Here’s an interesting read, the first in a 29-part series on how to think like Warren Buffett
This article, “Dreadful Stocks to Avoid,” explains a few good rules of thumb for conservative stock picking (also applies to mutual funds since they can own stock too!).
Stocks to avoid:
- Businesses that bet the farm – “In some industries, companies periodically have to make critically important decisions. If the company makes the wrong choice, it will be dealt a crippling blow.” As an example, “. . . Boeing is betting the farm against the superjumbo, opting instead to develop the 787, a smaller, long-range jet that it expects to better address the market’s needs. But if Boeing’s analysis is incorrect and the market moves toward the superjumbos, it will lose customers.”
- Businesses dependent on research – “. . . there is a downside to research. Often, innovative companies are required to do research simply to maintain their competitive position. And if the research dries up, the company suffers.” Although it was not for lack of innovation or good ideas coming from research, this rule would have prevented the majority of Canadians from buying Nortel and preventing a lot of pain.
- Debt-burdened companies – “In general, Buffett avoids companies with a lot of debt. This makes sense. During the best of times, large amounts of debt mean that cash that could be put toward growing the business or rewarding shareholders is instead servicing the debt.” This seems like a no-brainer.
- Companies with questionable management – “Some clues to look for here include excessively optimistic press releases, overly generous compensation or options grants, or the constant use of external circumstances to excuse operational shortcomings.”
- Companies that require continued capital investment – “Over the long term, shareholders make spectacular returns by buying businesses that are able to achieve extraordinary returns on capital. This leads to excess capital that the company can use to repurchase shares, pay a dividend to shareholders, or reinvest in further growth.”
Warren Buffett’s annual reports are famous. But there are many other value investors whose reports are must-reads. One of those is Martin Whitman:
Savvy value investors shouldn’t stop with Warren Buffett’s letter. Another renowned value investor’s reports are also well worth reading.
Martin Whitman provides his interesting take on value investing every three months in the Third Avenue Value Fund’s (TAVF) quarterly report. Whitman founded the U.S.-based Third Avenue Value Fund and is the author of Value Investing: A Balanced Approach (ISBN: 0471398101), which is one of the more insightful books on value investing.
Martin Whitman’s quarterly reports (from 1995 to 2004) can be found on the Third Avenue Fund’s web site. Whitman is a deep value investor and often buys distressed debt at deep discounts. For instance, last quarter he started investing in scandal-plagued Parmalat. Whitman said, “Parmalat, a massive fraud, is an Italian-based worldwide company essentially selling dairy products. The fund established a toehold position based on the view that Parmalat seems reorganizable because it is likely that many of its businesses are well entrenched and profitable.” If you think that such situations can’t have a suitable margin of safety, or result in a profit, then you should take a look at the Third Avenue Value Fund’s track record. According to Morningstar.com, the Third Avenue Value Fund beat the S&P500 by over 2% annually during the last ten years and it did so with below-average risk. Mind you, Whitman would likely have more than a few things to say about Morningstar.com’s definition of risk.
In Canada we also have our own value investing guru who writes excellent reports, Irwin A. Michael, manager of ABC funds. He provides monthly commentary, ABC Perspectives, and several other features available through the ABC Funds client page. Not to mention his excellent Value Investigator site.
The Fool.com has an excellent little summary of two of the key concepts from the Intelligent Investor: 1) Buying stocks makes you an owner and 2) Always buy with a margin of safety.
The author expands on 1), saying that as an owner of a stock you have a right to get answers from management about their performance and to demand better. Doing this kind of thing is not out of the reach of people like Buffett or Bill Ackman who own significant portions in common stocks. But I think it is important to think about buying stocks as ownership in a company and not just a randomly fluctuating ticker symbol. It’s helpful to ask, as Graham often does, if this business were a private business, would you buy it at the current market price? 2) Always buy with a margin of safety, is extremely important. The article says,
Graham details just how to buy with a margin of safety, which he calls the “central concept” of investing. Put simply, the “margin of safety” is the difference between the intrinsic value and the price at which a stock trades. For example, a security worth $50 per share but trading at $25 per share enjoys a massive 100% margin of safety. Buying in that situation heavily stacks the odds in favour of the investor.
The margin of safety concept is very important. The term “safety” reminds me that buying low not only improves the odds of a greater return in the future, but ensures greater “safety” against a significant loss, compared to a stock which is trading at a high price. After all, this is the main purpose of investing, as Graham defines it at the beginning of Chapter 1 of the Intelligent Investor, where Graham quotes himself, from the 1934 edition of Security Analysis: “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” How can one ensure a margin of safety? Graham hints at this early on, in the Introduction, entitled, What This Book Expects to Accomplish: “we shall suggest as one of our chief requirements here that our readers limit themselves to issues selling not far above their tangible-asset value [book-value, or net-asset value] . . . The ultimate result of such a conservative policy is likely to work out better than exciting adventures into the glamorous and dangerous fields of anticipated growth.”
Clearly, Graham was not about speculation, and he favoured a conservative and boring approach to investing. In the Appendixes, written by Buffet, he tells about a man named Walter Schloss. Walter never went to college but took one course taught by Ben Graham at Columbia and later worked at Graham-Newman. His strategy? Buffett recalls Adam Smith wrote about him in Supermoney,
He has no connection or access to useful information. Practically no one in Wall Street knows him and he is not fed any ideas. He looks up the numbers in the manuals and sends for the annual reports, and that’s about it. . . Money is real to him and stocks are real–and from this flows an attraction to the “margin of safety” principle.
Walter has diversified enormously, owning well over 100 stocks currently. He knows how to identify securities that sell at considerably less than their value to a private owner. And that’s all he does. . . He simply says, if a business is worth a dollar land I can buy it for 40 cents, something good may happen to me. And he does it over and over and over again. [italics his]
Looking at Walter Schloss’s returns in the Appendixes show some pretty amazing returns. From 1956 to 1984, WJS Limited Partners had a 16.1% annual compound return and WJS Partnership had a 21.3% annual compound return. That compares to an 8.4% return for the S&P500 over the same period. Pretty impressive returns for what sounds like a very simple approach to investing, on the surface. We cannot forget of course that Walter J. Schloss probably spent his entire day pouring over annual reports for many companies, which is no small chore.
Finally, the author of the Fool article offers a glowing recommendation for the Intelligently Investor:
I’ve read and re-read my copy of The Intelligent Investor. It is lined with yellow highlighter ink. Reading that book was one of the most important steps I took toward developing a lucid investment strategy. And I believe Buffett was right when he called it the “best book on investing ever written.”
I second his comments, and that reading this book was one of the best investments I ever made, after getting a university education. I am just now going through it for the second time, only now I am covering it in yellow highlighter ink as well. I’ve had to take a short break this week as I need to buy a new highlighter already, after just the first two chapters!
This article, Berkshire’s a Bargain lays out a convincing argument to buy Berkshire Hathaway:
“Rather than the historical increases in book value of 22% or 19%, I assumed that Berkshire’s book value only grows by 15% per year for the next 10 years. At that rate, the book value per share would go from $57,010 today to $230,637 by 2015. I then assumed that in 2015, the stock would be trading at a historical low in terms of multiple of book value (1.35 times). That would mean that the shares would be priced at $311,360. On the basis of those assumptions, if I buy the shares today at $85,200, I would earn a 265% return on my initial investment or a compound annual rate of return of 13.8%. On a risk-adjusted basis, I have a hard time coming up with anything that comes close.”
He refers to this site, which calculates Berkshire Hathaway’s intrinsic value. The author quotes Buffet in 1995, when his stock was trading at 2.44 times book value (price/book value of 2.44) as saying “historically, Berkshire shares have sold modestly below intrinsic value. But recently, the discount has disappeared, and occasionally a modest premium has prevailed.” Then, in 2000 when “new hot issues” (as Graham would describe them) were at their peak, boring stocks like Buffett’s were trading at lows. Berkshire Hathaway was trading at 1.35 times book value. When this Fool article was published on November 2, Berkshire was trading at 1.5 times book ratio (which he says is still a bargain), and is today trading at 1.58 times book value.
The only assumption that I did not like at first was the fact that he assumes that Berkshire’s book value will increase just has it has in the past. However, Warren Buffett is seen as a value investor, and I am confident in the value investing approach and Warren Buffett’s track record to believe that he can achieve even the most conservative gain of 15% increase in book value over the next 10 years.