Memoire Online - Stock Market Success for Beginners

Warren Buffet is well known by all investors around the world for several reasons, one of them, which make him someone unusual is that he is the richest person in the world. In its annual ranking, the magazines Forbes of February 2008 had ranked Warren Buffet number 1, with a personal fortune estimated at $62 billion.

Born in Omaha, Nebraska in August 30, 1930, Warren Edward Buffett was pre-determined to work in the Stock exchange; his father was a local stockbroker. As a young boy, Warren Buffett was fascinated by numbers and mathematics. At only 8 years old; he was reading his father's books on the stock market. At the time he was in the University of Nebraska studying business, he read «The Intelligent Investor» by Benjamin Graham, professor at the Columbia University. So interested by the ideas of Graham, Buffet applied to Columbia University in order to study directly from Graham, who became Warren Buffett's mentor.

Only just graduated with a master in economics, Warren Buffett was going to work in Graham's company. During the Two years he worked in the Graham-Newman Corporation Buffett was immersed in Graham investment approach of the market. In 1956, Graham went to retire and Buffett went back to Omaha, where at only 26 years old he founded an investment partnership with seven partners and $100,000. For the 13 years he was CEO of this investment partnership, he has got an average annual rate of return of 29.5% a year. One of the most famous investments Buffet made at this time was with American Express which as victim of a scandal saw its shares drop from $65 to $35. Remembering a lesson of his mentor; that when stocks of successful company are trading under their value, investors have to act intelligently, Buffett bought $13 million of American Express shares (40 percent of the partnership's total assets). Two years later, and after a tripling of the prices of the shares, partners received a profit around $20 million. In 1969, because he was thinking the market was too speculative, Buffett closed the investment partnership. Buffet's shares of the investment partnership had grown to $25million, which was enough to take the control of Berkshire Hathaway.

At the beginning, Berkshire Hathaway was a textile company which quickly became the holding of Buffett to invest in other companies. At first, Warren Buffet through his holding purchased insurance companies. He had interest in insurance companies mainly for one reason: Insurance provide a constant stream of cash flow via the premium paid by policyholders. Following the advice of Graham, Warren Buffet was persuaded that there is an opportunity when a structural good company is under-evaluated by the market. That was the case with The Government Employees Insurance Company usually called GEICO. In 1976, GEICO' stock price dropped from $61 to $2, in five years, Buffet has invested about $45.7 million in this company, persuaded it was a good investment due to the competitive advantage of GEICO. Few years after, the company made impressive performance and Buffett continue to invest on it. In 1994, Berkshire Hathaway purchased all the company which is still making really good profits.

Berkshire Hathaway still exists today and it's still directed by Warren Buffett. He had closed the books of the Textile Company in 1985. Berkshire Hathaway now owns companies in many other sectors than insurance, like in the food industry, clothing, media or luxury industry. Warren Buffet took the control of Berkshire Hathaway, a company with a net worth of $22million, nowadays, the same company, 35 years in the hand of this man, has a net worth of $69 billion. If investors are interested investing in this company, they just have to know that the share is trading around $134,000. That makes it the most expensive share in the stock market.

With this kind of resume of Warren Buffet it's easy to understand why this paper wants to develop his strategy. Based on Graham's and Fisher's view of the market, Buffett's strategy is more contemporary, it's easier for the reader to understand what are the criteria that makes Buffett invest in a company. As well as Graham and Fisher, the strategy and the approach of Buffett is important for the strategy developed later, it gives a background in order to understand the context and the factors that are important for investing in good companies and make profit in the stock market.

The beginning of the strategy of Warren Buffett is made by some tenets that characterize his way to select a company in which he will invest. Following are the most important tenets that Buffet is using, there a combination of his personal experience, his mentor principle and Philip Fisher theory.

- For every dollar retained, make sure the company has created at least one dollar of market value.

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It's important to understand that for Warren Buffett, stocks are not the most important factor when he is doing an investment. Warren Buffett considers that investors have to use the same scrutiny in buying stock as they will do when they buy the whole company. He based his decision on how the business is done by the company and not on how the market perceived the business. Here are some fundamental principles Buffett is attentive of when he starts looking at a company.

The first tenet of Buffett is to understand very well the business in which the investor want to invest. It's important to know almost everything about the industry, the sector and the company. In doing so, any new information will be understood as a new factor that influences the portfolio of the investor. Although Buffett was a «disciple» of Graham, he took one of the main ideas of Philip Fisher when he is talking about investing within your «circle of competence». The purpose is not how big the circle of competence of the investor is, but how well he or she can understand all the parameters inside it.

In the Buffet's view of investing; investors have to avoid all companies that are changing radically their position in the business because the previous one is not efficient now. He also advocates to never buy stocks of a company which is actually solving difficult problems. Buffett emphasis the fact that he avoid Radical change and Difficult problem, in the sense that all companies are constantly modifying their positions in the market by launching new products and solving «day to day» problems. Buffett observes that «Severe change and exceptional returns usually don't mix.³⁷» For him, best returns are achieved by companies which are consistent on their product line in the long term.

In order to understand perfectly the long term view of Warren Buffet, it's important to distinguish the difference he made between what he called a «Franchise business» and a «Commodity business». A franchise business is characterized by the fact that they don't have a close substitute and they operate in a market which is not regulated. At the opposite; a commodity business' product is not distinguishable from competitor, like oil, gas or chemical product. According to Buffett, commodity businesses have a low rate of return and are more exposed to profit' problems whereas, franchise businesses he said, «Can tolerate mismanagement. Inept managers may diminish a franchise's profitability, but they cannot inflict mortal damage.³⁸»

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After having watched with scrutiny the business, Buffett tells investors to have a look at the management style of the company. He thinks that managers who are acting like the owner of the company are more able to see the long term objectives and so they will act with more rationality.

For Warren Buffett, the rationality of a management is seeing with the allocation of capital. For him, the allocation of capital is essential because that's what will create the future value for shareholders. The allocation of capital has to be in accordance with the position of the company on its life cycle (development, growth, maturity or decline). In Buffett's mind, all cash that invested internally will produce a rate of return on equity higher than the cost of capital has to be invested in the company. There is no logical reason to not reinvest those earnings. The only reason, for him to not reinvest this cash is that it will not produce a return higher that the cost of capital. In such situation, the company has to give this cash to shareholders trough dividend or share buy-backs that will increase the value of each share in circulation in the market. For Buffett, the way the cash is allocated between the company and the shareholders is the proof of the rationality of the management. Berkshire Hathaway, has almost never distributed dividends to shareholders.

Because management is human, Buffett insists on the fact that managers have to be respectful and honest with shareholders and always act on their best interest. He likes when annual reports contain explanations of what is right in the company, but he prefers to know what is wrong, and why. For him, managers who have the courage to discuss publicly the problems of the company are able to resolve those problems. It's normal that a company encounters problems, it's business, the most important is to not hide them. As all managers, Buffet is using the Generally Accepted Accounting Principles (GAAP), but he also refers to data that are not required by the GAAP.

Another point that distinguishes exceptional manager from others is their ability to resist what Buffett calls, the «institutional imperative». For him, the majority of managers are not independent in their way of thinking; they imitate other managers which also imitate them. Buffett saw «free-managers» as the top of the basket, they are making their decisions based on their own knowledge and understanding of a situation and will not fol low the group blindness.

Of course it's difficult to measure the quality of a manager; there is no quantitative data that can be used to identify strength and weaknesses of managers, all is about qualitative perception of a Human that by definition can make errors. «When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics,» Buffet w rites, «it is the reputation of the business that stays intact.³⁹»

When Buffett has selected companies which are running the firsts tenets, he analyzes how the company is doing financially. Mostly, he looks at 3 criteria that are non-negotiable, the return on equity, the high profit margin and the creation of market value, here are those criteria.

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After having looked at the business and the managerial skill of a company, Warren Buffett analyzes the financial situation of companies he is interested in. When most investors analyze the earning per share, one of the main criteria for Warren Buffet is looking the return on equity. For him the return on equity gives a better understanding of the financial health of a company than the earning per share. He explained that companies can accumulate previous earnings and use it to increase the actual earnings per share, so this time horizon problem can sidestep the analysis of the health of a company. In order to perfectly use the return on equity ratio that is more accurate of the company' used of shareholders equity, Warren Buffet told investors to make some adjustments. Investors should exclude of their calculation all the gains or losses due to capital operation as well as all extraordinary gains or losses that influence the earnings. Return on equity should reflect the normal activities of a company; it should show how the management is able to generate return with the capital employed. Always concerning the return on equity, Buffett point of view, is that a company should generate profits without or with few debts. There are 2 reasons to this «debt allergy». The first one is because with debt, a company can increase their return on equity through the leverage effect of the debt-equity ratio. The second reason is that company with no or few debts are more able to resist to bad economic conditions.

For Warren Buffett, investors should focus their attention to companies with high profit margin. He distinguishes 2 types of managers regarding the profit margin: those running a high-cost operation, and those who are running a low-cost operation. For him, high-cost operation managers always added overhead expenses and are fighting against cost only when it significantly reduces the profit. On the other hand, low-cost managers are always trying to find ways to reduce expenses.

Buffett reckons that when a company managed in a high-cost way tries to cut-off expenses through a «cost-killer program», it will affect the return of the company. He explains that «The really good manager does not wake up in the morning and say, this is the day I'm going to cut costs.⁴⁰» Buffett emphasizes the fact that the overhead expenses of his company, represent less than 1% of the operating earnings, when similar companies have something around 10% of overhead expenses; in doing so, shareholders are losing 9% of the operating earnings.

For every dollar retained, make sure the company has created at least one dollar of market value.

Another financial tenet Buffett considers is that for each dollar invested by shareholders, the company should generate at least one dollar of market value. Less than one-for-one is a loss for shareholders. Nobody wants to invest $1 and be the owner of 50cents a few years later. Good companies should increase their value in the market by more than the value of earnings they retained.

After having analyzed previous criteria, Warren Buffett is able to know if the company is a good one or not. If it's a good one, he will analyze how the market perceived this company. When most investors are looking at the market first, Buffet is looking at it at the end of his selection process. By analyzing the market he will try to know if it's time to invest on the company to take advantage of a bargain price.

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Buffett considers that the value of a company is the total amount of the net cash flows expected in the future discounted to an appropriate rate. In doing so, he explains any company, never mind the industry, will be judged equally in an economic point of view. Buffet also explains that if an investor can't estimate with precision the future cash flow of a company, he or she should not invest on it. That's why, Buffett don't invest in new-technology company because he can't estimate the future cash flow and he explains that those companies are out of his circle of competence. Once an investor has made a good estimation of the company, he or she has to discount this value to today; the investor will use a discount rate. Buffett considered that this rate should be a risk-free rate, that's why he advices to use the long term US government bond. (Those bonds are virtually risk-free, because the government will always pay its debts). Lots of investors will add a premium to this risk free rate considering the fact that the company's future is uncertain (in comparison to the certainty of the US government bond). Buffet doesn't add any premium; he prefers to adjust the discount rate. If the discount rate is too low, let's say 7% Buffett will correct it to 10%. In doing so, he increase the «margin of safety». If he is right he just used the good discount rate, if his wrong, he just increased his margin of safety of 3%.

In order to buy companies for less that their value, Buffett is using the margin of safety. This notion developed by Buffett's mentor, the professor Benjamin Graham, is the difference between the stock price of a company and its intrinsic value. If a company is a little bit undervalued by the market, there is a small margin of safety, if the value stock of the company is really undervalued there is a big margin of safety. This margin of safety is a tool to helps investors of 2 different ways. First of all, if the investor has made a bad evaluation of the company, the margin of safety will reduce the risk of looses. If an investor evaluate a company at $100 per share and the market undervalue it at $85, the investor has a margin of safety of $15. If the value of the company drops to $90, the investor has still $5 of gain. The second help, which is more or less the opposite of the first one, is the possibility to earn extra-returns.

All the strategy of Warren Buffett is a process which starts from the examination of the business in order to understand perfectly all factors that influence it. Then he looks if the top management of the company is good and rational. When Buffet has found a company with those criteria, he ana lyzes the financial health of the company in order to estimate its value. At the end of this process, he analyzes the market to see if the stock price of the company is under-valuated. Buffett likes to say that he is 85% Graham and 15% Fisher. His strategy for picking stocks is inspired by those two men. Buffett always buys quality companies at a bargain prices. A last remark is important to be made, Warren Buffett has more than 50 years of experience now, and he is lucky to have amazing business and financial skills. Most of beginning investors will not at the first time be able to analyze the market or companies like Warren Buffett. Investors can know perfectly each tenets or advice of Warren Buffett, but in order to invest like him, investors will need time to create their own experience and most of them will unfortunately never reach the success of Buffett.

Now that investors know about the way Warren Buffett selects the companies in which he will invest, it's interesting to have a look on what Warren Buffett says about portfolios. As well as selecting companies, Buffett is not acting like most of the investors.

The general idea about investment in the stock market is that there are mainly 2 strategies, the active portfolio investment and the index investment. Investors who trust in the active portfolio style are always trading lots of stocks in order to outperform the market. They don't select stock trough criteria based on the company but more on how they perceived the stock will fluctuate in the short term. For example intraday trading is an active portfolio style of investment. Investors are buying and selling the same stock during the day and hope they will outperform the market thanks to their superior market perception skills.

Investors who trust in the index investment are less presumptuous; their point of view is to stick the market. Because the market is composed of thousands of stocks, those investors are creating diversified portfolios which are similar to indexes like the S&P500, the Dow Jones or the Nasdaq100. Nevertheless, by acting like that, investors can't outperform the market because they are following it, so in the best chance they will have the same return of it but never more. Because of the different way of managing their investment active portfolio investors and indexes investors are constantly trying to proof that their way of investing is better than the other one. Now, it's commonly accepted that index investments have a higher return than the active portfolio. Nevertheless, those ways of investing have a common denominator; both are investing with a diversified portfolio. Many books will claim that diversification reduce risk and maximize profit. Thousands of business school' students have heard that diversification is the best, if not the only way to be successful in the market. Let's see what Warren Buffett proposes.

Because Warren Buffett is not satisfied of the result of the previous strategies, he advises investors to invest in a focused portfolio. The main aspect of this strategy is to select few stocks of good companies, to invest more money on high return' stocks and wait without worrying about market fluctuations.

As it's developed in the previous sections; Warren Buffett selects good companies through a process of 12 tenets. By doing the same investors should isolate some companies that are able to give high returns.

The main principle of focusing investment is to be able to invest in few companies with the highest chance of performance. Buffett explains: « If you are a know-something investor, able to understand business economics and to find five to ten sensibly priced companies that possess important lon g-term competitive advantages, conventional diversification [broadly based active portfolios] makes no sense for you.⁴¹» As he explains, the «know-something» investor, who is not a professional but someone interested in stocks with a basic knowledge, should invest money between 5 or 10 companies he or she knows very well, rather than investing in 50 companies that he or she doesn't know anything.

As Buffett says, he is 15% Fisher, one of the ideas of Fisher was to invest more in stocks that have a stronger opportunity, that mean, a higher return. Following this idea, Buffett says «With each investment you make, you should have the courage and the conviction to place at least ten percent of your net worth in that

stock.⁴²» That's why previously he advises to have at maximum 10 stocks. Nevertheless, some investments will have a higher return than others; investors should allocate more resources to those in order to have an overall higher return.

Focus investment is also different from diversified investment trough its relation to time. When diversified investment has a short term vision, Focus investment has a long term vision. One of the reasons to invest in the long term is to limit the risk. In short term, stock price will fluctuate due to several factors like a change in the interest rate, a new report concerning inflation, a natural disaster and so on; but in the long term share prices will more often increase. Buffett suggests having a relative turnover of the stocks contained between 10% and 20%, so the time horizon of an investor should be between 10 and 5 years.

Because prices fluctuate, and the value of stocks can drop investors are subject to panic. But because focus investors are running the long term, and because in the long term stocks are rising, there is no reason to be afraid of short term fluctuation. The reader will not be surprised to know that Warren Buffett never looks at short term fluctuation of his stocks.

1. Concentrate your investments in outstanding companies run by strong management.

2. Limit yourself to the number of companies you can truly understand. Ten is a good number; more than 20 is asking for trouble.

3. Pick the very best of your good companies, and put the bulk of your investment there.

4. Think long term 5 to 10 years, minimum.

5. Volatility happens. Carry on.

It can appear strange, selling stock is really easy. Investors will sell their stocks due to 3 factors. The first one is because something was wrong in the equation; stocks return is not as high as expected. The second reason a change in the equation; what was right yesterday may not be right tomorrow. The third reason is life cycle, your stocks as still a high return but new one have a higher return.

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Error is human; sometimes investors will make a mistake when they estimate the value of a company, it will appear interesting to invest and few times later investors will realize that it was not. In such occasion, the best thing to do is to analyze the actual situation with calm, try to see how bad the situation is. Maybe it will be necessary to sell the stocks and lose money. It's business, it happens. Beginning investors are the most exposed to make errors at the beginning, that's why experience is useful in investment.

Because focus investment is running in the long term, parameters can change. A really good company can become not so attractive a few years after. Top management can change, financial situation can become more risky, and there are several reasons this can affect a company. Even though good companies generally stay good companies in the long term, exceptions exist. In order to act and not to be subject of those changes, always staying informed of the business, the company, the sector is a way to anticipate them. If an investor sees that the company in which he or she has invested 5 years ago is not fulfilling the criteria that it should, he or she will have to sell and take his profit before the market understands the change and the stocks drop.

The main reason that makes investors sell stocks is that a better opportunity is coming. Investors can have a portfolio of really good stock, but sometimes, a new stock give higher expected return. The new stock will so take the place of an old stock in the portfolio. Generally, it will take the place of the stock with the lower return. Remember what Warren Buffet says about the turnover of a portfolio, it has to be between 10% and 20%, which mean a time horizon of 5 to 10 years. Investor will keep a stock during one or two years and others during 10 or more if the stock is always a top performer.

All the strategy of Warren Buffett can be summarized in one sentence. Buying quality companies at bargain prices. Warren Buffet told us to understand the market, the business, the company before investing on it; investors will have a better understanding of companies inside their circle of competence. He teaches us to buy stocks when the market underestimates the value of the company and so to take advantage of the margin of safety. Finally Buffet told us to have a focus portfolio and to run it in the long term.

«I'm the luckiest guy in the world in terms of what I do for a living. No one can tell me to do things I don't believe in or things I think are stupid.⁴⁴»