buffetts first billion
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Buffetts First BillionTRANSCRIPT
How Warren Buffe- Made His First Billion Dollars
Purpose: This document is purely for educa=onal and informa=on purposes only. It does not make offers to buy or sell securi=es. It does not intend to provide investment advice or research analysis. Recommenda2ons: This document is not a personal recommenda=on. You should base your investment decisions on your individual situa=on, financial posi=on and objec=ves. Also consider using such independent professional advice as you believe necessary. Disclaimer: Satyajeet may invest in shares from =me to =me in a personal or professional capacity.
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Warren Buffe- is now famous for amassing immense wealth by buying high-‐quality stocks and holding them for a long =me. We are big fans of that approach. Don’t get us wrong. But it’s a bit misleading. Especially if you’re a beginning investor. Here’s why: That’s not how Buffe- made his very first billion dollars.
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When he first began, Buffe- didn’t have the huge money working for him, that he does now. In fact, there is a li-le known secret behind how Buffe- went about making his very first billion. That li-le known secret is hidden inside a picture.
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Here’s the picture again…
That’s right. Cigar bu-s.
What is a Cigar Bu-?
Cigar bu- is a stock whose price has become very cheap. So cheap, that it is even less than the value of the assets that the company owns. It’s like buying a piggy bank with 100 one-‐rupee coins in it, but at a price of rupees 40.
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Why Would Any Stock be That Cheap?
A Stock Can Become Really Cheap if
• The company makes a string of losses. • The business is boring and unglamorous. • It’s an asset-‐heavy business like manufacturing, mining, banking, insurance etc.
• The industry it operates in is going through a tough =me.
• It’s a li-le-‐known stock and is not covered by many analysts.
• There is general pessimism in the stock markets due to a lot of nega=ve news about the economy.
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Why Should You Buy Cigar Bu-s? What’s the Benefit?
Inves=ng in cigar bu-s can be highly profitable.
As Warren Buffe- says, “Buying the stock at that price (is) like picking up a discarded cigar bu- that (has) one puff remaining in it. Though the stub might be ugly and soggy, the puff would be free…The many dozens of free puffs I obtained in the 1950s made that decade by far the best of my life for both rela=ve and absolute investment performance.” ~ Le-er to shareholders, 2014
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How to Value Cigar Bu-s?
Case # 1: Berkshire Hathaway Berkshire Hathaway is an example of a cigar bu- that Warren Buffe- bought. He valued it by looking at its assets. The balance sheet read*:
15
Equity & Liabili2es $ Assets $ Equity** 20.20 Fixed Assets 9.95
Working capital 10.25 20.20 20.20
The stock price was $7.50. That’s at a 63% discount to total net-‐assets of $ 20.20 and at a 27% discount to net short-‐term assets of $ 10.25.
* On a per share basis. **The debt figure was not available.
Source: Warren Buffe-’s le-er to shareholders, 2014
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What Safety Measures Should You Take Before Buying Cigar Bu-s?
You Should Make Sure 1. The stock price is a lot less than the value of assets on the
balance sheet. In fact, it should be less than even the short-‐term assets alone.
2. The business is at least of mediocre quality. There should be some hope of improvement in prospects. Of course, cigar bu-s will never really be high quality businesses. But make sure you avoid companies with absolutely no chances of improvement.
3. The assets actually exist. If possible, do some due diligence about the accoun=ng quality. Also check -‐ is the management honest?
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Should Your Pormolio be Concentrated or Diversified?
Your pormolio of cigar bu-s should be diversified. That’s because cigar bu-s are usually mediocre companies. One cannot be really sure of the quality of business. A given cigar bu- may turn out to be actually a really bad business instead of merely mediocre. Hence you should own not one, but several cigar bu-s. In other words, you should diversify. If you have taken the other safety measures, then the chances are very low that all the cigar bu-s in a diversified pormolio will turn out to be poor stocks. Hence, at the overall pormolio level, you’ll do well.
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How Long Should You Hold on to Your Cigar Bu- Stocks?
The holding period will usually be short. To quote Warren Buffe-, “Marginal businesses purchased at cheap prices may be a-rac=ve as short-‐term investments.” ~ Le-er to shareholders, 2014
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When Should You Sell Your Cigar Bu- Stocks?
As soon as something good happens (usually temporarily) in the business, industry or economy; the news comes out and there is a bump in the stock price. In Warren Buffe-’s words, “One puff remaining in it. Though the stub might be ugly and soggy, the puff would be free. Once that momentary pleasure was enjoyed, however, no more could be expected.” ~ Le-er to shareholders, 2014 It is important to be disciplined about this. Do not expect too much from the cigar bu-. A mediocre company wont miraculously turn into a great one just because we hold it.
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Should the Churn be High or Low in Your Pormolio of Cigar Bu-s?
Pormolio churn will be high. As Warren Buffe- says, “There it was – my free puff, just wai=ng for me, aper which I could look elsewhere for other discarded bu-s.” ~ Le-er to shareholders, 2014
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At What Stage of Your Inves=ng Career are Cigar Bu-s Useful?
In the early stages of your career. When you’re just star=ng out. The short-‐term, high-‐churn nature of a cigar bu- pormolio can be a real blessing when you’re trying to increase the size of your small fund. Later, with a larger fund, you have to look at be-er quality stocks. As Warren Buffe- puts it, “My cigar-‐bu- strategy worked very well while I was managing small sums. But a major weakness in this approach gradually became apparent: Cigar-‐bu- inves=ng was scalable only to a point. With large sums, it would never work well.” ~ Le-er to shareholders, 2014
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Why Could Buffe- Buy Many Cigar Bu-s in the 1950s? Is it Possible Today?
Cigar Bu-s Worked in 1950s Because There were fewer asset-‐light service companies. Most listed companies were in manufacturing, mining and transporta=on with asset-‐heavy balance sheets. Stock markets weren’t as compe==ve as they are today. Exchanges weren’t electronic. There was no internet to provide quick informa=on. There were fewer money managers. Fewer equity research analysts. Also, markets were s=ll feeling the aper-‐effects of the great depression. Cigar bu- inves=ng is well-‐suited to bearish markets. It is indeed more difficult to apply the cigar bu- approach to inves=ng today. Difficult, but not impossible. Mainly because human psychology has not changed. There is much irra=onality s=ll in the stock markets. So if an investor is pa=ent, then the easy access to informa=on etc. is actually a great advantage. Things are actually easier now for such an investor. Warren Buffe- made this very point in an interac=on with students during a visit to India.
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Can You Buy Cigar Bu-s in India Today? Where Would You Find Such Stocks?
Look for Indian Cigar Bu-s in
• Small caps and not large caps. • Inefficient, shallow pockets of the stock market.
• When markets are depressed like they were between 2008 and 2012. Not in 2014.
• Boring, unglamorous sectors. Manufacturing companies and not in service companies like IT or asset-‐light companies like FMCG.
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When Does the Cigar-‐Bu- Inves=ng Fail?
Difficult to Apply Cigar Bu- Inves=ng if
• It’s an asset-‐light business like services, consumer goods etc.
• The company is profit making. • The industry it operates in is a hot, sunrise sector. • The business is glamorous. • It’s a well-‐known stock and is covered by many analysts.
• In strong bull market condi=ons when there is euphoria due to a lot of posi=ve news about the economy.
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Where Can You Learn More About Cigar Bu- Inves=ng?
• Benjamin Graham’s book Security Analysis – There are 6 edi=ons of the book. Warren Buffe- himself recommends the 2nd edi=on. Buy Indian print of the 6th edi=on because it includes the 2nd edi=on as a sop copy and is inexpensive.
• Warren Buffe-’s le-ers to partners – Buffe- began his inves=ng career with his own hedge fund. He ran it for 13 years. You can get 28 of the le-ers he wrote to his partners during that =me. It is the bible for cigar bu- inves=ng in ac=on.
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