity. Without  the aid of leverage, you should be suspicious
  • 00:21:48
    of any companies that rely on leverage to  produce good return on. The second financial
  • 00:21:54
    tenant in RIM’S book is to calculate owner’s  earnings to get a true reflection of value.
  • 00:22:00
    [00:23:02] Buffett says that not all  earnings are created equal. Two companies
  • 00:22:04
    might have the same level of earnings, but  one company might be asset heavy while the
  • 00:22:09
    other might be asset light. Inflation and  the need to replace the assets in the asset
  • 00:22:14
    heavy business make the earnings between  the two companies not really comparable.
  • 00:22:18
    [00:23:20] Oftentimes investors use free cash  flow in estimating the earnings that a company
  • 00:22:22
    produces. Free cash flow is calculated as  net income after taxes, plus depreciation,
  • 00:22:28
    depletion, amortization, and other non-cash  changes. Buffett says that the problem with this
  • 00:22:34
    figure is that it excludes capital expenditures,  which includes investments for new equipment,
  • 00:22:39
    plant upgrades, and other improvements needed to  maintain its economic position and unit volume.
  • 00:22:44
    [00:23:46] In calculating the economic earnings,
  • 00:22:47
    Buffett wants to take the cash flow and adjust  it for the capital expenditures as well as the
  • 00:22:52
    working capital that might be needed in  the future. The issue with calculating
  • 00:22:56
    owner’s earnings is that it’s really up to  the investor to estimate what the capital
  • 00:23:00
    expenditures might be for a given year,  and it’s not really a precise calculation.
  • 00:23:04
    [00:24:06] It’s really an estimate to the  discretion of the investor hacks. Fromm
  • 00:23:09
    quotes John Keens in his book with regards  to this quote, I would rather be vaguely
  • 00:23:15
    right than precisely wrong. End quote.  The third financial tenant is to look
  • 00:23:20
    for companies with high profit margins. High  profit margins show that a particular company
  • 00:23:25
    is able to control costs and continues to  produce free cash flows into the future.
  • 00:23:29
    [00:24:32] In my mind, this tenant also ties  into finding a quality management team because
  • 00:23:35
    a quality management team is always looking  for ways to cut unnecessary costs and increase
  • 00:23:40
    their profit margins. If you want to learn  from someone who is good at cutting costs,
  • 00:23:44
    Buffett is one of the best managers at  doing this as Berkshire has completely
  • 00:23:49
    minimized their corporate expenses, at least  relative to their peers in their industry.
  • 00:23:54
    [00:24:56] All right. The fourth and final  financial principle or tenant is for every
  • 00:23:59
    dollar that is retained within the company,  make sure the company has created at least
  • 00:24:03
    $1 of market value. This tenant, I found  to be an interesting one that hacks from
  • 00:24:09
    included in his book. From a high level, the  stock market tells you what the market is.
  • 00:24:14
    [00:25:15] Valuing any particular  public company. Buffett believes
  • 00:24:17
    that if he has selected a company with  favorable long term economic prospects,
  • 00:24:22
    run by able and shareholder oriented managers,  the proof will be reflected in the increased
  • 00:24:28
    market value of the company. So if the company  is not doing a good job at redeploying their
  • 00:24:33
    retained earnings over extended period of  time, then the share price will be punished.
  • 00:24:37
    [00:25:39] If the company has an above  average return on invested capital over
  • 00:24:41
    an extended period of time, then this  share price will be rewarded assuming
  • 00:24:45
    that you paid a fair price for the business.  So Buffett has what’s called the $1 Rule. He
  • 00:24:51
    applies in determining the economic  attractiveness of a business and how
  • 00:24:55
    well management has accomplished its  goal of creating shareholder value.
  • 00:24:59
    [00:26:01] Hack Fromm states quote, The  increase in value should at the very least,
  • 00:25:03
    match the amount of retain earnings dollar  for dollar if the value goes up more than
  • 00:25:08
    the retained earnings, so much the better end. So  Buffett wants each dollar of retained earnings to
  • 00:25:14
    eventually be translated into at least a dollar  of increased market value in the business.
  • 00:25:19
    [00:26:21] So that wraps up the financial tenants  To recap, number one, focus on return on equity,
  • 00:25:24
    not earnings per share. Two, calculate owners  earnings to get a true reflection of value. Three,
  • 00:25:31
    look for companies with high profit  margins and four for every dollar
  • 00:25:35
    retained. Make sure the company has  created at least $1 of market value.
  • 00:25:40
    [00:26:42] So far, we’ve looked at the business  tenants, the management tenants, and the financial
  • 00:25:45
    tenants. All of these are looking at the actual  business, the people managing that business,
  • 00:25:50
    and then the financial results from the  business. What we haven’t analyzed yet is
  • 00:25:55
    the intrinsic value in comparing that to the  market value or market price of the company.
  • 00:26:00
    [00:27:02] The market determines  the price for the company,
  • 00:26:03
    but it is the investor’s job to determine  what the actual or true or intrinsic value
  • 00:26:09
    of the company is. And remember that  price and value are not necessarily the
  • 00:26:15
    same. Sometimes Mr. Market has these massive  mood swings to the upside or to the downside.
  • 00:26:20
    [00:27:22] For example, in March, 2020 when we had  a massive sell off after looking, in hindsight,
  • 00:26:26
    that was obviously an opportunity to purchase many  companies that were down 20, 30, 40% in the matter
  • 00:26:33
    of weeks. In 2021, we saw many gross stocks rise  by multiples above what they were in 2020. And
  • 00:26:39
    now in hindsight, we can likely say that those  prices went far above their intrinsic values.
  • 00:26:44
    [00:27:46] In many cases, if the prices offered  by the market were always efficient, then Warren
  • 00:26:50
    Buffett would not be who he is today. He’s been  able to identify great companies that are trading
  • 00:26:55
    at prices well below their intrinsic value, and  then taking advantage of these opportunities.
  • 00:27:01
    So in the market tenants, the first market  tenant is to determine the value of the business.
  • 00:27:06
    [00:28:09] Warren Buffett tells us that the value  of a business is determined by the net cash flow
  • 00:27:12
    expected to occur over the life of the business  discounted at an appropriate interest rate. N S
  • 00:27:17
    T I P has talked about for many years. This is  really how you can value any financial asset,
  • 00:27:23
    whether it be a bond real estate or  anything that produces cash flow.
  • 00:27:28
    [00:28:29] You project out what the asset is  going to make each year and then discount that
  • 00:27:32
    back to today at an appropriate interest rate,  starting with the earnings or the company’s cash
  • 00:27:37
    flows. It’s so much easier to determine the value  of a business if the business has steady cash
  • 00:27:43
    flows similar to a bond. I wanted to pull up two  examples to talk a little bit about what I mean.
  • 00:27:49
    [00:28:51] If you take a company  like Coca-Cola, which Buffett owns,
  • 00:27:53
    I pulled up our TIP Finance tool to take  a look at the free cash flows shown on our
  • 00:27:58
    website in 2018. They’re free cash flows  for 6.3 billion 20 19, 9 0.4 billion,
  • 00:28:05
    2020 8.9 billion, and in 20 21, 11 0.3  billion. So an investor would be able to
  • 00:28:13
    take some sort of average over the past five  years or come up with some sort of reasonable
  • 00:28:17
    assumption for the earnings and project  that forward with some degree of confidence.
  • 00:28:21
    [00:29:24] On the other hand, if you  look at a growth stock like Tesla,
  • 00:28:25
    their top line revenue growth has been over  100% just over the past two years. In 2018,
  • 00:28:32
    their free cash flows were negative. 2019,  they were 970 million in 2020 2.7 billion,
  • 00:28:40
    and in 2021, 5 billion. Just a slight tweak  in your assumptions for the free cash flow.
  • 00:28:45
    [00:29:46] Growth of Tesla can drastically  change your output for the intrinsic value
  • 00:28:49
    of the company. Whereas with Coke, it’ll  be much easier to come up with some sort
  • 00:28:54
    of conservative and reasonable intrinsic  value because the cash flows are much more
  • 00:28:58
    stable and you can be much more confident in  what the cash flows will be in the future.
  • 00:29:03
    [00:30:05] If Buffett can determine the free  cash flows with a high degree of certainty,
  • 00:29:07
    then he probably won’t even go about  valuing the company. Over the years,
  • 00:29:12
    Buffett has used the long term US government  treasury rate as his discount rate,
  • 00:29:16
    but now that interest rates are so low  today, it’s likely that he is using
  • 00:29:21
    something higher for the discount rate to  reflect a more normalized interest rate.
  • 00:29:25
    [00:30:27] Environ. Now when it comes to  valuation, many people like to categorize
  • 00:29:29
    companies into two camps, value  investors versus growth investors.
  • 00:29:34
    The value investing camp is people who want to  invest a little bit more conservatively, and
  • 00:29:39
    oftentimes they’re purchasing companies with low  price or earnings ratios and high dividend yields.
  • 00:29:44
    [00:30:46] These types of companies  have been back tested to perform well,
  • 00:29:48
    so that is the method of investing that many  people will go. As for growth investors,
  • 00:29:53
    they’re looking for companies that are growing  revenue and earnings at an above average clip,
  • 00:29:58
    but that growth does not come without  a price. So that’s why these types of
  • 00:30:02
    companies tend to have a higher PE  and little to no dividends paid.
  • 00:30:06
    [00:31:08] Many people think that they  have to pick one strategy or the other,
  • 00:30:09
    but Buffett says that the debate between  the two schools of thought is nonsense,
  • 00:30:14
    and that growth and value investing are joined  at the hip. Growth is actually a component of
  • 00:30:19
    value and it is actually counted for in  Buffett’s calculation of intrinsic value.
  • 00:30:24
    [00:31:26] So it’s not necessarily true  that just because a company has a low PE
  • 00:30:28
    means that Buffett will like it. And just  because a company has a high PE means that
  • 00:30:32
    Buffett won’t like it. All it really comes  down to is whether the intrinsic value is
  • 00:30:37
    training well below the market price  for him to consider buying it or not.
  • 00:30:41
    [00:31:43] This will bring us  to our second market tenant,
  • 00:30:44
    which is to buy at attractive price. Buying a  great business with capable management that is
  • 00:30:50
    simple to understand and has an attractive  business, economic simply isn’t enough. The
  • 00:30:55
    final piece of the puzzle is to ensure that you  are purchasing the company at a sensible price.
  • 00:30:59
    [00:32:01] If you listen to my previous two  episodes, which discussed Buffett’s investment
  • 00:31:04
    journey, you know that Buffett took to heart,  Benjamin Graham’s idea of ensuring an adequate
  • 00:31:09
    margin of safety when making a purchase. A  margin of safety allows for some room for
  • 00:31:14
    error in his assessment of the business and  how they end up performing in the future,
  • 00:31:18
    a margin of safety will give Buffett  some downside protection as well.
  • 00:31:22
    [00:32:24] For example, Apple today is  trading at around 150 or $160 a share.
  • 00:31:28
    If Buffett thinks the intrinsic value of Apple  is $200 and he is incorrect and is assessment
  • 00:31:34
    of the intrinsic value, and it’s actually  lower than 200. Well then he isn’t going to
  • 00:31:39
    lose money unless he is drastically often  his assessment of what the true value is.
  • 00:31:43
    [00:32:46] So there is some protection from  the downside risk because he is ensuring that
  • 00:31:48
    he is investing with a margin of safety. The  other reason he wants to buy with a margin of
  • 00:31:53
    safety is because this will help lead to above  average returns. If he is buying something that
  • 00:31:59
    is worth $200 for $160, then if he is right  in his assessment of the intrinsic value.
  • 00:32:05
    [00:33:07] He will not only earn a  return on how the business performs,
  • 00:32:09
    but he will eventually realize the return  of the stock price, eventually reaching the
  • 00:32:14
    intrinsic value of the company. So if a company  earns 15% on its assets over the long run,
  • 00:32:20
    the value of the stock will continue to trend  upwards in that manner on top of the market,
  • 00:32:25
    potentially recognizing that the company  was trading below its intrinsic value.
  • 00:32:29
    [00:33:31] So the margin of safety is  like the icing on the cake as the stock
  • 00:32:33
    may continue to trade well below  its intrinsic value for some time,
  • 00:32:37
    but it should continue to march upwards if it’s  a company with above average economic returns. So
  • 00:32:43
    that wraps up Warren Buffett’s 12 investment  principles that are laid out in RIM’S book.
  • 00:32:48
    [00:33:50] Again, those principles  are grouped into business tenants,
  • 00:32:52
    management tenants, financial  tenants, and market tenants.
  • 00:32:56
    Next. I wanted to walk through some of the  ideas around portfolio management as well as the
  • 00:33:02
    psychology aspect of investing. Hagstrom outlined  how Buffett considers himself a focus investor.
  • 00:33:09
    [00:34:11] This means that he focuses on just  a few outstanding companies and typically holds
  • 00:33:14
    these companies for many years. A lot of the work  is done up front in finding the right companies,
  • 00:33:19
    and this greatly simplifies the task of portfolio  management for him as an investor. Most of you are
  • 00:33:27
    probably aware that anyone can invest passively in  index funds, such as the s and p 500 in Buffett.
  • 00:33:33
    [00:34:34] Recognizes that anyone who invests  in this manner while outperform most investment
  • 00:33:38
    professionals. However, since Buffett has read  practically every investment book ever written,
  • 00:33:43
    he knows that he has research investing  enough to really know what the heck he’s
  • 00:33:48
    doing and what he’s talking about,  and how he can potentially outperform
  • 00:33:51
    the market and achieve exceptional  returns even better than the indexes.
  • 00:33:55
    [00:34:58] He believes that focused investing  significantly increases the odds of beating
  • 00:34:01
    the index. This approach includes choosing a  few stocks that are likely to produce above
  • 00:34:06
    average returns over the long. Concentrating  the bulk of your investments in these stocks
  • 00:34:11
    and having the fortitude to hold steady  during any short term market fluctuations.
  • 00:34:15
    [00:35:18] Following the 12 Tenets  laid out previously, inevitably leads
  • 00:34:20
    to great companies with a long history of  superior performance and stable management.
  • 00:34:26
    In that stability leads to companies that  are likely to provide solid returns in
  • 00:34:30
    the longer term future as they have in  the past. The heart of this approach is
  • 00:34:35
    concentrating into companies with the highest  probability of above average performance.
  • 00:34:40
    [00:35:42] Too often investors are chasing  these long shot picks that have, you know,
  • 00:34:45
    a potentially incredible payout, but most likely  won’t end up doing very well for investors. You
  • 00:34:51
    want to invest in a way that stacks the odds  in your favor and has a high probability of
  • 00:34:56
    succeeding for patient investors. Hagstrom  states that although focus investing stands
  • 00:35:02
    the best chance among all active strategies,  it does require investors to patiently hold
  • 00:35:07
    their portfolios when it appears that  other strategies are marching ahead.
  • 00:35:11
    [00:36:13] It’s almost certain that at some point,  a focus portfolio will underperform the market,
  • 00:35:16
    but over the long run, superior businesses  will win. If you were to ask Buffett what
  • 00:35:22
    his preferred holding period would be for  stock, he would probably tell you that he
  • 00:35:26
    would prefer to hold it forever. Or as long as  the company continues to generate above average
  • 00:35:31
    economic returns and management allocates the  earnings of the company in a rational manner.
  • 00:35:36
    [00:36:38] One of the biggest benefits of holding  forever or for a very long period of time,
  • 00:35:41
    and I think this is often underappreciated,  is the enormous value of unrealized capital
  • 00:35:48
    gains. Hagstrom says, quote, When a stock  appreciates in price but is not sold,
  • 00:35:53
    the increase in value is an unrealized gain. No  capital gains tax is owed until the stock is sold.
  • 00:36:00
    [00:37:02] If you leave the gain in place,  your money compounds more forcefully. Overall,
  • 00:36:05
    investors have too often underestimated the  enormous value of this unrealized gain. What
  • 00:36:11
    Buffett calls an interest free loan from the  treasury and quote, both Buffett and Munger
  • 00:36:16
    consider inactivity in portfolio management  to be highly intelligent behavior because of.
  • 00:36:22
    [00:37:24] Also managing a focus portfolio  requires you to think of the ownership of
  • 00:36:27
    stocks as ownership in real businesses. You  must be prepared to study the businesses you
  • 00:36:32
    own to understand it very well. You need  to have an investment time horizon of at
  • 00:36:37
    least five years. You shouldn’t use any  leverage in your portfolio and learn how
  • 00:36:41
    to detach your emotions when investing in the  stock market Related to the emotional aspect,
  • 00:36:47
    oftentimes the investor’s worst enemy  is not the stock market, but one.
  • 00:36:51
    [00:37:53] Someone could be very knowledgeable  about mathematics, accounting, and finance, but
  • 00:36:56
    if they haven’t learned to master their emotions,  then they probably don’t have what it takes to
  • 00:37:01
    be a great investor. Benjamin Graham said that  having an investor’s attitude is a matter of being
  • 00:37:07
    prepared both financially and psychologically  for the markets inevitable ups and downs.
  • 00:37:12
    [00:38:14] Not only knowing that downturns  will inevitably happen, but to have the
  • 00:37:17
    emotional fortitude to react appropriately when a  downturn does. From Benjamin Graham’s perspective,
  • 00:37:23
    when a downturn occurs, you should react  to an unattractive price to sell the same
  • 00:37:27
    as if someone knocked on your door to purchase  your house at half the price you bought it at.
  • 00:37:31
    [00:38:33] You just simply ignore such an offer. I  find behavioral finance to be an interesting topic
  • 00:37:37
    that is worth covering, so I’ll touch on that a  bit here. Overconfidence is the first investor
  • 00:37:42
    bias I wanted to mention. If you ask the average  person what their skills are on a particular
  • 00:37:48
    topic, odds are more than 50% of people would  tell you that their skills are above average.
  • 00:37:53
    [00:38:55] It’s a natural human tendency  for people to overestimate their ability
  • 00:37:57
    to do things. Investing included. Most investors  are highly confident that they are smarter than
  • 00:38:03
    everyone else. Thus, they have the tendency to  overestimate their skills and knowledge. Also,
  • 00:38:08
    people tend to rely on information that  confirms whatever it is they believe.
  • 00:38:12
    [00:39:14] They also disregard any information  that is contrary to their opinion. Overconfidence
  • 00:38:18
    can lead to us making some really simplified  and dangerous assumptions. This is why bubbles
  • 00:38:24
    occur. People see that a stock has doubled  over the past three months, so they think
  • 00:38:27
    that trend must continue, and it’s very likely  that it will continue when in fact, it’s not.
  • 00:38:32
    [00:39:34] If you’re applying  Buffett’s focused investor approach,
  • 00:38:35
    my best advice to overcome over  confidence would be to thoroughly
  • 00:38:40
    study whatever company it is you’re looking  to purchase and make sure it checks all the
  • 00:38:45
    boxes. As far as the investment tenants go  that I outlined earlier, This means reading
  • 00:38:50
    the company’s annual reports and taking a  look at their quarterly filings as well.
  • 00:38:54
    [00:39:56] If you’re just getting started,  in my opinion, it’s probably a good idea
  • 00:38:58
    to limit your individual stock. Picks to only  be a small portion of your overall portfolio,
  • 00:39:03
    say less than five or 10% of the total  for beginners. This ensures that any
  • 00:39:09
    mistakes you make won’t substantially hurt  your overall investment returns too much.
  • 00:39:13
    [00:40:15] The investor bias that Hagstrom  says is the most difficult hurdle that
  • 00:39:18
    prevents investors from successfully applying  Buffett’s approach to investing is loss aversion.
  • 00:39:23
    Loss aversion is the human tendency to dislike the  loss of capital. More than the same level of gain.
  • 00:39:29
    According to a study by Daniel Conman, they were  able to prove mathematically that people regret
  • 00:39:35
    losses more than they welcome gains of the same  size, up to two, to two and a half times more.
  • 00:39:41
    [00:40:42] Actually. In other words,  the pain of a loss is far greater than
  • 00:39:45
    the enjoyment of a gain. This loss  aversion tends to make investors
  • 00:39:49
    more conservative than they potentially  should be in some cases. For example,
  • 00:39:54
    someone who is in their twenties might have some  portion of their portfolio allocated to bonds.
  • 00:39:58
    [00:41:00] Even though bond yields are very low  today and likely won’t outperform stocks from now
  • 00:40:04
    until they hit their retirement age because  of the long time horizon they have. I think
  • 00:40:08
    that loss a version also might keep people from  investing in the stock market in general, even
  • 00:40:13
    though you’re very likely to make money in stocks,  if you have a five or 10 plus year time horizon.
  • 00:40:18
    [00:41:20] Many people look at what happened in  2000 or 2008 and think they can’t afford to lose
  • 00:40:24
    30 or 40% of their money in stocks, so they end up  just holding something that is perceived as safer,
  • 00:40:30
    such as bonds or cash, even though  they could make much more money just
  • 00:40:34
    continually buying and holding stocks and not  even checking their account balances over that.
  • 00:40:39
    [00:41:41] It’s important to remember that there  will always be many days or even months where the
  • 00:40:45
    stock market is down. But when you look at the  data, the stock market is up 87% of the time
  • 00:40:50
    when held for a five year period, stocks are up  94% of the time when held for a 10 year period.
  • 00:40:56
    So as you extend your time horizon, you increase  your chances of making money in the stock market.
  • 00:41:01
    [00:42:03] Even when looking at just a one  year period. Stocks increase 74% of all years.
  • 00:41:07
    But when you zoom into a single day, stocks are up  53% of the time. So it’s essentially a coin flip
  • 00:41:14
    day by day by day. So down days and down weeks  are expected and are actually pretty common,
  • 00:41:20
    and occasionally, quote unquote, losing money  is to be expected, but when you hold stocks
  • 00:41:25
    for a long period of time, it’s likely you will  end up making a good return on your investment.
  • 00:41:30
    [00:42:32] Additionally, loss aversion might  prevent someone from selling a stock that they
  • 00:41:35
    know is a losing company and actually realize  their loss because it hurts to realize that loss,
  • 00:41:40
    even though that money could be allocated to  a better company. Loss aversion also relates
  • 00:41:45
    to what is called the disposition  effect, which is the tendency to
  • 00:41:49
    defer regret by holding onto losers and to  avoid being greedy by selling our winner.
  • 00:41:54
    [00:42:56] Even worse would be to sell  your winners, to allocate to your losers,
  • 00:41:58
    and eventually you’ll end up with a portfolio  full of bad companies. The most powerful
  • 00:42:03
    element in investing is time, and you’re  wasting it by sticking with an investment
  • 00:42:07
    strategy that isn’t working. To me, this is  one of the most difficult biases to overcome.
  • 00:42:12
    [00:43:14] On the one hand, you might see  that a particular individual stock or asset
  • 00:42:16
    class is overheated. So I can see the case to  sell your winners to rebalance. Additionally,
  • 00:42:22
    the best performing investments tend to be  the most volatile. So I can also see why
  • 00:42:27
    selling when there is a bit of an irrational  exuberance can help you sleep better at night,
  • 00:42:32
    because eventually there will be a big draw down.
  • 00:42:34
    [00:43:36] You just don’t really know when,  and that’s why I really like Warren Buffett’s
  • 00:42:38
    approach of not letting the irrational  exuberance get the best of you. He’s
  • 00:42:43
    essentially playing a totally different game  than most other investors. This reminds me of
  • 00:42:47
    Warren Buffett’s investment in Coca-Cola many  years ago. In 1988, Buffett purchased 1 billion
  • 00:42:54
    worth of Coca-Cola shares, and over the next 10  years, the price of the stock went up tenfold.
  • 00:42:59
    [00:44:01] While the S&P 500 went up by  threefold, You might be thinking that,
  • 00:43:03
    hey, Coca-Cola must have been an easy  pick. It was a very well-known brand,
  • 00:43:07
    trading at a reasonable price, and it was growing  at a pretty fast clip at the time. But over that
  • 00:43:12
    10 year period, Coca-Cola only outperformed  the market during six of those 10 years.
  • 00:43:17
    [00:44:19] Based on loss aversion, this  underperformance on four of those years
  • 00:43:21
    would naturally lead to many people not wanting  to own the stock. But given that Buffett had
  • 00:43:27
    overcome this natural tendency, he was able to  know what the true value of Coke was over that
  • 00:43:32
    time and really take advantage of it even when the  market temporarily disagreed with his assessment.
  • 00:43:37
    [00:44:39] Buffett would continually check in on  the economic progress of the company and see that
  • 00:43:43
    the overall company was doing an excellent job.  So he just continued to own the business while
  • 00:43:47
    everyone else would pay closer attention to  the day to day price movements of the stock.
  • 00:43:51
    So Buffett is stepping in and buying  a great company at a fair price while
  • 00:43:56
    a lot of investors are piling into the  stock in the years that it’s doing well,
  • 00:44:00
    and maybe even getting rid of the shares in  the years that the stock isn’t doing as hot.
  • 00:44:05
    [00:45:07] I’ll end this part with  a quote from Benjamin Graham, quote,
  • 00:44:08
    The investor who allows himself to be  stampeded or unduly worried by unjustified
  • 00:44:14
    market declines in his holdings is perversely  transforming his basic advantage into a basic
  • 00:44:20
    disadvantage. That man would be better off if  his stocks had no market quotation at all, for
  • 00:44:25
    he would then be spared the mental anguish caused  by another person’s mistakes of judgment, quote.
  • 00:44:32
    [00:45:34] Next, I wanted to walk through a case  study that Hagstrom laid out in chapter four of
  • 00:44:37
    his book with real purchases that Buffett has  made. The nine examples that Hagstrom walked
  • 00:44:43
    through in his book were Washington Post,  Geico, Capital Cities slash abc, Coca-Cola,
  • 00:44:48
    General Dynamics, Wells Fargo,  American Express, IBM, and Hines.
  • 00:44:53
    [00:45:55] And it’s important to keep in mind  that Hari’s book, the Warren Buffettt Way,
  • 00:44:57
    was released in 2013. I noticed that IBM  and Hines ended up being complete duds
  • 00:45:03
    for Buffett. So it just goes to show  that even the best investors on the
  • 00:45:07
    planet still make mistakes even after  being in the game for so many decades.
  • 00:45:11
    [00:46:13] However, his investment in Apple in  2016 and beyond has more than made up for such
  • 00:45:17
    mistakes. Buffett first started buying IBM in  2011, initially having a $10.7 billion position.
  • 00:45:24
    After six to seven years of declining revenues and  a subpar stock performance, he then fully exited
  • 00:45:30
    his position in IBM. In 2013, Buffett partnered  with 3G Capital to buy Heinz for 23 billion.
  • 00:45:37
    [00:46:39] In 2015, Heinz merged with  Kraft foods, and since then the stock
  • 00:45:42
    is down nearly 50%. I didn’t want to  dive too much into these stock picks,
  • 00:45:47
    but I did want to rewind back to 1988 to  look at his purchase in Coca-Cola as it’s
  • 00:45:53
    a company that all the listeners are familiar  with to some degree. Like I mentioned earlier,
  • 00:45:57
    in 1988, Berkshire purchased 1  billion worth of Coca-Cola shares,
  • 00:46:02
    which at the time was a third of the Berkshire  portfolio and 7% of the shares outstanding.
  • 00:46:07
    [00:47:09] Wall Street was quite surprised  by this as the stock was trading at five
  • 00:46:11
    times book value and 15 times earnings, which  was a premium above the market at the time.
  • 00:46:17
    Hagstrom deviated from the order of tenants  I listed earlier, so I’m going to stick with
  • 00:46:22
    the order he presents in the book, so please  bear with me tenant one simple and understand.
  • 00:46:28
    [00:47:30] The business of Coca-Cola is relatively  simple as they purchase commodity inputs and mix
  • 00:46:33
    these commodity inputs to manufacture concentrate  that is then sold to bottlers. The bottlers then
  • 00:46:39
    sell the finished product to retail outlets  of all variations to get the product to the
  • 00:46:44
    end consumer. The company also provides Softing  syrups, two restaurants and fast food retailers.
  • 00:46:50
    [00:47:52] It doesn’t take a rocket scientist  to understand Coca-Cola’s business model ten
  • 00:46:56
    two consistent operating history. The business  started in 1886 and today is selling the same
  • 00:47:02
    beverage plus many others. Practically  no business has been around longer than
  • 00:47:07
    Coca-Cola. They are the number one global provider  of beverages, ready to drink coffees and juices.
  • 00:47:13
    [00:48:15] So we got simple and understandable and  consistent operating history. Check for both of.
  • 00:47:18
    Three favorable long term prospects.  When Buffett had made his purchase,
  • 00:47:23
    he had said that he was certain that  in 10 years Coca-Cola would be doing
  • 00:47:27
    substantially more business than  when he had originally purchased it.
  • 00:47:31
    [00:48:33] Buffett had obviously been  aware of Coke his whole life as he sold
  • 00:47:35
    Coke bottles as a kid and followed the company  as an investor. The company performed poorly
  • 00:47:40
    in the 1970s and underperformed  the market. But during the 1980s,
  • 00:47:44
    Buffett saw that the leadership team had been  pointing the ship in a much better direction.
  • 00:47:49
    [00:48:51] They brought in a new leadership  team and Buffett recognized that they were
  • 00:47:53
    taking intelligent risks, cutting costs, and  optimizing their return on assets within each
  • 00:47:58
    business unit. Tenant four high profit margin.  In 1980, Coca-Cola’s pre-tax profit margins
  • 00:48:05
    were a measly 12.9% down from 18%. In 1973 with  the new CEO of Roberto Goa, his profit margins
  • 00:48:14
    rose to 13.7%, and by 1988, when Buffett first  purchased, the profit margins had risen to 19%.
  • 00:48:21
    [00:49:23] So profit margins were definitely  heading in the right direction under the new
  • 00:48:25
    leadership team, 10 at five, High return  on equity. The new CEO clamped down and
  • 00:48:31
    divested from any business unit that  wasn’t producing an adequate return
  • 00:48:35
    on equity. During the 1970s, the ROE was  20%, and in 1988, the ROE had risen to 31%.
  • 00:48:43
    [00:49:46] The high return on equity helped fuel  positive stock performance during the 1980s as a
  • 00:48:49
    market value of Coca-Cola stock compounded by  19.3% per year from 1980 to 87. 10 Number six.
  • 00:48:58
    Canor Canor isn’t a term I hear often, so for  those not familiar, it essentially means that
  • 00:49:05
    managers are open, honest, and not trying to  hide anything to the benefit of themselves.
  • 00:49:10
    [00:50:12] The CEO wrote two shareholders.  We shall over the next decade remain totally
  • 00:49:15
    committed to our shareholders and  to the protection and enhancement
  • 00:49:19
    of their investment. In order to give our  shareholders an above average total return
  • 00:49:23
    on their investment, we must choose businesses  that generate returns in excess of inflation.
  • 00:49:28
    [00:50:30] End quote. The leadership team  knew that in order to increase the value of
  • 00:49:33
    the company for the shareholders, he would need  to increase profit margins and return on equity,
  • 00:49:37
    as well as the dividends paid over time.  All three of these when Buffett purchased,
  • 00:49:42
    were all trending in the right direction,  so Roberta wasn’t just talking a big game.
  • 00:49:46
    [00:50:48] He actually had the proof  and the performance of the business. In
  • 00:49:51
    order to do so. He was cutting investments  from areas that didn’t provide an adequate
  • 00:49:55
    return on investment and redeploying that  capital where he could earn a sufficient
  • 00:50:00
    return. He wasn’t pursuing growth just for  the sake of growth. He was ensuring that
  • 00:50:05
    the capital was being redeployed back into  the business effectively, which at the time
  • 00:50:09
    the highest returns were to be found in the  soft drink core business unit, 10 at seven.
  • 00:50:14
    [00:51:15] Rational manage. In addition to what  I mentioned under the candor tenant previously,
  • 00:50:19
    management was definitely taking the  company in the right direction. In 1984,
  • 00:50:24
    management announced that the company would  repurchase 6 million of their own shares of
  • 00:50:28
    stock in the open market. This is  always a benefit for shareholders,
  • 00:50:32
    assuming that the stock is trading at a price  that is below its estimated intrinsic value.
  • 00:50:37
    [00:51:39] 10. Each dollar retained must lead  to at least a $1 increase in value. In 1973,
  • 00:50:45
    owner’s earnings were 152 million in  1980. Owner’s earnings were 262 million,
  • 00:50:52
    which amounted to an 8% annual growth rate  from 81 through 88. Owners earnings grew
  • 00:50:59
    from 262 million to 828 million, which is an  average annual compounded growth rate of 17.8%.
  • 00:51:07
    [00:52:09] And this is before Buffett had  purchased this difference in the growth
  • 00:51:11
    rate of the owner’s. Earnings was clearly  reflected in the growth rate of the stock
  • 00:51:15
    price. Hagstrom outlines that from 73 to 82,  the total return for shareholders was 6.3%.
  • 00:51:22
    Then from 83 to 92, the total return  was 31.3% annually, 10 at nine and 10.
  • 00:51:30
    [00:52:31] The institutional imperative in  calculating owner’s earnings. When the CEO
  • 00:51:34
    first entered the CNET Koch, his first move  was to divest from businesses that weren’t
  • 00:51:39
    earning an adequate return and investing that  capital where higher returns could be achieved,
  • 00:51:43
    which was their core business of selling syrup.
  • 00:51:46
    [00:52:48] This is a great sign of resisting  the institutional imperative as many managers
  • 00:51:51
    will invest in new segments or just go out and  buy out their competitors just for the sake of
  • 00:51:56
    growth of the top line revenue and make it look  like they’re doing their job effectively. It
  • 00:52:01
    was very telling that the new CEO went against  what other managers would do in that situation
  • 00:52:06
    and stick with what he knew would likely  benefit long term shareholders The most.
  • 00:52:10
    [00:53:12] Simply investing capital where  the highest returns can be made. Sounds easy,
  • 00:52:15
    and it sounds simple, but you know  who wouldn’t want that. But it took
  • 00:52:19
    a lot of mental fortitude for him to make  that move as most of his competitors were
  • 00:52:23
    doing the exact opposite in investing  in unrelated businesses. For example,
  • 00:52:28
    Anheuser Bush was using their profits from  selling beer to invest in theme parks.
  • 00:52:33
    [00:53:34] Pepsi bought snack businesses free  to lay in restaurants such as Taco Bell, kfc,
  • 00:52:38
    and pizza. So from what I’ve read, the new  CEO and management team were definitely
  • 00:52:42
    resisting the institutional imperative and  ignoring what other companies were doing.
  • 00:52:47
    10 11 determined the value. When Buffett  purchased Coke, the company was trading at
  • 00:52:53
    15 times earnings and 12 times cash flow, which  was a 30 and 50% premium to the market average.
  • 00:52:59
    [00:54:01] Buffett bought the company when  it had a 6.6% earning yield at a time when
  • 00:53:04
    long term bonds were yielding 9%. Just because  Coca-Cola was yielding less than a long term bond,
  • 00:53:10
    doesn’t mean that the value isn’t significantly  higher. As we all know, the value of a stock is
  • 00:53:16
    the projected future earnings for the company  discounted at an appropriate discount rate.
  • 00:53:20
    [00:54:22] In 1988, owners earnings  for Coke totaled 828 million,
  • 00:53:25
    and the 30 year US Treasury yielded 9%. If  you assume that the company had zero growth,
  • 00:53:31
    you would just need to simply take 828 million  and divide it by 9% and giving you a value of
  • 00:53:37
    9.2 billion. However, it would probably  be foolish to assume that Coke wouldn’t
  • 00:53:43
    grow at all in the future as earnings had  grown at nearly 18% per year since 1981.
  • 00:53:49
    [00:54:51] In the book, Hagstrom takes a  simple two stage process to value Coke. He
  • 00:53:55
    makes an assumption that Coke will be able to  grow their cash flows for the next 10 years at
  • 00:54:00
    15% per year. Then from year 11 onwards, they  would grow at 5% per year. Projecting out these
  • 00:54:06
    cash flows and discounting them back to today,  that would give you a valuation of 38.16 billion.
  • 00:54:12
    [00:55:14] This is far greater than the  market valuation of 14.8 billion. Even
  • 00:54:17
    if Coke only grew at 10% per  year over the first 10 years,
  • 00:54:21
    the estimated intrinsic value would be 32.5  billion. If they grew at 5%, it would be 20.7
  • 00:54:27
    billion. This isn’t bad for a softing company, 10  at 12, buy at attractive prices. At this point,
  • 00:54:33
    you probably know that a strong margin of safety  was built into the price that Buffett bought it.
  • 00:54:38
    [00:55:40] A conservative valuation even had a  27% margin of safety built into the price, but the
  • 00:54:44
    margin of safety was more likely to be over 50%.  He acquired over 93 million shares at an average
  • 00:54:51
    price of $10 and 96 cents, which represented  35% a Berkshire stock portfolio. Note that
  • 00:54:59
    when Buffett does his intrinsic value analysis,  he isn’t really looking at the market price.
  • 00:55:03
    [00:56:05] He determines what he thinks  the total value of the company is,
  • 00:55:07
    and then comparing that against the price offered  by the market. Buffett often said that price has
  • 00:55:12
    nothing to do with value. Coca-Cola stock had  done exceptionally well throughout the eighties,
  • 00:55:18
    so this was definitely not a beaten down  stock that was totally ignored by the market.
  • 00:55:22
    [00:56:24] It was a top performer, or as  Buffett would say, a great company that
  • 00:55:26
    was trading at a fair price or maybe even  a great price in this case for Coke to,
  • 00:55:32
    in this analysis on Coca-Cola, I wanted to read  Hagstrom final paragraph about the company on
  • 00:55:37
    page 110, quote. The best businesses to own  says Buffett is one that over a long period
  • 00:55:44
    of time can employ ever larger amounts of  capital at sustainably high rates of return.
  • 00:55:49
    [00:56:50] In Buffett’s mind, this was the  perfect description of Coca-Cola. 10 years
  • 00:55:54
    after Buffett began investing in Koch, the market  value of the company had grown from 25.8 billion
  • 00:55:59
    to 143 billion over that time period. The  company produced 26.9 billion in profits,
  • 00:56:07
    paid out 10.5 billion in dividends to shareholders  in retained six 16.4 billion for reinvestment.
  • 00:56:14
    [00:57:16] For every dollar the company retained  it created $7 and 20 cents in market value. At
  • 00:56:21
    the end of 1999, Berkshire’s original 1.023  billion Investment in Coca-Cola was worth 11.6
  • 00:56:29
    billion. The same amount invested in the s  and p 500 would be worth 3 billion in quote.
  • 00:56:35
    All right, so that just goes to show how  well Buffett did investing in Coca-Cola,
  • 00:56:40
    and I hope you found this episode really helpful.
  • 00:56:42
    [00:57:44] We had a ton of information jam packed  into this episode, so I really hope you found it
  • 00:56:47
    helpful. Sometimes it’s good to just go back  to the basics and help recognize some of our
  • 00:56:52
    weak spots as an investor, and I found a lot  of good insights going back through Buffett’s
  • 00:56:57
    investment principles. All thanks to Robert  Hagstrom in his great book, The Warren Buffett.
  • 00:57:01
    [00:58:04] If you found this episode  helpful, I would love it if you could
  • 00:57:05
    just do me a quick favor and simply share  this episode with one of your friends who
  • 00:57:09
    you think might find it helpful as well.  This will really help support and grow the
  • 00:57:13
    show so we can continue to provide great  content for you all for the years to come.
  • 00:57:18
    [00:58:20] I really appreciate you tuning in. I  had a lot of fun putting together this episode,
  • 00:57:22
    so I really hope you enjoyed it. So with  that, we’ll see you again next week.
Tag
  • Warren Buffett
  • Investment Principles
  • Business Tenets
  • Management Quality
  • Financial Metrics
  • Market Conditions
  • Coca-Cola
  • Margin of Safety
  • Circle of Competence
  • Value Investing