focus investing – lecture 2 grw (1)

7/27/2019 Focus Investing Lecture 2 GRW (1)

1/27

Focus Investing Lecture 2

1


2/27


3/27

Buffett on Risk

Buffett manages risk by: (p. 31 WBP) Examining the certainty with which the long-term

economic characteristics of the business can be

evaluated. Examining the certainty with which management

can be evaluated.

Examining the certainty with which management

can be counted on to channel the rewards fromthe business to the shareholders.

Examining the purchase price of the business.

3


4/27

Buffett on Diversification

Diversification serves as protection againstignorance. If you want to make sure that nothingbad happens to you relative to the market, you

should own everything. There is nothing wrongwith that. Its a perfectly sound approach forsomebody who doesnt know how to analyzebusinesses.

Modern Portfolio Theory will tell you how to doaverage. But I think almost anybody can figureout how to do average in the fifth grade.

4


5/27

Buffett on Index Investing

Buffett favors index investing over investment inactively-managed mutual funds.

The internal dynamics and reward systems in themutual fund industry make it almost impossiblefor fund managers to look beyond the short term.

Fund managers are generally evaluated onquarterly performance measures.

Fund managers run the risk of large redemptionsif they keep losers in their portfolios. Window-dressing is common, and turnover rates

are in excess of 100%. Buffetts is below 20%.

5


6/27

Buffett on Efficient Market Theory

The market is frequently efficient, but not alwaysefficient.

Investors do not always behave rationally.

Performance yardsticks emphasize short-termperformance.

Buffett doesnt try to forecast where the marketis going; instead tries to find good companies thatare positioned to do well in any economicenvironment. Bottom-up approach instead oftop-down approach results in lower turnover.

6


7/27

Munger on efficient markets

In the short term, the market is a votingmachine but in the long run it is a weighing

machine

7

KKD
http://finance.yahoo.com/q/bc?s=KKD&t=my&l=off&z=l&q=l&c=http://finance.yahoo.com/q/bc?s=KKD&t=my&l=off&z=l&q=l&c=


8/27

Buffetts Business Tenets

Is the business simple and understandable?

8

In March 2001, in an article titled Is Enron Overpriced?, FORTUNEpointed out that Enron's financial statements were nearly impenetrable.
http://money.cnn.com/2006/01/13/news/companies/enronoriginal_fortune/index.htmhttp://money.cnn.com/2006/01/13/news/companies/enronoriginal_fortune/index.htm


9/27

Quotes from the article

9

While tech stocks were bombing at the box office last year, fans couldn't getenough of Enron, whose shares returned 89%. By almost every measure, thecompany turned in a virtuoso performance: Earnings increased 25%, andrevenues more than doubled, to over $100 billion. Not surprisingly, the criticsare gushing. "Enron has built unique and, in our view, extraordinary franchisesin several business units in very large markets," says Goldman Sachs analyst

David Fleischer.


10/27


11/27


12/27

12

0

10

20

30

40

50

60

70

80

90

100

14

-Aug

-94

12-N

ov

-94

10

-Fe

b-9

5

11-M

ay

-95

9

-Aug

-95

7-N

ov

-95

5

-Fe

b-9

6

5-M

ay

-96

3

-Aug

-96

1-N

ov

-96

30

-Jan

-97

30

-Apr-

97

2

9-J

ul-97

27

-Oct-

97

25

-Jan

-98

25

-Apr-

98

2

4-J

ul-98

22

-Oct-

98

20

-Jan

-99

20

-Apr-

99

1

9-J

ul-99

17

-Oct-

99

15

-Jan

-00

14

-Apr-

00

1

3-J

ul-00

11

-Oct-

00

9

-Jan

-01

9

-Apr-

01

8-J

ul-01

6

-Oct-

01

4

-Jan

-02

4

-Apr-

02

3-J

ul-02

Fortune article

Price of Enron common stock, $/share


13/27

13


14/27

Business Tenets (Cont.)

Examples of Buffetts understandable businesses: Benjamin Moore (2000) 5th largest paint manufacturer in

U.S. Developed first color-matching system.

Coca-Cola concentrate sold to bottlers and provides soft

drink syrups to fountain retailers. Washington Post Buffett knew the newspaper business

(grandfather ran a newspaper, dad edited the DailyNebraskan, Buffett ran the circulation desk for the Lincoln

Journal). Gillette razor blades and grooming products

Justin Brands cowboy boots and bricks

14


15/27

15

We have 7% of Coke. There are 660 million eight ounce servings of CocaCola products being served around the world today, so in effect, weve got a45 million soft drink business with our 7%. We think of businesses that way. Isay to myself just increase the price a penny and thats another $450,000 aday for Berkshire. I mean, its a nice sort of thing. When I go to bed at night I

figure that by the time I wake up 200 million Cokes will have been consumed.Weve got some Gillette too, and every night I think about two billion plusmens hair growing and four billion womens legs with hair. It goes all nightwhen I sleep.


16/27


Does the business have a consistent operatinghistory?

Examine historical financial statements (company

website, www.morningstar.com)

Examine dividends (www.finance.yahoo.com)

16
http://www.morningstar.com/http://www.finance.yahoo.com/http://www.finance.yahoo.com/http://www.morningstar.com/


17/27


Does the company have pricing flexibility?

17


18/27

From Notre Dame speech

18

A couple of fast tests about how good a business is. First question ishow long does the management have to think before they decide toraise prices? Youre looking at marvelous business when you look inthe mirror and say mirror, mirror on the wall, how much should I chargefor Coke this fall? [And the mirror replies, More.] Thats a greatbusiness.

When you say, like we used to in the textile business, when you getdown on your knees, call in all the priests, rabbis, and everyone

else, [and say] just another half cent a yard. Then you get up andthey say We wont pay it.


19/27


20/27


21/27

Management

21

My own role in operations may best be illustrated by a small tale concerning mygranddaughter, Emily, and her fourth birthday party last fall. Attending wereother children, adoring relatives, and Beemer the Clown, a local entertainer whoincludes magic tricks in his act.

Beginning these, Beemer asked Emily to help him by waving a "magic wand"over "the box of wonders." Green handkerchiefs went into the box, Emilywaved the wand, and Beemer removed blue ones. Loose handkerchiefs wentin and, upon a magisterial wave by Emily, emerged knotted. After four suchtransformations, each more amazing than its predecessor, Emily was unable to

contain herself. Her face aglow, she exulted: "Gee, I'm really good at this."

And that sums up my contribution to the performance of Berkshire'sbusiness magicians - the Blumkins, the Friedman family, Mike Goldberg,the Heldmans, Chuck Huggins, Stan Lipsey and Ralph Schey. Theydeserve your applause.

From the Chairmans letter, 1990 Berkshire Hathaway report


22/27

Buffetts Management Tenets

Is management rational? How does the management allocate capital?

If extra cash can be reinvested at a return that is higher thanthe cost of capital, the company should retain all earnings

and reinvest. A company with average or below-average investmentreturns, but with cash in excess of its needs can:

Ignore the problem and continue to reinvest Try to buy growth Return money to stockholders.

Buffett is skeptical of firms that must buy growth. Looks to see if company raises dividend or buys back

shares.

22


23/27

Management Tenets (Cont.)

Is management candid with shareholders? Look at annual letters to shareholders

Are both good and bad outcomes discussed?

See what happens later did management do what itsaid it would do?

Beware of companies displaying weak accounting(esp. expensing stock options)

Beware of companies with unintelligible footnotes. Be suspicious of company that trumpet earnings

projections and growth expectations.

23


24/27


Does management resist the institutionalimperative? Organization resists any change in current direction. Corporate projects or acquisitions will materialize to

soak up available funds. Support cravings by the business leader The behavior of peer companies will be mindlessly

imitated.

Difficult for managers to go against the crowdBuffett looks for managers who are willing to actindependently.

24


25/27

25

Never confuse activity with productive activity.


26/27


Examples: Shaw Industries (2000 2002) retrofitted all of its machines in

1986 when DuPont came out with new stain resistant fibers. In1980 Bob Shaw predicted that his company would quadruple its$214 mill. In sales in 10 years; he did it in 8 years.

Fruit of the Loom (2002) Bought by William Farley in 1985Farley started aggressively acquiring firms and over-leveragedthe company. Didnt pay suppliers; moved headquarters toCayman Islands to avoid U.S. taxes on foreign sales. Filed forbankruptcy in 1999. John Holland, a former 20-year executive,was brought back as executive VP in 2000. Holland restructured

to lower costs, disposed of sideline businesses, trimmedinventory, and improved manufacturing processes.

Coca-Cola in 1992, announced that through 2000 would buyback 100 million shares of stock (7.6% of shares outstanding).

26


27/27

Calculating Intrinsic Value

Buffett discounts owner earnings at the rate onlong-term government bonds (or at 10% if bondyields dip below 7%

Owner earnings = net income + depreciationminus capital expenditures minus additionalworking capital needed. Buffett realizes that capital expenditures and

additional working capital may be difficult to estimate,

but would rather be vaguely right than preciselywrong.

Frequently uses 2-stage dividend discount model.

27

focus investing – lecture 2 grw (1)

Documents