How's my Luck now?

Reflections, views and descriptions during my stay at IIM Lucknow from July 2004 to March 2006

Location: India

Wednesday, August 17, 2005

'The Warren Buffett Way'

I took a long, long time in reading up this book on the 'investment strategies of the world's greatest investor', written by Robert G. Hagstrom, Jr. (John Wiley & Sons, 1995). Written in very simple language, it details the simple and logical, but unconventional, tenets of Warren Buffett in choosing his investments. The timing in reading this book was good, because a background of Valuation helped in easily understanding the basics.

Warren Buffett is a 'value investor' - a person who closely examines a business for its fundamental value before investing in it. He received most of his principles in investing from two great financial minds - Benjamin Graham and Philip Fisher. Buffett's great skill lies in operationalising this set of principles successfully for decades.

Easily the most important lesson for all investors - whether institutional or individual - from Buffett's approach is that 'diversification is necessary only for those who do not know each of their investments enough'. If a close study of each business is made before investing in it, you can get extraordinary gains from only a few investments. Diversification across businesses and industries is not required. So, the investor should look at each of his investments like a business, not merely as a stock price.

A lot of detail is given on most of the major investments that Buffett has made over the years, mostly in common stock (equity), but sometimes in fixed-income instruments as well. His acumen, not only as an investor, but as a businessman & a manager is evident from reading these. The 'Warren Buffett Way' is condensed into four simple, but difficult to employ, steps by the author:
1. Turn off the stock market
2. Don't worry about the economy
3. Buy a business, not a stock
4. Manage a portfolio of businesses

As one can see, these steps are difficult because they are so unconventional. When evaluating a business, Buffett's principles are crystallized into the following tenets by the author:
a. Business tenets:
- Simplicity and understandability of the business
- Consistent operating history
- Favourable long-term prospects
b. Management tenets:
- Rationality of management in allocation of earnings
- Candour of management in sharing firm-related news with shareholders
- Resisting the 'institutional imperative', i.e. blind imitation of other firms
c. Financial tenets:
- Focus on return on equity, not on earnings per share
- Focus on 'owner earnings' (net income + depreciation - capital expenditures)
- High profit margins
- At least one dollar of market value created from every dollar reinvested
d. Market tenets:
- Finding the value of the business
- Buying a business only if it is available at a significant discount to its intrinsic value (the stock market helps here)

While the reading of the book was highly educational, it raised a question: if, like Buffett, everyone wants to buy 'simple and understandable' businesses, and not invest in sectors like, say technology (Buffett has never invested in a tech stock), then where will these firms with evolving business models get their funding from? Perhaps the private equity firms which are mushrooming today are doing this job more and more today. It would be interesting to compare their investment strategy with that of Buffett. And, I think, we do need a new Buffett who understands the new dynamics of business today, who can bring sanity to markets.


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6:07 PM  

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